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Mezzanine finance

1.0 What is Mezzanine Financing?

Mezzanine finance is a collective term for hybrid forms of finance: it has features of both debt and equity, and is considered to be unsecured as it is the last debt in line for any claim on assets. There are usually both debt (debenture) and equity (shares or warrants) instruments involved. The existing shareholders avoid the dilution levels of a straight equity deal while the mezzanine debt investors have security, unlike a straight equity deal. This is what makes mezzanine financing attractive to investors and lenders it offers the yield of an equity investment, with the protection of being in a creditor position.

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Who can be the Investor?


a) b) c) d) e) f) Hedge Funds Leveraged public funds Business development companies Private Equity funds Insurance companies Banks with established mezzanine departments

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What are the most important uses of mezzanine?


a) b) c) d) e) f) Balance sheet restructuring - to reduce debt amortization and extend maturity Development Capital to fund business expansion Acquisitions and management buyouts, New product launches and diversification, Long-term working capital to support growth, Equipment and owner-occupied real estate purchases, dividends.

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Requirements for a Company to obtain Mezzanine Finance

Mezzanine investors look for companies with the following characteristics: a) b) c) d) e) f) g) h) Proven and predictable cash-flow Well-established operations Clear competitive advantage(s) Reasonable and sustainable market position Strong and focused management team Predictable exit route Alignment of interest Prudent and transparent accounting and budgeting

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Typical Mezzanine Terms

Mezzanine financings tend to be highly negotiated transactions, customized for the particular situation. The more heavily negotiated terms are those relating to: Type of instrument Maturity Interest rates and fees Ranking in the capital structure Security Covenants Redemption and Call protection Equity participation Transferability

5.1

Type of Instrument

Mezzanine financings typically consist of unsecured debt or, less frequently, preferred stock. An issuer (that is, an issuer of, or borrower under, the applicable mezzanine instrument) may have a preference for one or the other depending on its capital structure or tax and accounting considerations. Investors may also have preferences based on their investment guidelines or their assessment of the potential investments risk profile. The most common forms of Mezzanine financings are listed below Subordinated Loans - Is an unsecured loan with a lower ranking in case of bankruptcy compared to senior debt. Providers of subordinated loans receive a fixed interest rate and are ranked before equity investors should the borrower be wound up. Participating Loans These are normal loans, but rather than there being a fixed return, their remuneration is contingent upon the results of the business. Despite sharing in profits, participating loans do not give rise to an ownership relationship. Participation in losses is contractually excluded.

Silent participation - In legal terms, a silent participation is closer to a stockholding than a subordinated or participating loan. The distinguishing feature of this form of financing is that one or more persons take an equity stake in a company, but without assuming any liability to the companys creditors. The typical silent participation affects only the companys internal affairs and is not apparent to outside observers. Participation in profits and losses and contractual rights of approval and control are structured flexibly. Mezzanine products with profit participation rights These are more related to equity and under company law the holder is entitled to rights over the companys profits. In general the financier has no voting or management rights. However, the instrument is rather flexible and the right to be consulted on business decisions can be included in the contractual documents. Convertible bond In addition to the usual right to fixed interest payments and repayment of principal, holders of convertible bonds or bonds with warrants have the right to acquire shares in the company instead of accepting repayment of the bond. This right is exercisable for a defined period and at a predetermined conversion or subscription rate. This way the issuer may convert debt into equity. Bonds with Warrants It is in principal is similar to the convertible bond. The main difference is that the warrants (subscription rights) are separate from the bond and thus can be traded independently

One characteristic which the various mezzanine instruments share is that they can be structured flexibly in many different forms, and can be combined in numerous ways, to provide tailor-made solutions for the specific financing needs of the company in question. Mezzanine products can be complex. In cases where they are not obviously debt or equity then the classification of the instrument depends on national and/or international regulations/principles such as the prevalent national accounting principles 5.2 Maturity

The maturity of mezzanine debt is typically five years or longer, but the maturity for a particular issue often depends on the scheduled maturities of other debt in an issuers capital structure. For mezzanine debt that is incurred at the same time as bank debt (such as at the time of an acquisition or buyout), senior lenders often insist that the mezzanine debt mature later than the bank facility. However, because mezzanine capital tends to have a higher rate of return relative to other debt in the capital structure, some issuers prefer shorter maturities. Conversely, some issuers agree to longer maturities on their mezzanine debt in exchange for more flexible optional redemption terms. 5.3 Interest Rates and Fees

Mezzanine lenders, typically specialist mezzanine investment funds, look for a certain rate of return which can come from four sources:

a) Cash interest A periodic payment of cash based on a percentage of the outstanding balance of the mezzanine financing. The interest rate can be either fixed throughout the term of the loan or can fluctuate (i.e., float) along with LIBOR or other base rates. b) PIK interest Payable in kind interest is a periodic form of payment in which the interest payment is not paid in cash but rather by increasing the principal amount of the security in the amount of the interest (e.g., a $100 million bond with an 8% PIK interest rate will have a balance of $108 million at the end of the period but will not pay any cash interest). c) Ownership Along with the typical interest payment associated with debt, mezzanine capital will often include an equity stake in the form of attached warrants or a conversion feature, similar to that of a convertible bond. The ownership component in mezzanine securities is almost always accompanied by either cash interest or PIK interest and in many cases by both. d) Participation payout Instead of equity, the lender may take an equity-like return in the form of a percentage of the companys performance, as measured by total sales, or EBITDA as a measure of cash flow, or profits. As in other forms of leveraged debt financings, various permutations of interest rates and fees are used within mezzanine transactions to accommodate the needs of the specific issuer and investors. While many mezzanine debt instruments feature a cash coupon with a fixed rate, which can be payable semi-annually or quarterly, others carry a floating rate or give issuers an option to pay interest in-kind (by issuing additional mezzanine debt) in certain circumstances. Mezzanine investors usually target a higher internal rate of return (IRR) on their investment than high-yield or bank loan investors, and seek to achieve their target IRR by a combination of the interest rate, fees and the equity component. Mezzanine preferred equity investments are typically structured with a high fixed-rate dividend, which may be paid in cash or in-kind, and may feature an optional or mandatory conversion into common equity. In addition, to achieve their target rate of return, mezzanine investors may negotiate for different types of onetime or periodic payments, including structuring, commitment or other fees and they may request that mezzanine debt is issued at a discount to par (original issue discount (OID)), which has the effect of increasing the instruments yield. It is also not uncommon for mezzanine investors to be reimbursed for their legal and other out-of-pocket fees. 5.4 Ranking in the Capital Structure

A key consideration in structuring a mezzanine financing is determining the position of the mezzanine debt in the issuers capital structure. In some situations, mezzanine investors agree to invest in a preferred equity instrument that is junior to all debt in the capital structure. For mezzanine investments structured as debt, senior lenders generally expect that the mezzanine debt is subordinated to the credit facility and possibly other senior lenders, such as high-yield

bondholders. Therefore, mezzanine debtholders typically agree to be contractually subordinated to existing and certain future holders of senior debt of the issuer. 5.5 Security

One of the defining characteristics of mezzanine debt is that it is typically unsecured. In those instances where mezzanine debt is issued on a senior basis at the same level with other debt of the issuer, the remaining senior debt is secured, so the mezzanine debt will be effectively subordinated to any secured debt of the issuer to the extent of the value of the collateral securing that senior debt. 5.6 Covenants

Key negative covenants in mezzanine debt may include limitations on: Incurrence of debt. Restricted payments. Liens. Change of control transactions. Asset sales. Affiliate transactions.

Affirmative covenants may include those relating to: 5.7 Financial reporting. Maintenance of insurance. Redemption and Call Protection

Redemption and call protection provisions vary widely in mezzanine financings based on changing market expectations and the specific purpose of each financing. 5.8 Equity Participation

Mezzanine investors regularly seek to enhance their returns by negotiating for equity participation alongside their debt investments (sometimes referred to as an equity kicker). Mezzanine equity investments can take various forms, including: Warrants or options to purchase a specified percentage of equity (often 1% to 5%) in the issuer. A right to co-invest in the issuer alongside the controlling stockholder or a private equity sponsor. In these cases the co-investment is typically at the same price as the controlling stockholders or sponsors investment and the purchased equity is bound

by the terms of any stockholders agreement or other arrangements among other stockholders A conversion feature that allows mezzanine investors to convert all or a portion of their principal investment into common equity of the issuer

Importantly, mezzanine investors are generally not looking to be long-term stockholders, but rather to achieve a target rate of return. As a result, transactions are structured with fixed rates of return (that is, higher interest rates) without equity kickers. 5.9 Transferability

Historically, mezzanine investments have been buy-and-hold products and are rarely traded. As a result, many mezzanine investments have limited liquidity.

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Advantages of Mezzanine to Borrowers


No equity dilution Mezzanine keeps the family in control of the business and limits valuation negotiation between investor and company Eases pressure on cash flows The non-amortizing nature of mezzanine and the use of PIK interest allows cash to be invested in the business for a longer period of time Allows highly leveraged companies to access capital - Companies that can no longer borrow senior debt may be able to borrow mezzanine to fund growth Allows companies to restructure their balance sheet - Allows companies to reduce debt amortization and extend maturity of debt No heavy collateral focus as with senior debt - Lending is based on company cash flows vs. fixed asset-based lending. This is especially advantageous during periods of economic downturn when collateral-based lending tends to discount sources of collateral (accounts receivable, inventories, fixed assets) Cheaper than equity Mezzanine is a cheaper source of financing than equity Flexibility and ease of execution Terms are flexible. Mezzanine can be raised relatively quickly and discreetly, making it attractive for small, private companies Certain exit for the investor - A Company typically uses mezzanine capital to grow and generate enough cash in 3-5 years to de-lever and refinance the mezzanine with cheaper senior debt

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Advantages to the Lender?


High rate of return (>20%) The loan can be quickly converted to equity if the borrower does not pay the loan back in time or in full

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How Mezzanine Financing can be Obtained

A. Obtain Mezzanine financing after obtaining traditional loan from the bank to bridge the gap between what is required and what bank is willing to pay B. Company seeks Mezzanine financing before obtaining traditional loan from the bank. The bank views Mezzanine capital as equity and would agree to pay a higher loan amount because they feel that the investor who has given money will want their money back, they want a rate of return and so are likely to take an active role to ensure that the company pays their money back

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Risk of Borrowing through Mezzanine Financing


High interest rate (it is typically between 15-20% but on average comes out to be > 20%) Displacement of right of equity holders in case of default Bank (or bond holders) first, mezzanine lenders, preferred stock holders, common stockholders Some loss of control in case the terms of the agreement allow lending party to gain equity in the Company

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List of Companies providing Mezzanine Funding in MENA

1. Standard Chartered Private Equity Limited (SCPE) Investment Criterion: SCPE invests in companies in the MENA region, with an emphasis on the GCC. It invests across all sectors in mid to late stage companies with proven business models, robust cash flows and disciplined strong management teams. Their average investment is US $25-$100 million per transaction and it can be teamed-up with other investors on larger deals. 2. Gulf Credit Partners Gulf Credit Partners is the regional credit business recently launched by Gulf Capital. Gulf Credit Partners provides financing facilities to Private Equity Acquisitions and growth capital for small and medium sized companies in the Middle East, North Africa and Turkey through its 'Gulf Credit Opportunities Fund L.P.I.' The Company has recently completed $25 million financing transaction for a locally based company SES FZCO (SES). The financing takes the form of mezzanine and structured credit financing providing flexibility generally unavailable in the region, which is both timely and extremely valuable to its clients

3. List of other Private Equity firms operating in UAE

1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12.

Abraaj Capital Dubai International Capital Injazat Tech. Fund Ithmar Capital Shuaa Capital The GCC Energy Fund Managers The National Investor HSBC Private Equity The Group SW Source Capital Scimitar Ventures MFA (DIB)