Markus H. Michalow: Mezzanine capital – Innovative financing methods for medium-sized businesses

The most innovative financing methods for medium-sized enterprises lie in in­­tegrated consulting approaches. Espe­cial­­ly in owner-managed enterprises, a close connection exists between private and business finances. Together with his consultant, the client decides which fi­­­­nancial instrument best suites his po­­sition and long-term business goals. In this way individual needs and business objectives are coordinated.

In addition to equity capital as an as­­set creating substance, it is primarily the private and business risk position of the enterprise that is of key importance. The interdependencies that could oc­­cur in this connection also justify the necessity for an integrated risk management system.

Business analysis in two steps
Once the first contact has been established with the capital-seeking enterprise, the potential investment manage­ment com­pany is matched to the cri­teria of the financial institution in a multi-­stage process. In this way a precise insight is created into the enterprise as regards all its strengths and weaknesses in or­der to more accurate­ly grasp the op­­por­tu­nities and risks of an investment. A rough assessment is first made prior to meas­­uring the economic position in detail. In the process, the market op­­por­­tunities and marketing potential as well as the ge­­neral business conditions for the en­­terprise are analyzed. The rough as­­sess­ment is to be seen as a type of preli­mi­nary ex­­amination. Within the scope of this pre­­­liminary examination it is to be de­­­­­termined whether the enter­prise fundamentally fulfills the standard criteria for the possible granting of a loan. An es­­sential part of this examination is a business plan, on the basis of which the financing possibilities are reviewed. De­­cisive inspection features here relate to the business market of the enterprise and its management. This rough as­­sess­­­­ment demands a high­ly structured ap­­proach in order to mi­­ni­mize costs and to avoid the oversight of promising success possibilities.


In a second, more detailed examination, the focal point shifts to questions regarding societal topics, tax laws and fi­­nance. This examination primarily pursues three main objectives:
1. Disclosure of company information
2. Analysis and inspection of the company
3. Creation of a basis for decision-ma­k­­ing and the support of pricing/con­­dition determination

An integrated consultation should not only secure and optimize the assets of an organization, but rather also check whether there is a gap in the equity base of the organization that is to be bridged. Faulty equity facilities currently represent a central problem for many medium-sized enterprises. Frequently the own capital contribution is marginal and the portion financed by the bank high. In addition, the value of many securities is eroded. For this reason, the question of external financing through own capital becomes an ever more cen­tral issue for these or­­ganizations. The creation of equity ca­­pital through the issuance of shares on the stock ex­­change is however only reserved for companies. Consequently this eliminates the majority of smaller or medium-sized enterprises from creating equity capital in this way. It is pre­­cisely for this reason that alternative financing models are in demand.

Mezzanine financing
Since the German medium-sized enterprise sector requires more risk-financing for future growth, the banks at this point are ensuing new innovative concepts. In order to strengthen the equity capital base of organizations, banks are increasingly offering standardized mezzanine products, which also open the doorway to the capital market for small­er organizations.


Mezzanine capital offers external fi­­nan­­­c­­ing solutions which are tailor-made and situation-specific. It can not be assigned to one of the two ideal types of categories which are eqiuity capital and external finance. For the term mezzanine financing there is neither a clear definition represented in eco­nomics nor in law. The word mez­­zanine has its origin in architecture and in Ital­­ian, it symbolically stands for a floor between the ground and first floors. From an economic point of view, this “in between floor” is about a hybrid structure between external and equity capital. However, these hybrid instruments can, within the scope of legal consideration, clearly be assigned to equity or external capital respectively, according to design. Despite its legal gra­ding into equity or external capital, the distinctive feature lies therein that each form still possesses characteristics of the other. In this way this hybrid finan­cing form can for instance be de­­vel­oped in such a way that the in­­ves­ted capital en­­sures tax benefits (for ex­­ample through the deductibility of the interest) and is furthermore preferential in comparison to equity capital, but nevertheless displays characteristics of equity capital.
In mezzanine financing, the financier with a subordinate loan participates com­­­­mer­cially in the organization. There­by this can only be a pure loan or the financier holds the position of a silent part­ner or a pro­fit participation proprietor. Thus, de­­pen­ding on the proximity of the struc­­ture to pure equity or pure external ca­­pital, mez­­­zanine capital distinguishes it­­self in equity mezzanine and debt mezzanine.

From a risk point of view, mezzanine fi­­nancing takes a mid-position between the classical loan issued against security and equity capital. The characteristics of this financing concept are subordination, tax deductibility, redeemability, flexibility, a broad range of investors and versatile application possibilities. The creditworthiness of the organization alone is not decisive for the financier in the provision of mezzanine fi­­­­­nancing: He mostly orientates himself to the expected cash flow or a commitment from the capital seeker, by means of his acknowledgement of specific rights to information, cooperation and control. As a rule, repayment only oc­­curs after seven to twelve years, which, in com­­­pa­rison with six to nine years with other bank loans, means a really long time-span.
In the absence of security for his loan, the subordinate financier obtains an in­­­­terest rate at least two per cent high­er than the conventional loan financier. Mezzanine financing offers itself when liable equity cannot sufficiently be ob­­tained and conventional, commercial loans are not or only restrictedly al­­lowed due to a lack of security.

Mezzanine capital gains in importance
Furthermore, any such financing, with the correct structuring, through the addi­­tion of mezzanine capital to the equity capital of the organization, could lead to a corresponding im­­prove­­ment of ra­­t­­ing at the bank. It is to be assumed that such innovative financing methods will gain in importance within the next few years. This upstream proposition will ul­­­­timately exert pressure on the current conditions. From the perspective of me­­­­dium-sized enterprises, capital mar­­ket friendly fi­­nancing methods are likely to become cheaper within the next few years, which could partially compensate for the ex­­pected in­­crease in the general interest level. Therewith one thing is evident: Al­­ter­na­tive financing methods will also in fu­­ture become notably more attractive.


porträtThe author is the area manager for Per­­sonnel, Private & Business Banking at the Dresdner Bank AG in Dresden. He com­pleted his training at the Deutsche Bank AG in Frankfurt as a forex dealer and in financing. He recently worked in various leadership positions at Deut­­sche Bank, Dresdner Stadtwerke (municipal utility company) as well as Dresdner Bank.