Mezzanine Funds- Alternative capital for emerging companies

In the first quarter of 2007, the first Mezzanine Fund was introduced to the South African market. FAnews takes a look at this new and innovative offering.

South African companies enjoy a number of options when seeking to raise capital for expansion. The most common methods include raising capital directly from banks in the form of long-term loans, or to raising money from shareholders through the issue of new shares.

A third alternative often explored by start-ups and young companies is that of venture capital. Companies which were unable to meet strict bank lending criteria, or whose management preferred not to dilute their equity holdings were generally unable to secure any funds at all.

Niche opportunity

That was until Vantage Capital entered the market with a new and innovative 'mezzanine' offering. Inspired by the current low inflation environment, the company identified a niche opportunity to provide mezzanine finance to local borrowers. In the first quarter of 2007, Vantage Capital introduced the first Mezzanine Fund to the South African market.

Vantage Capital's Mezzanine Fund has already secured R100 million from a UK private equity firm. In their official statement, Chief Executive Officer Mutle Mogase said the fund will target "a mixture of growth, buyout and refinancing capital." The fund aims to raise between R150 and R750 million rand.

What is a Mezzanine Fund?

The simplest definition of a fund providing mezzanine finance is contained in the phrase "risk lender." The term 'mezzanine' refers to "unsecured, high-yield, subordinated debt or preferred stock that represents a claim on a company's assets that is senior only to that of a company's shareholders."

Companies use mezzanine finance as a stop-gap measure until such time as they are able to replace it with a more conventional form of borrowing. As soon as alternate forms of funding are in place, the Mezzanine Fund (or investors) who supplied the financing will withdraw their capital and look for other suitable opportunities to put it to best use.

Mezzanine finance is a great option for a company with solid growth and earnings potential. If the bank refuses to provide funding due to lending criteria not being met or management prefers not to loose control over the firm by diluting its shareholding, mezzanine finance is the perfect solution. The main benefit to the company is that management is not forced to dilute control of the company as part of the funding process.

Riskier finance comes at a cost

Mezzanine finance is not issued according to common banking practices. They are based on cash flow and growth projections rather than standard collateral and surety requirements. The finance is effectively unsecured and the Mezzanine Fund enjoys no protection in the event of a company failure.

These funds typically expect a reward commensurate to this risk exposure. The typical structure demands returns of between 15% and 20% per annum. In addition, beneficiaries of such funding will also pay an investment fee of between 0.5% and 2% and a fixed commitment fee.

Huge growth expected

Mezzanine Funds have an obvious role to play to the benefit of small and emerging companies with entrepreneurial management teams. Vantage Capital believes that the local Mezzanine finance market could grow to as much as R5 billion in coming years.

At present, this type of lending will be available for large investors only. Large private equity funds will remain the most likely source of capital for mezzanine funding. But, with a large and innovative local investment environment, it will probably not be long before a pooled investment mechanism allows smaller private investors access to this rewarding lending practice.