Search for...

How Mezzanine Financing Can Assist Entrepreneurs Amid Times of Recession

Mezzanine Financing
, ~

In the 2000s, mezzanine finance was still an alien concept in Central Eastern Europe. That changed in 2003 with the arrival of the region’s first dedicated mezzanine fund – the €115M Accession Mezzanine Capital fund. 

Mezzanine financing, which refers to a form of debt that combines both equity and debt characteristics, proved to be particularly useful for companies that were not yet ready or did not have suitable equity financing options. 

During the early years, mezzanine financing in CEE was mainly provided by foreign banks and private equity firms, as there were few local players in the market. However, as the market developed, local banks and funds began to offer mezzanine financing, leading to increased competition and a greater variety of financing options for businesses.

In recent years, mezzanine financing has become an increasingly popular option for CEE companies looking to raise capital for growth and expansion. While it is typically more expensive than traditional bank loans, it offers several advantages, such as more flexible repayment terms and the ability to access professional investors’ funds and value without diluting ownership.

With the decrease in bank liquidity and the increase in bank rates, the interest toward private equity and mezzanine financing goes up. Many companies have reached the limits with available bank financing and require alternative instruments to support their growth goals. 

Some of the mezzanine funds that have been historically active in Central Eastern Europe include Abris Capital Partners, Mezzanine Management Central Europe (MMCE), and Innova Capital. In 2021, Silverline Capital, the first Bulgarian mezzanine fund, launched investment activity, to provide local mid-market mature businesses with mezzanine and equity financing. 

Where is mezzanine financing positioned between bank loans and equity?

As its name suggests (a mezzanine floor is an intermediate floor between the main floors of a building) mezzanine financing is an instrument that stays between bank and equity financing in the capital structure of a company.  It is a hybrid financing instrument that allows companies to operate with long-term capital in order to accomplish their concrete growth targets. 

Read more:  Czech AI-Powered E-Commerce Guide Outfindo Secures €900K Seed Round to Help You Buy the Right Products Online

“Mezzanine financing is tied to bank financing in the way that it is always subordinated to bank debt. In the cases that a company has received bank financing and has reached a certain limit, mezzanine is the only instrument that would allow it to receive growth capital without changing its shareholder structure,” Diana Aladzhova, Partner at Silverline Capital, says. 

Unlike bank loans, mezzanine financing allows for a longer repayment. If with a bank loan, the principal is paid in installments starting between 1st and 13th month, with the mezzanine, this happens as a bullet repayment in total after a period of 3-4-5 years. During this period, the company only pays monthly cash interest. This allows the company to operate with a cash resource for a longer time and achieve its growth objectives without high cash outflows to the financiers over the short term. 

As an instrument, the mezzanine is riskier than debt financing because it is almost unsecured. Therefore, as a risk profile, this instrument is closer to equity than to bank debt and involves several components. One is interest cash that is paid quarterly, an additional interest that is capitalized into the principal and paid at the maturity, and options to acquire a minimum equity percentage at the maturity of the loan. 

However, unlike equity financing, mezzanine does not dilute the cap table. Companies that are already established in the market and have a long history with their current shareholders do not always feel comfortable accepting investors as new shareholders, and would rather consider an investor who enters rather as a creditor.

Generally, there are two main investment mezzanine financing thesis – companies that want to engage in M&As and companies that wish to expand their current operations capacity. 

“This means that businesses have to invest in new production facilities or expand in new geographies, increase their organizational capacity, grow their sales and marketing efforts, until they start achieving results. This takes time. It is usually appropriate in these situations to take longer-term capital that is not paid out immediately. Similar is the case with companies that are planning acquisitions. Once the acquisition itself is paid for, time is required until synergies are realized with the new company. Time is also required before the two companies accomplish integrations, unify their internal organization and manage to increase margins and sales. Roughly, we are talking about anything between 2 and 3 years,” the Silverline Capital’s partner explains.

Read more:  Inside the Innovation Ecosystem in Burgas: Top Startups, Hackathons, and Tech Communities

This is one of the biggest advantages and differentiators of the mezzanine tool according to her. Companies have the cash they need to grow and are required to pay back at maturity when they should have already increased their cash flow, revenue, and profits. 

Last but not least, mezzanine is an instrument that is given by a professional investor who enters into a relationship with the company. “As investors, we keep in touch with our portfolio companies and strive to give them much more value than just funds. Our team combines people with broad investment experience across the CEE region and we have more than 200 deals combined behind our backs. This gives us the ability to assist the companies at a strategic level, we sit on the board as members or as observers. We also give founders access to our network, help them restructure the business into a corporate organization with established departments and processes that allow them to scale fast,” Diana adds. 

“Silverline Capital is a special fund because its team has a very deep financial focus and willingness to help portfolio companies with their expertise. Every company experiences many unknowns in the early days of increasing its market share. These include the efficiency of the business model, the balanced price of the product, and the long periods of pilots before the customer signs a long-term contract. Most investors advertise how much they would help with these unknowns, but very few actually have the time and desire to dive into the details and offer persistence, which is far more important than the investment itself,” Vince Gaydarzhiev, President and founder of the US-Bulgarian company for autonomous access control Alcatraz AI, shares for The Recursive. 

In September 2022, Alcatraz AI raised a $25M Series A round by Almaz Capital, EBRD (The European Bank for Reconstruction and Development), Endeavor Catalyst, Silverline Capital, and Golden Seeds, along with participation from existing investors JCI Ventures (the corporate venture arm of Johnson Controls), Ray Stata, LDV Partners, and Bulgarian angel investors.

Read more:  The first Bulgarian mezzanine fund Silverline Capital launches with €42М to offer alternative SMEs financing

Why and when should I consider mezzanine financing?

The mezzanine is a suitable instrument for businesses with established business models and predictable cash flows which require larger growth funding (EUR 3-10m+) from investors to support their expansion goals. Mezzanine is more of a private equity type of investment as it provides larger tickets to more established businesses that are looking for expansion opportunities. Startups are not the target for mezzanine since they do not have predictable cash flows and established business operations that can support this instrument. 

By the end of this year, when its investment period ends, Silverline Capital will invest in 9 more companies with tickets between EUR 2.5m and 7m. “With all its downsides, the recession provides companies with good business models, good commercialization strategy, and strong products with an opportunity for growth. Given the increased risk criteria and reduced liquidity of the banking institutions, mezzanine financing is attracting an ever-increasing interest among such growing companies,” Diana concludes. 

 

Thank you for reading The Recursive!

Over 1 million people from all over the world have learned about the tech ecosystem in Central and Eastern Europe thanks to The Recursive. In order to keep our content free for everyone, we need your help. If you believe what we do is important and have the means to do so, support us in giving a voice to Central and Eastern Europe with as little as €7. Thank you!

DONATE Keep reading this article

Help us grow the emerging innovation hubs in Central and Eastern Europe

Every single contribution of yours helps us guarantee our independence and sustainable future. With your financial support, we can keep on providing constructive reporting on the developments in the region, give even more global visibility to our ecosystem, and educate the next generation of innovation journalists and content creators.

Find out more about how your donation could help us shape the story of the CEE entrepreneurial ecosystem!

One-time donation

You can also support The Recursive’s mission with a pick-any-amount, one-time donation. 👍

Elena is an Innovation Reporter at The Recursive, an online media dedicated to the emerging tech and startup ecosystems in Southeast Europe. She is keen on sharing the innovation stories that shape the regional ecosystem and has a great interest in fintech, IoT, and biotech startups. Elena is currently finishing her Bachelor's Degree in Business Administration and Political Science at the American University in Bulgaria.