MEZZANINE DEBT FINANCING EXPLAINED

By Conrad Atuhire, LLM Commercial and Corporate Law (QMUL) | Partner | Adalci Advocates

Published on 24th May 2022.
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Uganda has been awash with news and developments coming out of a commercial dispute between Simba Group of Companies, a group of interrelated Ugandan Companies spanning different sectors, and Vantage Mezzanine Fund II Partnership, a South Africa based fund manager.

Briefly, Vantage extended a Mezzanine loan facility to Simba in 2014. The former alleges that the latter has failed to repay the loan. This has led to a litany of court filings that have formed part of the current legal, financial and social discourse.

The question on many people’s minds is, “What is Mezzanine Financing, and How does it work?”. This article seeks to answer those two pertinent questions without necessarily going into the merits of the dispute(s) at hand.

Companies/Businesses need equity financing or debt to grow and expand. In most cases, when diligently applied and managed, debt does more good than harm.

To understand why a company/business may resort to Mezzanine debt financing as opposed to traditional debt, it’s best to first understand what Mezzanine financing is.

Simply put; it is the sweet spot between the Senior (conventional), low risk (secured), and low interest debt you would typically get from your banker and the diluting/encroaching, higher risk equity debt. Mezzanine debt is usually provided by firms that are willing to take on a higher risk, and or, are willing to patiently wait on their debt than your traditional bank, such as Investment Funds and Private Equity firms among others.

Mezzanine debt may contain some hybrid features of senior and or equity debt such as a charge on company assets or shares of the company depending on the print of the governing agreement.

Due to the higher risk involved, naturally a higher interest/coupon will follow. So why take on a more expensive debt?

Mezzanine financing comes in handy when the borrower has exhausted their capacity to borrow from conventional sources (has existing debts), the borrower wants to preserve their capacity to take on future conventional/senior debt or needs patient capital to fund a specific growth project which typically is unavailable from conventional/traditional sources, BUT the Borrower does not want to dilute their equity in the business or company through Equity financing. Lenders are attracted to such companies or business for the higher interest or coupon rate as opposed to secured/senior financing.

Debt will mainly take the following categories; Senior debt (usually secured) and subordinated debt that includes both Mezzanine and Equity debt. This categorization is crucial in the event of insolvency where lenders are as secure as their ranking in the insolvency waterfall i.e. the order in which creditors are paid from the liquidation of assets of an insolvent company. Though, priority is given to the recovery of administrative costs (lawyers/accountants/auditors), taxes, and employee remunerations, the most secure and highest ranked creditors are the senior debt holders, followed by the subordinated debt holders; Mezzanine (usually unsecured) and lastly the shareholders / Equity debt holders respectively. The same was emphasized by the UK Supreme Court case of Lehman Brothers International (Europe) where it held that Subordinated debt holders were at the bottom of the waterfall. The lower ranking justifies the higher interest rates or coupons.

In a nutshell, if a company was to go through an insolvency process, secured debt creditors would enforce their security and the remaining assets would be liquidated to pay off other senior unsecured debt holders (if any), and if there is money to spare, the same would be allocated to pay subordinated claims such as Mezzanine debt creditors with the residue, if any, going to shareholders/equity debt holders.

There are several risks faced by lenders of mezzanine debt and these risks increase with cross border financing where issues pertaining to governing law, jurisdiction, specific legal/registration requirements, or faith in the justice system come into play.

The above risks can be mitigated by advisory Counsel doing the necessary legal due diligences on the parties transacting, the lender doing back ground checks on the borrower (reputation and credit worthiness) and crucially ensuring that the Governing Law, Jurisdiction and Forum are in jurisdictions where the Lender is domiciled or a reputable neutral jurisdiction e.g., London or New York.

London has been infamously dubbed the “Insolvency brothel” as companies undergoing insolvency will often shift COMI (jurisdiction where a party is closely associated) to take advantage of the tried and tested (CERTAINITY) English Courts and Law.

As a financial destination in need of cheap foreign capital, Ugandan/African businesses and Government(s) intent on borrowing must be wary of the adverse consequences (higher interest rates, low capital inflows etc.) that may result from foreign lenders being frustrated out of debt recovery processes.