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.
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.
The 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.