Mezzanine Capital

What is mezzanine capital?

Mezzanine capital describes forms of financing that sit economically between equity and senior debt capital, such as bank loans that are served first in a worst case. The terms mezzanine financing and hybrid capital mean the same thing. The funds rank behind the other creditors, are remunerated more highly than a bank loan and, unlike company shares, generally carry no voting right. The name comes from architecture: like a mezzanine floor between the ground floor and the first floor, mezzanine capital lies in the order of priority between bank loans and the shareholders' equity.

Mezzanine capital is used when bank loans alone are not enough and new equity is not wanted or not available. Typical occasions are growth financing for medium-sized companies (Mittelstand), company acquisitions and succession solutions, and strengthening the equity base before a bank financing. Providers include mezzanine funds, investment companies such as the regional SME investment companies of the German federal states, development institutions, banks and family offices. The relationship to the bank loans is regulated by an intercreditor agreement. Real estate developers also often use mezzanine capital to close the gap between bank loans and their own equity.

Forms of mezzanine capital

• Subordinated loan: A loan with an agreed subordination (Rangrücktritt) behind the other creditors (subordinated liabilities). If the remuneration depends on profit or revenue, it is a profit-participating loan (partiarisches Darlehen).
• Silent partnership: A contribution to the company's assets in return for a share of profit (Sections 230 et seq. of the German Commercial Code, HGB), without the investor becoming a shareholder. Participation in losses can be excluded by contract (Section 231(2) HGB). The typical silent partnership essentially grants a share of profit. The atypical silent partnership additionally covers the hidden reserves, that is, value increases not shown on the balance sheet, or far-reaching rights of co-determination. For tax purposes, the investor then regularly becomes a co-entrepreneur.
• Profit participation rights: contractual rights to profit and, where applicable, to liquidation proceeds without voting rights, the terms of which can largely be freely designed.
• Convertible and warrant bonds: Debt securities with a conversion or subscription right for shares (Section 221 of the German Stock Corporation Act, AktG). They presuppose a stock corporation; for a GmbH (German limited liability company), the convertible loan performs this function.

The remuneration rarely consists of a single interest rate. Current interest is paid in cash; deferred interest is added to the principal and falls due only at the end of the term (payment in kind). In addition come fees and often an equity component (equity kicker), such as a conversion or option right to a small stake. The total remuneration is clearly above that of a secured bank loan and below the return expectation of equity investors. The term is often five to ten years, with repayment in one amount at the end of the term (bullet repayment). Collateral is usually not provided, but the contracts contain obligations (covenants), for example on the debt ratio and the equity ratio.

Mezzanine capital as accounting or economic equity

In annual financial statements under the HGB, subordinated loans are liabilities despite the subordination. Silent contributions usually appear on the balance sheet as a liability or as a separate item. Under statement IDW HFA 1/1994 of the Institute of Public Auditors in Germany (Institut der Wirtschaftsprüfer, IDW), profit participation rights are equity if four conditions coincide: subordination, performance-based remuneration, participation in losses up to the full amount and provision for the longer term. Commercial accounting and tax law follow their own criteria here, and the classification can diverge.

Banks and rating models, by contrast, look at economic equity. They often attribute mezzanine capital with a qualified subordination, without collateral and with a longer remaining term than the bank loans wholly or partly to equity. This improves creditworthiness and the room for senior loans; how far a bank goes in doing so depends on its internal rules.

Under insolvency law, the qualified subordination is what matters. With it, the claim is left out of account when testing whether the assets still cover the debts (over-indebtedness, Section 19 of the German Insolvency Code, InsO). For shareholder loans, Section 19(2) sentence 2 InsO regulates this expressly. Under case law, it must also block payments before insolvency proceedings are opened that would trigger insolvency. If the liability may be repaid only out of future profits or a liquidation surplus, it may not be shown as a liability in the tax balance sheet under Section 5(2a) of the German Income Tax Act (EStG). Its falling away can trigger taxable income. It is therefore usual to add that repayment may also be made from other free assets.

Tax treatment of mezzanine capital

For the company, the remuneration for subordinated loans and typical silent partnerships is in principle a deductible business expense. The interest barrier rule (Section 4h EStG, Section 8a of the German Corporation Tax Act, KStG) can limit the deduction of high interest expenses. For trade tax, payments for debt and profit shares of silent partners are partly added back (Section 8 no. 1 of the German Trade Tax Act, GewStG). Remuneration on profit participation rights with a share in profit and in liquidation proceeds, by contrast, does not reduce the income of a corporation (Section 8(3) sentence 2 KStG). On remuneration for silent partnerships and profit-participating loans, the company may have to withhold tax on investment income. Because even individual clauses shift the classification, the draft contract is reviewed for tax before signing.

Mezzanine capital in bank financing and company acquisitions

In growth financing, mezzanine capital closes the gap between what banks finance against collateral and from cash flow, and the total requirement. Because it raises the equity ratio from the bank's point of view, it can make additional senior loans possible in the first place. The intercreditor agreement then blocks interest and repayments to the mezzanine provider as long as the bank's covenants are breached.

In company acquisitions, mezzanine capital sits between the acquisition loan and equity, for example in a management buy-out. A related form is the vendor loan, in which the seller defers part of the purchase price. Later buyers and investors review all mezzanine contracts for termination rights on a change of control, prepayment penalties and conversion rights. Outstanding amounts generally count towards net debt in the purchase price bridge and reduce the purchase price for the shares.

Worked example: mezzanine capital as a subordinated loan

A medium-sized software company with total assets of EUR 20 million and book equity of EUR 3 million takes up a subordinated loan of EUR 2 million with a qualified subordination. The loan runs for five years. Current interest of 6% on the original amount is paid in cash annually. In addition come deferred interest of 4% per year with compound interest and a processing fee of 1.5%.

• Current interest: EUR 2 million × 6% = EUR 120,000 per year, over five years EUR 600,000
• Deferred interest: EUR 2 million × 1.04 to the power of 5 = around EUR 2.43 million repayment at the end, of which around EUR 433,000 is interest
• Fee: EUR 2 million × 1.5% = EUR 30,000
• Total cost: 600,000 + 433,000 + 30,000 = around EUR 1.06 million, effectively around 9.9% per year
• With an equity component worth EUR 600,000 on a sale after five years: effectively around 14.2% per year
• Equity ratio on the balance sheet: before 3 / 20 = 15%, afterwards 3 / 22 = around 13.6%
• Equity ratio from the point of view of a bank that counts the subordinated loan in full: (3 + 2) / 22 = around 22.7%

The balance sheet ratio falls because the loan raises total assets and remains debt capital. The economic ratio rises significantly and can tip the balance for additional bank financing. A financial model that contains only the current interest shows EUR 600,000 instead of around EUR 1.06 million of costs and thus underestimates them by a good 40%.

Distinctions: mezzanine capital, equity and venture debt

• Equity: grants voting rights and an unlimited share in value growth, with no claim to repayment. Mezzanine capital must be repaid and limits the investor's share in success.
• Subordinated liabilities: umbrella term for claims with a subordination. Mezzanine capital combines the subordination with an increased, often performance-based remuneration.
• Venture debt: a secured, usually senior loan to venture-capital-financed companies, repaid in instalments. Mezzanine capital is generally unsecured, subordinated and bullet.

Common mistakes

• Only the current interest planned for. The financial model often contains only the interest paid in cash. Deferred interest, fees and the equity component raise the actual costs considerably and belong in every comparison calculation.
• Subordination worded incompletely. If the effect before the opening of insolvency proceedings is missing, the agreement does not relieve the over-indebtedness test. If repayment is permitted only out of future profits, taxable income is a risk.
• Term shorter than the bank loans. Banks generally count mezzanine capital towards economic equity only if it is available for longer than their own loans.
• Covenants without a stress case. Metrics such as the debt ratio or equity ratio are met in the base case, but often not in the cautious case. Termination or expensive renegotiation is then a risk.
• Conversion rights not in the cap table. Conversion and option rights dilute the shareholders when exercised and therefore belong from the start in the fully diluted ownership overview (cap table).

Frequently asked questions

Is mezzanine capital equity or debt?

On the balance sheet under the HGB, mostly debt; economically often similar to equity. Only profit participation rights and comparably structured silent partnerships can, under strict conditions, appear in book equity. For banks, subordinated, long-term mezzanine capital often counts as economic equity.

What are the advantages and disadvantages of mezzanine capital?

The most important advantage: the shareholders keep their shares and voting rights, with dilution at most through a small equity component. Banks often treat subordinated capital as economic equity, and collateral is usually not required. Disadvantages are higher costs than a bank loan and obligations with a right of termination. In addition, the capital usually falls due in one amount, which requires refinancing or sufficient liquidity at the end of the term.

When is mezzanine capital preferable to an equity round?

When the capital requirement is clearly limited, cash flow can carry the remuneration and repayment from the business or from a refinancing is foreseeable. For projects with an open outcome whose risk the investors are meant to share, equity is the more suitable form.

Does mezzanine capital have to be entered in the commercial register?

As a rule, no. Subordinated loans and profit participation rights are not entered, and the silent partnership, as an internal partnership, cannot be entered. For a stock corporation, however, a silent partnership counts as a partial profit transfer agreement, which requires the approval of the general meeting and entry in the register. Whether this applies correspondingly to a GmbH is disputed, which is why a shareholders' resolution is often passed as a precaution.

What is the interest rate for mezzanine capital?

There is no uniform rate. The total cost is clearly above that of a secured bank loan and below the return expectation of equity investors. Only the total remuneration from current interest, deferred interest, fees and equity component, converted into an effective annual rate, can be compared. In the worked example, the assumptions give around 10% per year without and around 14% with an equity component.

The Roemer Capital view

We run mezzanine offers through the financial model with all remuneration components, that is, including deferred interest, fees and equity component. Alongside, we set an equity round and a pure bank financing. The calculation covers at least three years in the base, cautious and optimistic case, because the covenants decide on termination and renegotiation precisely in the cautious case.

Before signing, we clarify with the financing bank whether and to what extent it attributes the mezzanine capital to economic equity, because the benefit often depends on this. In succession solutions and company sales, we structure the financing gap economically; subordination, accounting and tax consequences are the responsibility of the client's law firm and tax adviser.