Paul Wilson, Chief Investment Officer, Channel Capital Advisors LLP
Soaring inflation and rising interest rates have been the defining global economic trends of the past 12 months. Businesses, consumers, investors, and governments have witnessed seismic shifts that have taken place in the aftermath of the Covid-19 pandemic.
Set against this challenging backdrop, there is another interesting trend taking shape in the global capital markets: the rising demand for mezzanine and growth funding in the fintech lending industry.
Mezzanine finance has historically played a role in facilitating lending activity, which in the current economic climate has become even more critical following shifting market dynamics. 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.
What is mezzanine finance?
Mezzanine financing is a form of junior capital, sitting below senior debt, which typically comes from a bank or institutional investor, and equity capital.
Let us take it from the perspective of an alternative lender. The company some capital to lend, but not nearly enough to expand their loan book as desired – so it requires a larger investment from a senior debt provider, which will make up most of its ‘funding stack’ (the pool of money that can then be deployed in the form of business loans).
However, this is where shifting market dynamics are impacting senior lenders in the current economic climate. Some senior lenders are adjusting their risk appetite in the current economic climate, and inserting more conservative features including lower advance rates and greater subordination levels.
For some alternative lenders, this means it may be more difficult to secure senior debt at historical levels, in turn preventing or limiting lenders from being able to issue loans.
This is where mezzanine finance comes in. Lenders secure mezzanine finance to develop a stronger funding stack – combining with their own equity position an additional mezzanine level investment from a third party investor, creating a greater buffer between the senior debt provider and any potential losses incurred by the lenders (loan defaults, for instance).
Sticking with our very simple example: a business lender requires a £100 million pot of capital to issue out as loans to small businesses. It has £15 million of its own capital and then works with a mezzanine finance provider to secure a further £15 million. With £30 million already committed, it is in a better position to access the £70 million of senior debt it needs from an institutional investor or bank at attractive funding rates.
The rates and risks
Mezzanine finance is more expensive than senior debt, with interest rates typically starting in the mid-teens. That is due to the hierarchy of debt outlined above – the mezzanine finance provider only gets repaid once the original ‘senior’ debt repayments have been fully satisfied. As the senior debt provider less likely to incur losses (thanks to the buffer provided by first the lender’s own capital and combined with the mezzanine investment), it can provide more capital at a lower cost of funds than otherwise.
That buffer is of utmost importance to the senior lender in times of economic uncertainty, given the greater risk of higher default rates in more difficult economic circumstances. And so, demand for mezzanine finance to build a robust funding stack that will then get the backing of a senior debt provider is on the rise today.
Supporting lenders, enabling growth
As explained above, mezzanine finance has a critical role to play in enabling fintechs’ lending activities, particularly small and medium-sized enterprises (SMEs). This is of utmost importance as countries globally are seeking means of boosting economic growth post-Covid.
In the UK, there are some 5.5 million SMEs, accounting for 99.9% of the business population, three-fifths of the employment and around half of turnover in the UK private sector. However, SMEs 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. Indeed, a report from PayPal found that more than three-quarters (78%) of small businesses cite the rising cost of living as the biggest threat to their business. Inevitably, pursuing growth opportunities has become an increasingly challenging endeavour.
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.
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.
Mezzanine finance undoubtedly has a central role to play in breaking that cycle. It is one of the missing pieces in lenders’ funding stacks today, enabling them to access attractive senior debt and, in turn, enabling them to issue loans to SMEs crying out for financial support.
With macroeconomic trends like high inflation, rising interest rates and greater corporate default rates likely to continue in 2023, we should expect to see continued high demand for mezzanine finance by alternative fintech lenders. Indeed, the greater awareness and knowledge of this vital source of funding, the more agile and fluid a lending sector we can create – and there can be no mistaking how important that is for SMEs and the economies they underpin.
Paul Wilson is the Chief Investment Officer at Channel Capital Advisors LLP. Channel delivers better financial results for its partners and their B2B clients with non-dilutive capital. Channel recently closed the Channel Fintech Lending Fund I, which invests in mezzanine tranches of fintech lending portfolios. Over 15 years, it has managed over $20 billion of credit assets, including loans, working capital facilities, and securities, as a UK-based, FCA-authorised and regulated asset manager.