Private Equity and Mezzanine Financing: Is it the answer to Kenya’s SME financing challenge?
The lack of access to finance is one of the most prevalent challenges entrepreneurs and business owners face. Due to the interest rate regulation, Kenyan banks are now much more selective, preferring to focus their efforts and credit on larger corporates which have good borrowing standing and the advantage to offer collaterals.
In September 2016 the banking sector in Kenya started to operationalize the Banking (Amendment) Act 2015. This law sought to set the maximum lending rate at no more than 4% above the Central Bank rate. With this regulation, banks became more risk averse towards borrowers since they could not charge higher rates to compensate them for the additional risk they were taking.
The perception exists among many local banks that Small and Micro Enterprises (SMEs) have insufficient assets or collateral, making them a riskier and therefore less desirable proposition. When banks do decide to lend to small and medium sized enterprises, the terms offered are often unsuitable, given the stage of the respective company.
Banks fail to tailor debt-service schedules according to a given business plan, and tenors are often very short term, usually three years, which is not the type of patient capital small and medium sized companies need to grow. There is typically a mismatch between the debt structure and the entrepreneur’s business plan. This lack of access to bank loans leaves the SMEs to the other available option of turning to private equity and venture capital for early stage and growth capital.
The two sources of alternative finance often provide capital in form of either Mezzanine financing or Equity financing. The two forms of financing are gaining popularity as they are seen to provide capital which is lacking in the SME sector.
Mezzanine financing is not pure debt and is not pure equity, but can be anything in between. Mezzanine debt is privately negotiated and the structure of a mezzanine deal will vary by transaction, and ultimately depends on the cash flow profile of the company, but there are common pillars that drive the composition of a mezzanine investment.
The first is the contractual element, comprising both cash interest and PIK (“pay-in-kind”) interest, which accrues and is paid when the loan is repaid in full (a benefit of PIK interest is that it enables the company to efficiently defer payment of a portion of its interest, reducing the immediate financial burden on its cashflows thereby allowing it to invest cash into growing its business). The second component of a mezzanine instrument is the equity kicker or performance-based which through a variety of mechanisms entitles the investor to acquire or have a right to an equity stake in the company at a fixed price for a fixed percentage that is agreed upfront. Mezzanine financing are usually subordinated / unsecured loans which therefore bear high risk compared to Senior Secured loans and investment in preference shares.
The equity kicker ensures an alignment of interest between the entrepreneur and the investor as a portion of the investor’s flows come from the equity accretion in the company. By combining the contractual claim of a debt instrument with the potential capital gains from equity-linked instruments, investors can earn attractive returns while at the same time limiting the downside risk.
Mezzanine financing can address this funding gap that is present in the SME segment by providing an alternative that is more flexible than pure bank debt and by tailoring each investment to the company’s business plan and cashflows.
Unlike a private equity fund that might be looking to take a significant minority equity stake or control in the business, mezzanine investors only require a small minority interest due to their reduced return threshold. This is an attractive component of mezzanine financing for entrepreneurs or family owned businesses who look to retain control.
The other form of financing, Equity financing, is where the entrepreneur cedes part of shareholding to the potential investor. This form of financing provides most patient capital to a business. With this form of financing most investors have different criteria in form of equity stake they seek and amount of financing they can provide to an SME. Coupled with the two criterion the investor also has to do a business valuation to ascertain the actual value of the business to enable structuring of the investment.
The two forms of financing are the best alternative for SMEs in Kenya. To be able to access the Private Equity funds, it is always advisable that the SMEs put proper company structures. Owing to the challenge of accessing credit from banks Kenyan SMEs must now embrace other forms of financing to unlock their potential.
Redacted versions of this article were originally published in the Daily Nation and The Standard on Thursday 8th August 2019 by Eric Magu