Initially used in the 1980s for leveraged buyout transactions [where public companies were converted to private entities], it is now a frequent element in most property development schemes.
A quasi-equity, quasi-debt position, mezzanine can be a powerful tool to fund new developments, but a dangerous line item to have on your books if not understood and handled correctly from day one.
What is Mezzanine?
The single most important fact about mezzanine is that, quite simply, it reduces the amount of equity you need to put in to a project. This is particularly useful when you don’t have significant liquid assets, or if you want to spread your available cash across multiple schemes and therefore reduce the individual risk.
Mezzanine fits in after senior debt, but before the developer’s equity. This means that when monies are repaid, either by pre-sales or in the event of a default, the senior debt takes first priority, followed by the mezzanine. As the developer, your own equity is therefore most at risk but naturally you will have entered into this project betting on your ability to repay the entirety of debt without too many difficulties!
What are the benefits?
When used correctly and prepared for sufficiently, mezzanine can bring a whole host of advantages to a development project.
It is more cost effective than an equity or JV structure, which usually requires a profit split of some sort. It allows costs of capital to be kept comparatively low, as well as maximising returns on developer equity without having to give away the lion’s share of the end profits to another party. Granted it is more expensive than senior-charge bank debt, but it should [in theory] be less expensive than the total returns of the project itself.
Because it comes from private sources, mezzanine financing is more flexible with its covenants and can take on riskier positions than banks would normally approach. Where banks may draw the line anywhere between 50-70% funding, mezzanine can often go as high as 90% total costs, depending on their belief in your capabilities, the scheme and the current market.
When you come to the table armed with sufficient knowledge and experience, but not enough capital, mezzanine funders can be seen as strategic, long-term partners for multiple schemes. They not only offer their funds, but more often than not they are themselves ex-developers or long-term development funders and therefore can provide practical advice on the scheme itself to maximise value and therefore realise greater profits. Not being a JV partner, the mezzanine funders don’t benefit directly from this, except to enable you to achieve at minimum the original GDV and therefore they will be certain their funds will be returned.
Provided you work to schedule and allow for adequate time and cost contingencies, mezzanine funders will very rarely interfere, taking the sidelines until needed, or upon exit of the loan.
Why does Mezzanine have a poor reputation?
As with all areas of finance, mezzanine carries a very real risk when things do not go according to plan, including the potential threat of taking control of the project in the event of a default, after repaying the senior debt. To avoid this, they can impose certain covenants which may at times seem restrictive.
Entering into additional loans might be prohibited, for example mortgages or other development projects – this is more often in the case of developers with higher risks and lower personal assets, where they might struggle to pay out in the event of something going wrong. You may be required to spend money in a certain way, either by employing a project manager if it is felt you and your team’s own ability may not be sufficient, or to carry out additional surveys and reports.
Mezzanine is more expensive than senior and stretched senior debt; some funders can command as high as 25%+ all in, and can get away with doing so because of the demand in the market. Not only that, it can take some time to agree and arrange. From initial enquiry to drawdown can take several months. This is largely due to the mezzanine lender being put in such a position of risk with the project that in order to feel comfortable, they need to know the ins and outs of all elements of the scheme, developer track record and quite often the developer’s financial history.
While these points may at times feel excessive and unnecessary, the important thing to remember is that you have a scheme you believe in, but not enough money to carry it out. For the rights to someone else’s money, you need to give them the trust and belief in you and the scheme, and then you’ll be in the money.
Mezzanine lending from the lender’s point of view:
No two mezzanine loans are alike; they are highly tailored to each client, project and amount, usually influenced by the position in the debt structure, local market conditions, size of the loan and its duration.
From a lender’s point of view, no matter what your previous credit history is like, or how highly geared you need this scheme to be, or if this is actually the “perfect” scheme, there is one thing above all else that can ruin your chances of getting the funds: quality of information.
It’s very easy to put down headline information on an email, but do you have supporting sales figures for the GDV? Are more homes and flats selling in the area similar to your 2,000 sq ft apartments, or in fact are there more flats selling for 1,000 sq ft? Why do you believe in this scheme, and why should we?
Many developers we work with have all the information in their heads; sadly [or thankfully] we aren’t mind readers so you need to come to the meetings with us well-prepared with everything in writing. It isn’t enough for us to be told that “so and so contractor can do it for under £150 sq ft”; we haven’t met them and we don’t trust them, so we need hard evidence, especially when we might see other builders not going below £200 sq ft [for example].
We understand that time is of the essence with many of our clients, but if we don’t have exactly the information we need, it will be a case of question-email-tennis until we are confident we know the scheme as thoroughly as you do [or should!]. At the end of the day, it’s about trust – in you and your scheme.
Our advice to any developer is this: come to us with an initial pitch, but be ready to follow up with the full information on the project, your experience and any information we should be aware of immediately after. Be prepared for us to need to ask questions; don’t be offended, it’s how we are learning about you and building our confidence up. We want to give you the money [after all, we’re in it for the returns just as much as you are], but we are the ones taking most of the risk.
Mezzanine is a handy type of finance to have when you don’t want to or can’t put in the 35-45% shortfall into a project behind most senior banks. When the risks are understood correctly, it can enable you to generate higher returns on lower amounts of equity. On the flip side, it can be prohibitively expensive when things don’t go according to plan.
Attributed to Laura Jane McCauley of Imperial Blue Finance