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(Mckean, 2005. Law, 2005. Moles and Terry 1997). For example, Junk Bonds whether secured or unsecured are always subordinate to debts to banks and Subordinated debt that ranks behind other issues of the same class is referred to as junior debt. (Law, 2005).
Mezzanine finance, a typical example of subordinated debt is funding that possesses both equity and debt characteristics and it is usually provided by specialists’ financial institutions. This funding like other forms of subordinated debt carries a very high risk of default and as a result earns a higher rate of return than pure debt although less than equity. Mezzanine finance can be secured or unsecured. (Smullen and Hand, 2005).
Due to its mixed nature of both equity and debt characteristics, investors have the opportunity to earn interest alongside their equity stake in the company. (Terry and Brian, 2000). Mezzanine financing is also attractive to banks since it offers interest higher than that paid for senior debt especially in environments where competition makes it difficult for them to provide funding at the normal lending rate thus encouraging banks to embark on mezzanine financing as a means of earning higher returns. (Terry and Brian, 2000).
The borrowing base of potential takeovers in the UK has increased as a result of increase willingness by UK lenders or investors to provide mezzanine finance. For example, bids for the Gateway and Magnet companies in the UK involved very large amounts of subordinated debt and as such reflect the importance of mezzanine finance to borrowers in large acquisitions, were financing required is beyond the limits set by equity and senior debt providers in their own lending criteria. (Terry and Brian, 2000).
Terry and Brian (2000) assert that because inclusion of mezzanine debt allows a lower equity share as a percentage of the total funds provided than straight equity investment, equity investors prefer such inclusion in deal structures since it will improve returns to the equity shareholders. Including mezzanine in a deal reduces the investment required from equity investors by a percentage, which is higher than a reduction in their ultimate shareholding and therefore increases the overall return on investment.
Mezzanine finance has also been used as a strategy for leveraged buy-outs, corporate takeovers and other acquisitions. The first instance of using mezzanine finance in such a way was in the United States of America. (Terry and Brian, 2000). The first instance in the United Kingdom was for the buy-out of Evans Halshaw. (Terry and Brian, 2000).
Because of the separation of ownership from control and also as a result of information asymmetry between debt holders and the management of the company, it is has become a common practice that the loan agreement or indenture contains ratio covenants and other covenants so as to prevent the debt holders from losing their money in the event of insolvency or bankruptcy liquidation. In the preceding paragraph, we take a closer look at some of the covenants and assess their validity in actually providing protection to lenders or debt holders.
Covenants and Events of Default
Terry and Brian (2000) define Covenants as promises by the borrower to do or not to do certain things during the term of the debt facility.