It is often seen as a hybrid of bank debt and private equity, as it shares similar characteristics. For example, mezzanine has fixed interest payments and a maturity date for loan repayment, but additionally, mezzanine lenders have the option to take a stake in your business.

Related: How mezzanine finance can help ambitious SMEs to grow

‘The beauty of mezzanine is its flexibility – it has a wide range of applications, and can be structured and priced in various ways,’ asserts Colin Swanson, director of equity and mezzanine at the Bank of Scotland.

Timing is right

In the past mezzanine has been used to bridge a funding gap between debt and equity, but it is now increasingly being used as a stand-alone finance facility for a range of deals such as management buy-outs (MBOs), growth capital or acquisition finance.

According to Katherine Belsham, assistant director at specialist provider of mezzanine finance Intermediate Capital Group (ICG), there is a desire in the market for more and more mezzanine deals – ‘equity houses want to put in less money, and mezzanine fills a gap.’

In line with this growth, there are various finance houses that deal with such transactions. Besides specialist providers and venture capitalists, banks, such as Barclays, the Bank of Scotland (BOS) and the Royal Bank of Scotland (RBOS) provide mezzanine facilities for various situations. For example, RBOS lends finance in leveraged transactions where there is no private equity sponsor.

‘In most deals, mezzanine will be sitting behind senior debt and will be a secured loan with subordination. The market for this type of finance has definitely picked up and can be quite cheaply priced with warrants,’ explains Bruce McLaren, head of debt ventures at RBOS.

Smaller sums too

Mezzanine is also available from regional support bodies such as Finance Wales, which provides mezzanine at the lower end of the market. Its mezzanine fund, established just over two years ago, has so far completed 32 investments ranging from £10,000 to £175,000. It is aimed at entrepreneurs whose businesses seek the kind of growth investment provided by venture capital, but who are reluctant to give up a large equity stake in the company.

‘We don’t take equity with the companies we invest in – only options and we have fixed interest rates. We review eight to ten business plans a month, and take two forward,’ affirms Tania Costigan, mezzanine fund manager of Finance Wales Investments.

For company owners, mezzanine finance can enable you to tailor the repayment and exit demands to your requirements. As it is more long-term than bank debt, there are no regular debt payments, which frees up cashflow to grow the business.

Whilst it is costly (with interest rates that can vary from 8-16 per cent), the other advantage is that there is less dilution involved than if your business was funded by venture capital. In addition, the mezzanine lender in general plays no part in the day-to-day management of your business. But mezzanine is not suited to all companies.

Persuading the lenders

Unlike venture capital, companies seeking mezzanine finance must fulfil certain criteria besides the usual solid business plan. Top of the list is the quality of your cashflow – any mezzanine financier has to be convinced that you can service the debt.

‘The two main areas we look at are the management team and the quality of cashflow in the business – everything else is probably of secondary importance,’ states RBOS’ McLaren, adding that their minimum investment is usually £2 million.

ICG’s Belsham, who handles deals that start from £5 million, looks for a track record of both cashflow and profit generation.

‘A strong management team is important too, and we look closely at whether the company’s market has strong barriers to entry. All together, we see around 200 deals a year, of which 25 are converted,’ she explains.

Colin Swanson says that a less profitable business but one with a strong growth story, would also be considered – but the mezzanine is likely to be provided at a higher price. The bank also tends to favour more stable, asset-backed businesses that can clearly demonstrate they can service the debt element and which have some kind of asset-backing such as plant, machinery or property.

But beware the risks

Mezzanine is suited to those companies with visible cash flow generation and which are unwilling to give up a large slice of the company – but on the flip side it comes at a much higher cost than senior debt.

‘If there’s a default on the repayment terms, you are pretty much led through the nose and will not be in a position to bargain or negotiate. The consequences would be pretty draconian – private equity houses don’t have those obvious weapons at their disposal,’ believes Alexander Janes, a partner in the banking and finance group at law firm Coudert Brothers.

This is a view echoed by BOS’s Swanson – who stresses that you run the risk of a bank stepping in before a private equity backer would, and that you have to live with debt-type controls on your investment.

‘There is less to give up in terms of ownership, but the fact is that mezzanine is secured debt. Banks are a bit more aggressive than private equity houses, and will take a slightly different view of company performance. The bottom line is that mezzanine is debt and it will have to be paid back,’ adds RBOS’ McLaren.

Case Study

— Backing product development

Caernarfon-based, biotechnology consultancy Picosorb secured £150,000 in mezzanine finance from Finance Wales Investments.

The company develops equipment that can tackle outbreaks of infections caused by bugs such as salmonella. The company is headed by Osborn Jones, who has established a solid track record in the business, having already developed several high-tech companies, including ADC Systems, a company which manufactures robotic systems for health laboratories.

‘The funding we have agreed with Finance Wales ensures that production of the new product can go ahead to meet the keen interest that the BactiProbe has aroused on the part of distributors in many countries,’ explains Jones.

Need to know — Where to go for mezzanine finance

Alliance Fund Managers, minimum investment – £100,000

Bank of Scotland, minimum investment – n/a

Finance Wales, minimum investment – £10,000

Intermediate Capital Group, minimum investment – £5 million

Mezzanine Management, minimum investment – £5 million

Royal Bank of Scotland, minimum investment – £2 million.