A mezzanine-type hybrid loan is a new financing trend on the young Baltic capital market. It is a mezzanine between equity and debt capital. A mezzanine-loan provides the entrepreneur term debt capital, which can be used as equity capital. For an entrepreneur, the most affordable source of funding is a long-term bank loan. An obstacle to getting a bank loan may be lack of sufficient equity capital. In these cases, the traditional solution is to find co-investors, who would make the additional equity capital investment. An alternative may be raising the capital as an additional loan, which replaces the missing equity capital. For creditors, such a loan carries higher risk and higher interest for the entrepreneur. In certain cases, the high interest is smaller than the unearned income – in such cases, a mezzanine-loan is a sensible solution for the entrepreneur. Instead of a loan, also preference shares with obligatory redemption could be used. The principle of the transaction remains the same – an entrepreneur can use term debt capital as equity capital.

An opportunity for investors

A hybrid loan carries lower risk than a share investment and provides a simpler exit from an investment. Unlike a share investment, a hybrid loan has a term. So the investor need not worry about retrieving the capital. Liquidity is an important added value for investors, as most local companies are non-public and the secondary market is thin.

Due to the term, this is a liquid investment for an investor. As the loan replaces the entrepreneur’s equity capital, then the interest has to be motivating for creditors. Usually a mezzanine-loan’s interest rates are double and an additional interest is written in the loan terms and conditions, which depends on the company’s business results. An entrepreneur and creditor may reach an agreement, whereby the loan issuer may convert the loan into the company’s shares under previously agreed conditions – the value of the shares may increase over time and become additional income for the creditor. So a mezzanine-loan may be similar to a share investment.

Instrument subordination

An investor should watch out for loan subordination. In other words, how many other creditors the company has and which assets have been pledged to them. If a hybrid loan is subordinated to some other commitment on the basis of a contract, then it is necessary to analyse the content of the subordination contract.  The borrower must consider that subordinated capital may come with an additional framework or conditions, which restrict the company’s operations. For example, a situation may arise where the entrepreneur is not allowed to pay back the hybrid loan before the bank loan based on the subordination agreement signed with the bank.

Mezzanine popularity is on the rise

A number of finance sector companies operating in the Baltics have used hybrid loans in recent years: Admiral Markets, Bigpank, Inbank and LHV. Hybrid loans have also been used by real estate developers, making transactions on the basis of crowd-funding platforms. In recent years, mezzanine has found its way to pension funds’ and private investors’ portfolios. Hybrid capital is a flexible solution for a growing company, offering the investor a reasonable debt-to-return ratio. Both entrepreneurs and investors should take into account that this is a financing solution slightly more complicated than the usual ones. Therefore, it is important to analyse the terms and conditions of the transaction carefully.