Small- to medium-sized enterprises (SMEs) have a multitude of funding mechanisms available to them. From government grants and alternative funding vehicles to traditional loans from banks, there are many ways for SMEs to get funding.
The funding SMEs get is determined by various factors such as business stage, revenue, market traction and, in some cases, the credit score of the business or founder. Now, it can be time-consuming to qualify for funding, especially for micro enterprises; however, for high-growth SMEs – usually mid-size enterprises – the funding can get quite tricky.
As a high-growth SME, you need to start considering other forms of funding to help you reach your goals. This can be anything from equity funding, pricey business loans or a much less used funding mechanism: mezzanine financing.
In this article, we outline what exactly mezzanine funding is, how it works and give you an example of such a deal by one of the country’s best mezzanine funders.
What is Mezzanine Financing?
Mezzanine financing is a non-traditional form of funding that borrows against shares of the company, meaning that if the borrower defaults, the lender receives shares to cover the debt. It is the last resort for businesses that desperately need a loan but cannot get approved by traditional lenders.
This only happens when the company is unable to clear senior debt before acquiring a new loan. Whenever equity funding is needed, the equity funding gap can be filled with mezzanine debt to prevent shareholders from giving up too much equity and suffering too much equity dilution.
Structure of Mezzanine Financing
Mezzanine financing exists in a company’s capital structure between its senior debt and its common stock as subordinated debt or preferred equity, or a combination of these two. The most common structure for mezzanine financing is unsecured subordinated debt.
Key structural characteristics
- No principal amortisation: Typically structured as “patient debt” where regular payments cover interest while the principal is repaid in a lump sum at maturity.
- Minimal or no collateral: Frequently unsecured or junior-lien, relying on cash-flow generation rather than hard asset pledges.
- Intercreditor agreements: Governed by legal contracts with senior lenders that outline default triggers, standstill periods, and payment subordination.
- Tax-deductible interest: Interest payments on the debt portion are generally tax-deductible for the operating business.
Kholo Capital’s Isambane Mining Management Buy-Out
Earlier this year, fund management company Kholo Capital, through its Mezzanine Debt Fund I, provided R275 million in mezzanine debt funding to support the management buyout of mining contractor Isambane Mining. The deal transitioned Isambane into a 100% management-owned and majority Black-owned and Black-controlled mining services company.
The management buy-out is a compelling example of mezzanine financing in action. The deal was successful due to various factors that other SMEs can learn from. Speaking to the founder of Kholo Capital, Mokgome Magoba, he outlined some of the critical success factors behind the transaction.
Importance of Credible Management Team(s)
The first factor he highlights is the quality and credibility of the management team. Because mezzanine loans are typically subordinated to senior debt and are often unsecured, investors rely almost entirely on the management team’s ability to execute their business plan to get paid back.
“Other SME management teams can learn that capital raising is not only about having a good business; it is about demonstrating leadership quality, creating alignment among stakeholders, and approaching the process with strong structuring discipline and commercial realisation,” explained Magoba.
Role of Predictable Cash Flow and Long-Term Contracts
Another important factor in the Isambane Mining transaction was its predictable cash flows and long-term contracts. Isambane provides open-cast mining operations, including drilling, blasting, loading, hauling, site rehabilitation, and day-work services. Also, the company operates under multi-year service contracts with tier-1 mining clients; this creates strong, visible and predictable revenue streams.
The lesson for SMEs? Not having long-term contracted revenue does not mean you are ruled out of mezzanine funding. You can still achieve it by demonstrating repeatability and resilience of earnings. Investors understand that not every business will have multi-year contracts, but they do want to see evidence that revenues are not purely opportunistic or one-off in nature.
Magoba says the SME founders need to focus on showing a track record of recurring customers, stable margins, strong customer retention, diversified revenue streams, and the ability to convert revenue into cash consistently.
“In essence, even where revenue visibility is lower, the business must still demonstrate that earnings are predictable enough to support the type of funding being sought,” he said.
Is Mezzanine Financing Right for Your SME?
Mokgome explained that to determine if mezzanine financing is the right vehicle for a business, there needs to be an assessment of various factors within the business. The most practical starting point is to assess the company’s cash flow profile, asset base, growth trajectory and intended use of funds.
Mezzanine funding is suitable for businesses that have strong underlying cash-generating capacity but need a more flexible repayment structure, especially in situations involving growth, acquisitions or shareholder transitions.
“Senior debt is generally most appropriate where cash flows are stable, assets can support security, and the business can meet scheduled amortisation and covenant requirements,” said Magoba.
Qualifying for Mezzanine Financing
To qualify for mezzanine financing, your business needs to demonstrate a combination of financing health, growth potential and strategic alignment with lender expectations.
Strong and Predictable Cash Flow
Lenders want to see that your business has strong and predictable cash flows to ensure debt servicing capabilities. A solid history of generating consistent earnings before interest, taxes, depreciation, and amortisation (EBITDA) is critical. To ensure that the mezzanine lender has some protection below the equity layer, which also absorbs initial losses.
Growth Potential
Your business must display clear growth potential. Mezzanine lenders typically look for companies with opportunities for expansion, acquisitions or other strategically advantageous initiatives.
Experienced Management Team
A strong, experienced management team with a credible track record of executing business strategies successfully is crucial for lender confidence.
Clear Use of Funds
Clearly defined use of funds, such as for acquisitions, growth, or recapitalisations, helps align the borrower’s objectives with the lender’s risk appetite.
Solid Business Plan
A comprehensive business plan outlining strategic initiatives, financial projections, and risk mitigation is critical.
Industry Position
A solid position within the industry, including competitive advantages or market leadership, increases a company’s attractiveness to lenders.
Equity Cushion
An appropriate equity cushion ensures that the mezzanine lender has some protection below the equity layer, which also absorbs any initial losses.
Financial Covenant Compliance
Willingness to adhere to financial covenants that protect the lender’s interests throughout the loan term.
Meeting the above criteria can help high-growth businesses secure mezzanine financing, allowing for capital access to support growth while balancing risks and requirements.
