By Paul Wilson, Chief Investment Officer, Channel Capital Advisors LLP
The past 12 months have been marked by significant economic headwinds, such as soaring inflation and rising interest rates. These factors have caused unprecedented challenges for businesses, consumers, investors, and governments globally.
Against this complex macroeconomic landscape, an emerging trend is gaining ground in the global capital markets: the demand for mezzanine and growth funding in the fintech lending industry is on the rise. Indeed, its role in facilitating lending activity is becoming increasingly vital in the current economic climate.
This demand is being driven by a variety of factors, including the continued rise of fintech lenders as a credible alternative to traditional banks, as well as the growing appetite among investors for higher yields and greater diversification in their portfolios. Indeed, fintech startups across the UK raised $12.5bn in 2022 despite the economic headwinds at play. This followed a record year of investment of $39bn from private equity and venture capitalist firms in UK fintech.
Mezzanine finance has also been important in supporting SMEs who may find it challenging to access traditional bank loans or private equity funding. Given the ongoing economic uncertainty and volatility and the decline in SME bank lending, smaller businesses are crying out for capital that can support their growth and expansion plans. Mezzanine finance can bridge this gap by enabling lenders to provide SMEs capital that they would be unable to secure through traditional lending routes.
Yet for many, there is a need to raise awareness and knowledge of what mezzanine finance entails, how it works and why lending companies would seek it.
Demystifying mezzanine finance
Mezzanine financing is a type of funding that sits below senior debt, typically from a bank or institutional investor, and above equity capital in a company’s capital structure. As a hybrid financing instrument, mezzanine finance provides borrowers with flexible capital that combines the characteristics of both debt and equity.
Named for its place in the capital structure, mezzanine financing is considered junior capital and has a lower priority of repayment compared to senior debt in the event of a company’s default.
Mezzanine finance can facilitate a wide variety of transactions, but its role is becoming increasingly important across the lending space. Let’s examine why.
For alternative lenders, securing enough capital to lend can be a challenge. Sometimes, a larger investment from a senior debt provider is needed to expand their loan book. This senior debt typically makes up the bulk of the “funding stack,” which is the pool of money that can be deployed in the form of business loans.
However, in the current economic climate, senior lenders are becoming more risk-averse, which can make it harder for alternative lenders to secure senior debt at historical levels. Indeed, some senior lenders are adding more conservative features, such as lower advance rates and greater subordination levels, which can make it more difficult for alternative lenders to obtain the necessary funding to issue loans.
Consequently, alternative lenders are turning to mezzanine finance to develop a stronger funding stack. Mezzanine financing involves securing an additional level of financing from a third-party investor, which is used to support the lender’s own equity position. This creates a greater buffer between the senior debt provider and any potential losses incurred by the lender.
For example, let’s say a business lender needs a pot of capital of £100 million to issue loans to small businesses. However, they only have £15 million of their own capital available. By working with a mezzanine finance provider, they could secure an additional £15 million of capital. This would create a stronger funding stack of £30 million, putting them in a better position to access the £70 million of senior debt they need from an institutional investor or bank at more attractive funding rates.
Weighing the risks
Mezzanine finance typically carries a higher cost than senior debt, with interest rates starting in the mid-teens. This is because the mezzanine finance provider is lower down in the repayment hierarchy and will only receive repayment once the senior debt has been fully satisfied. Since senior debt has a lower risk of incurring losses due to the buffer provided by the lender’s own capital and combined with the mezzanine investment, it is able to provide more capital at a lower cost than mezzanine finance.
The buffer provided by mezzanine finance is particularly important for senior lenders in times of economic uncertainty, when the risk of higher default rates is greater. Therefore, there is growing demand for mezzanine finance as a means of building a robust funding stack that will then receive the backing of a senior debt provider.
As explained above, mezzanine finance has a critical role to play in enabling fintechs’ lending activities, particularly with small and medium-sized enterprises (SMEs).
SMEs are the backbone of the economy. According to government data, in 2021 there were 5.548 million small businesses (with 0 to 49 employees), making up 99.2% of the total business population. Further, turnover from SMEs was estimated at £2.3 trillion. However, smaller businesses are struggling in today’s challenging economic climate.
Smaller businesses with tighter finances and fewer cash reserves are likely to fare worst in a financial crisis. According to recent research by Lloyds Banking Group, 82% of SMEs state that the rising cost of living has had a negative impact on their business.
The impact this has had on businesses includes rising rent, bills, the cost of commodities, problems with the supply chain, and higher wages to support their workforce. At the same time, inflation is reducing the spending power of consumers.
Moreover, Channel’s own research, carried out in September 2022 among more than 500 UK SMEs, found that 59% of small businesses currently need funding to ease day-to-day cashflow issues and more than two-thirds (68% or 3.8 million) need funding to grow. Yet 47% feel high-street banks are reluctant to lend to smaller businesses.
As well as a reluctance to lend due to their high-risk perception, the financing processes at traditional banks are often slow and impersonal, as many of these institutions have been slow to fully adopt technology-based digital lending.
As such, more SME lending is required. But if SME lenders cannot secure attractive funding terms to on-lend to their clients, a vicious cycle is created. This is where innovative fintech plays a vital role, with alternative lenders stepping in to fill the funding gap. And mezzanine finance is key in facilitating this.
High inflation, rising interest rates, and greater corporate default rates are anticipated to continue throughout much of this year. Accordingly, we are likely to witness continued strong demand for mezzanine financing from alternative fintech lenders. And as awareness of this important funding source spreads, it will only increase the lending industry’s flexibility and agility, which is crucial for SMEs and the economies they support.