6.1 Introduction 287Mezzanine funding can therefore be an important part of the firm’s funding
mix. In particular, subordination can make it easier to raise senior debt and reduce
its cost. First, subordinated debt can act as a cushion in the event of insolvency.
Second, subordinated debt can also be subscribed for by insiders in order to miti-
gate senior lenders’ agency problems. For example, in project finance, the spon-
sors of the project sometimes subscribe for subordinated loan instruments issued
by the project company. This may help: to manage the agency relationship be-
tween sponsors and external investors; to signal that the sponsors are committed to
the project; to mitigate external investors’ perceived risk exposure; and to raise
funding and reduce its costs.
Mezzanine financing can work as a functional equivalent to shareholders’ capi-
tal. At the same time, mezzanine instruments can be a way to raise funding with-
out diluting the holdings of existing shareholders.
Some forms of mezzanine financing (such as Genussscheine, German participa-
tion certificates)^13 can be regarded as equity capital on the balance sheet of the
company for accounting purposes. Some forms of mezzanine financing can be re-
garded as equity capital for the purposes of company law or tax law.
Mezzanine instruments can also be used because of their impact on the firm’s
credit rating. If the mezzanine instrument is recognised as an equity instrument
for credit rating purposes, the issuing of mezzanine instruments is a way to im-
prove the firm’s rating and borrowing capacity.^14
In addition, mezzanine loans issued by many debtors can be securitised and
placed on the market by mezzanine providers. Mezzanine financing is thus a ser-
vice product, and there is a market for securitised mezzanine loans.
A further reason to use mezzanine financing is transfer of risk. Risk can be
transferred for the benefit of senior lenders. It is characteristic of mezzanine fi-
nancing that junior lenders are exposed to a higher credit risk than senior lenders
are. Risk can even be transferred for the benefit of the firm, if the firm can raise
financing without obligation to repay it in times of financial stress.
Transfer of risk, destocking. The combination of a debt instrument and payment
terms that make the value of the instrument track the value of equity instruments
gives the firm a chance to transfer aggregated risks to those who invest in mezza-
nine instruments.
As said above, mezzanine instruments can sometimes be used as a functional
equivalent to equity. For example, shareholders’ capital might be replaced by con-
tracts that offer contingent claims or loan agreements with a variable interest rate
and variable repayment schedule that depend on the outcome of certain events (for
contingent claims, see Volume II). In such a case, there is a difference between a
normal high-yielding debt instrument and the mezzanine instrument. Depending
on the terms of the mezzanine instrument, its holders can take the first hit and their
chances to receive payment may be completely wiped out if a certain event occurs.
(^13) § 221(3) and § 221(4) AktG.
(^14) Wiehe H, Jordans R, Roser E, op cit, pp 222–223.