Recently, we flagged off our new blog series on financing options for non-bank originators with our first post that explored debt-funding options in some depth. We progress southward on the balance sheet this week to explore financing instruments that are quasi-equity by design – mezzanine finance. This is the second installment in a series of blog posts that explore financing options for non-bank originators.
Providers of debt often look to cushion their risk with equity. While the microfinance sector has seen a growth in private equity funding in the past decade, this infusion has been restricted to the larger organisations in the sector. There are several hundred organisations in the Indian microfinance sector that are unable to attract equity due to their legal structure. This either results in limited access to debt funding or a situation of over-leverage, which could threaten the sustainability of the business in times of a crisis. In a situation where the legal structure is not conducive to equity investments or early equity investment dilutes the promoter’s stake, one has to look at capital structures that provide similar levels of comfort to senior debt providers.
Mezzanine finance is a hybrid variety of capital that straddles the vast and unexplored space between senior debt and equity. Mezzanine instruments combine various characteristics of debt and equity. The risk classification of these instruments depends on whether they have predominantly debt or equity characteristics and can be classified accordingly within the mezzanine space. For instance, the instrument could be in the form of subordinated debt, which has predominantly debt characteristics due to a fixed repayment schedule. The other example of a mezzanine instrument is preference shares, where the mezzanine provider takes risk which is only slightly less than an equity provider since the holder of the shares get preference when dividend is paid out. In the event that the business does not make profits, a preference share holder does not get a return, while the subordinated debt provider would still get the fixed payout that was decided.
One has to look closely at mezzanine debt to understand what gives it a hybrid nature.
Mezzanine debt is subordinated to senior, unsubordinated debt capital but ranks ahead of equity in the capital structure. The subordination to senior debt happens in two ways – senior lenders are often times, secured and subordinate mezzanine debt is unsecured. Secondly, the tenure of subordinate mezzanine funds is longer, which provides a cushion to senior debt. This means that in case a business goes bankrupt, the senior lender recovers dues first, followed by the mezzanine provider and finally the promoter/equity provider gets his/her share. Obviously, since the risk is higher in mezzanine instruments, the cost of funds tends to be higher.
Mezzanine financing, while more expensive than senior debt, also poses certain advantages to non-bank originators (established as NBFCs) that balances the cost of raising capital –
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Mezzanine funds, due to their innovative structure are classified under Tier II capital. Non-bank originators can leverage this capital with banks to raise additional funds. This effectively reduces the total cost of funds. For example, Tier II capital can be used to leverage bank finance up to 5 times. Hence for every 1 rupee of mezzanine debt raised, a maximum of Rs 5 can be raised as senior debt from a bank. If the interest rate for the mezzanine debt is 30% and the interest rate for the senior debt is 12%, the total interest paid would be 90 p on total debt of Rs 6. This is 15% of the loan amount and only 3% more than the cost of debt from banks.
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Mezzanine funds can also help in adhering to capital adequacy norms. For instance if the total risk weighted assets of a non-bank originator is Rs 100 and its networth is Rs 10. The CRAR (Capital to Risk-weighted assets Ratio) is 10% which is below the prescribed norm of 15% (effective from April 2011). If the non-bank originator were to go for an alternate capital structure with Rs 10 equity and Rs 5 worth sub-debt then the CRAR would become 15%, which is the prescribed, minimum CRAR.
Non-bank originators cater to households with highly complicated financial lives and the slightest shift in the provision of continuous, flexible, reliable and convenient access to financial services can trigger a setback in the intricate financial lives of low-income households. It becomes imperative therefore for a rigorous and effective due diligence process to be in place before access to mezzanine debt is made available to non-bank originators. IFMR Mezzanine Finance Private Limited, whose objective is to provide deserving non-bank originators access to long term funds through mezzanine products, has a thorough and comprehensive due-diligence process. It scrutinises and defines standards for a range of parameters including leadership, financial performance, processes, products and strategy.
Saurabh, from IFMR Mezzanine who works for the due-diligence team, sums up the characteristics of the “ideal candidate” to receive mezzanine funding, as we put it to him – ‘good promoter background, sound governance, standard processes and robust systems, established lending relationship with a bank which will be crucial to their ability to leverage the mezzanine funds, sound audit and internal control systems and finally good risk management practices’, he says. A little surprised by the weightage to financial parameters in the exhaustive list, we ask him if an indicator like PAR (PAR or Portfolio at Risk is the outstanding amount that is overdue past a certain period of time and is measured by dividing the Outstanding amount on loans overdue past a given date by the Gross loan portfolio outstanding) does not have any influence on their assessment of how strong the non-bank originator is. ‘PAR is important for a short term lender. From a long term stability point of view, it is important to examine the volatility in PAR. A high volatility is an alarming indicator, while a consistent PAR, while high is still indicative of stable processes’, says Saurabh.
Mezzanine funding is an innovatively engineered financing option, which seeks to offer non-bank originators much-needed capital. Due to its unique structure mezzanine funds can be employed to fuel growth, to seek standard funding and even to adhere to regulatory capital norms without any dilution in the promoter’s stake. Mezzanine financing, which was earlier only part of buy-outs and venture capital deals, can now fill the capital vacuum in the microfinance sector, provided, investments are backed by a rigorous due-diligence process that evaluates not only financial performance but also lays down benchmarks for corporate governance, best practices, systems, processes, risk-management and strategy.
With inputs from Jayshree Venkatesan, IFMR Mezzanine
