6. Hybrid instruments34
285. Hybrid financing instruments lie in the middle of the investors’ risk/return spectrum, from “pure”
debt to “pure” equity, combining features of both debt and equity into a single financing vehicle. These
instruments differ from straight debt finance, in so far as they imply greater sharing of risk and reward
between the user of capital and the investor. The latter accepts more risk than a provider of a senior loan and expects a higher return, which implies a higher financing cost for the firm. However, the risk and the
expected return are lower than in the case of equity, which thus implies the cost of financing for the
enterprise is lower. In the event of insolvency, where the firm is unable to meet all its contractual
obligations, investors in hybrid instruments have lower rankings than other creditors, but higher ranking
than investors in “pure” equity capital.
286. Some of the most commonly used hybrid instruments include: i) subordinated debt (loans or
bonds); ii) participating loans, with profit or earning participation mechanisms; iii) silent participation; iv)
convertible debt and warrants, whereby investors can convert debt into stock, thus receiving a reward that
reflects the increased value of the company enabled by the capital provision, and; v) mezzanine finance,
which combines two or more of these instruments within a facility.
6.1 Subordinated debt
287. Subordinated debt is composed of loans or bonds in which the lender agrees that senior or
secured creditors will be fully paid before any interest or principal is paid.
288. Subordinated loans (or junior debt) are unsecured loans where the lender’s claim for repayment
in the event of bankruptcy ranks behind that of providers of senior debt but ahead of equity investors.
Subordinated loans usually carry a specific rate of interest, which is independent of the state of the firm’s
finance. The provider of financing is entitled to this payment under all conditions, subject only to the
condition that senior debt holders must be paid in full before any payment is made to subordinated debt
holders. Principal is usually repaid in “bullet” form, i.e. at the end of the loan. In some instances, the
facility may provide for payment in kind (PIK) in which both interest and principal are paid at the loan’s
maturity. In this case, it carries a higher interest rate than one where interest is paid throughout the course
of the loan.
289. Subordinated bonds are unsecured bonds that offer the investor periodical interest payments
(coupons) and full redemption at maturity. In the event of liquidation or bankruptcy,
the claims of
subordinated bond holders are inferior to those of senior creditors, but are superior to those of
shareholders, because their bond coupons have to be honoured before any share dividends can be
distributed by the firm. The interest rate tends to be significantly higher than that of non-subordinated
bonds, to compensate for the higher risk.
6.2 Participating loans
290. Participating loans are loans whose remuneration is contingent upon the results of the debtor firm
rather than being fixed. The remuneration can be linked to the firm’s sales or turnover, profits or share
price. On the other hand, participating loans do not share losses. In the event of bankruptcy, providers of
participating loans share in the results of the liquidation in the same way as other loan creditors.
291. Sales or turnover participation rights provide the investor receives with a payment based upon
the performance of the firm, in terms of revenue, turnover, or earnings.
Both the interest rate and the
capital repayment can be linked to this performance and the payment can take the form of PIK, i.e.
received at the maturity of the loan.
292. Profit participation rights are equity investments that entitle the holder to rights over the
company’s assets (e.g. participation in profits or in the surplus on liquidation, subscription for new stock).
The owner of the profit participation right is not a shareholder of the company and is not entitled to
ownership rights, including voting rights and the right to attend the company’s shareholders’ meeting.
However, profit participation rights are not defined by law and can therefore to a large extent be negotiated
and designed to suit the parties. They can be designed to resemble borrowed capital by contractually agreeing on minimum interest payments which are independent of the company’s profits or resemble
equity capital if they grant the right to participate in the company’s profits and/or liquidation proceeds.
6.3 “Silent” participation
293. “Silent” participation is closer in legal form to an equity investment than subordinated or
participating loans. In this form of financing one or more persons take an equity stake in a company, but
without assuming any liability to the company’s creditors. In other terms, the silent partner is a “limited
partner”, since his/her liability is usually limited to the amount invested in the company. The typical
“silent” participation affects only the company’s internal affairs and is not apparent to outside observers.
The silent partner has the right to monitor the company’s business and can also be granted rights to be
informed and to participate in the company’s decision making. However, the details of participation in
profits or losses, involvement in the company’s management, supervision and information rights can be
structured flexibly. As a case in point, usually the silent investor participates in losses up to their invested
capital amount, but the parties may remove this feature partially or completely from the contract.
6.4 Convertible debt and warrants
294. Convertible debt is a debt instrument with a maturity date and stated repayment terms, which
includes an option to convert the debt into another financial instrument, such as other forms of debt,
derivatives or stocks. The conversion option is not separable from debt, hence the value of a convertible
bond is equal to the value of the bond component plus the value of the option component. Also, repayment
of debt and exercise of the conversion option are mutually exclusive, that is, exercise of the option
extinguishes the debt, and repayment of the debt cancels the conversion option35. Corporations usually
have call options on the convertible bonds they issue. This allows them to call the bonds in order to force
their conversion.
295. Detachable warrants, which give the holder the right to purchase a specific number of shares at a
predetermined price, differ from convertible debt in that they can be traded separately from the securities to
which they are related. Also, warrants are typically of shorter duration than convertible bonds. Their value
is the difference between the price at which a share of the company can be purchased by exercising the
warrant (the strike price) and the market price. The value of this instrument can be determined by market
process where the company is publicly traded or is sold to an outside investor through a merger or
acquisition (M&A). In cases where no such basis for pricing the equity interest is available, the value of
the equity warrant is determined using a valuation technique specified in the contract. In the case of both
convertible bonds and warrants, the holder is not entitled to receive any cash dividend distributed by the
firm before exercise of the option. However, the exercise prices are automatically adjusted for any stock
split or stock dividends.
6.5 Mezzanine finance
296. Although there is no commonly agreed definition of the term, mezzanine finance is generally
intended as a technique that combines two or more of the above investment instruments (tranches) within a
facility that is sold as a single entity to investors. The exact mix of instruments in a specific facility can be
tailored to suit the needs of the firm and the investors.
To the extent that the facility has a large share of
fixed rate current pay assets, it will tend to have a low but steady yield. Yield can be enhanced by
increasing the proportion of higher risk assets in the facility or by delaying payments until later stages of
the operation. The more risk assumed by the investor, the more the investor attempts to captures the
"upside” of the investment.
297. A simple mezzanine facility contains: i) one or more categories of subordinated debt; ii) a tranche
in which the investor receives a “success fee,” i.e. a share of the firm’s earnings or profits and/or; iii) an
equity-related tranche (“equity kicker”) in which an investor receives a payment whose value is contingent
upon a rise in the value of the company, usually reflected in the company’s share price.
298. A commercial mezzanine investment usually takes the legal form of a private investment
partnership, a vehicle that is restricted to a limited number of sophisticated investors (Limited Partners –
LPs) each of whom must commit a substantial sum.
The investment is organised by General Partners
(GPs), professionals in management of mezzanine investments who contribute their skills in identifying
good companies, guiding them through the mezzanine cycle, monitoring their performance, often
participating in their boards, and liquidating the fund at the end of its mandate. The GPs receive fees for all
assets under management (usually about 2%), as well as a share of the profits of the investment.
299. Due to the need to monitor companies actively, mezzanine funds usually only hold a limited
number of companies in their portfolios, with 20-30 companies on average. Furthermore, mezzanine
finance usually has covenants restricting the activities of the companies, although they tend to be less
rigorous than those of commercial banks.
300. The mezzanine fund has a pre-determined life (usually 7-10 years) and investors are expected to
remain invested throughout this period. Normally, in its early years, the fund will have large shares of
assets in cash as investible projects are sought. During the middle years of the fund life, assets are usually
fully invested. Toward the end of the fund’s life, earnings will flow into the fund and investors will receive
cash. At the end of its life, the fund is wound up and all investors receive a share of the earnings of the
fund.
301. Mezzanine investments are most often buy-and-hold products. Unlike high-yield bonds, which
are often listed on exchanges in Europe or made eligible for electronic trading between qualified
institutional buyers (QIBs) in the US market, mezzanine debt securities are rarely traded. As a result, many
mezzanine investments have limited liquidity (Robinson et al., 2013).
302. Typically, mezzanine investors expect to realise value by exiting in the later stages of the
investment. Most commercial mezzanine investments are taken out either through a change-of-control sale
or recapitalisation of the company. For this reason, mezzanine providers may look to invest in companies
that represent strong IPO candidates. In some cases, the company may be sold to strategic investors. More
frequently,
the mezzanine capital provider is bought out by the initial owner through a recapitalisation with
inexpensive senior debt, through the accumulated profits generated by the business or through an
acquisition of the company by a competitor.
303. Mezzanine investors generally do not wish to acquire more than 3-5% of the equity of any
company in their portfolio and do not seek to participate in its management (Credit Suisse, 2006).
However, in return for the lower ranking and unsecured nature of mezzanine capital, investors require
detailed and prompt information on the economic progress of the business, and usually define specific
financial indicators, or covenants, which the company must observe. For the investee companies –
especially SMEs – this gives rise to increased requirements as regards accounting, oversight, and
information policies. It also requires intensive monitoring on the part of mezzanine investors.
6.6 Profile of firms
304. Hybrid instruments represent an appealing form of finance for privately held companies that are
approaching a turning point in their life cycle, when the risks and opportunities of the business are
increasing, but they have insufficient equity backing, and, for this same reason, face difficulties in accessing debt capital (Credit Suisse, 2006). Thus, hybrid instruments may serve companies that are in
need of capital injection, but that cannot increase their leverage, are not suitable for public listing and/or in
case the owners do not want the dilution of control that would accompany equity finance. This can be the
case of:
a. Young high-growth companies, which may have used venture capital in earlier phases of
growth but seek for cheaper expansion capital and less dilution of control for the founding
entrepreneurs;
b. Established companies with emerging growth opportunities in cases where the funding
requirement exceeds what can be obtained using traditional debt financing and/or their profile,
in terms of sector, region or projected rate of return, does not appeal to venture capitalists;
c. Companies undergoing transitions and restructuring, as in the case of spinoffs or
transformation from a closely held family run business into a transparent company with
professional management.
d. Companies seeking to strengthen their capital structures, as in the case of SMEs that are
excessively leveraged, particularly closely owned and/ or family companies. In these
instances, mezzanine capital can be a bridge to equity finance, either because: i) the company
increases equity through retained earnings or ii) the company is recapitalised at the end of the
period for which mezzanine is utilised, either through a sale to strategic investors or through
an initial public offering (IPO).
305. An important precondition for raising mezzanine capital - intended as a single hybrid instrument
or a combination of two or more hybrid tranches - is that the earning power and market position of the
business should be well established and stable. A company must demonstrate an established track record in
its industry, show a profit or at the very least post no loss, and have a strong business plan for the future.
For this reason, mezzanine capital is a suitable form of finance for SMEs with a strong cash position and a
moderate growth profile.
306. The presence of a mezzanine finance facility may favour increased access to debt financing by
the firm and lower the financing costs with respect to equity. In fact, most debt incurred through
mezzanine facilities will be classified as “subordinated debt”, thus it will be considered equivalent to an
increase in equity by banks and other traditional borrowers. The more favourable ratio of equity to debt can
lead to an improvement in the firm’s credit rating, implying more favourable loan conditions and greater
scope for raising additional debt capital. At the same time, mezzanine investors generally target a 15 - 25
% IRR (internal rate of return) compared to more than 25% for equity investors (Credit Suiesse, 2006; EC,
2007b; Silbernagel and Vaitkunas, 2010) (Table 5).
307. Mezzanine finance is often used in conjunction with leveraged buy-outs (LBOs). In fact in most
countries, the bulk of mezzanine transactions occur in the buy-out market. However,
these operations
mostly involve larger companies. With regard to SMEs, it is a form of finance that mainly supports growth
plans of medium-sized companies, whereas it does not generally apply to the smaller segment of the SME
sector. The traditional market for mezzanine finance has been upper-tier SMEs, with high rating (BBB+ or
above) and demand for funds above EUR 2 million. Nevertheless, in recent years, some financial
institutions, particularly public financial institutions, have started to extend mezzanine finance to SMEs
below the upper tier and with smaller funding needs (EC, 2007b).
