Hybrid instruments in the middle of small business investor


6. Hybrid instruments34
285. Hybrid financing instruments lie in the middle of the investors’ risk/return spectrum, from “pure”
debt to “pure” equity, combining features of both debt and equity into a single financing vehicle. These
instruments differ from straight debt finance, in so far as they imply greater sharing of risk and reward
between the user of capital and the investor. The latter accepts more risk than a provider of a senior loan and expects a higher return, which implies a higher financing cost for the firm. However, the risk and the
expected return are lower than in the case of equity, which thus implies the cost of financing for the
enterprise is lower. In the event of insolvency, where the firm is unable to meet all its contractual
obligations, investors in hybrid instruments have lower rankings than other creditors, but higher ranking
than investors in “pure” equity capital.
286. Some of the most commonly used hybrid instruments include: i)

 subordinated debt (loans or
bonds); ii) participating loans, with profit or earning participation mechanisms; iii) silent participation; iv)
convertible debt and warrants, whereby investors can convert debt into stock, thus receiving a reward that
reflects the increased value of the company enabled by the capital provision, and; v) mezzanine finance,
which combines two or more of these instruments within a facility.
6.1 Subordinated debt

 Subordinated debt is composed of loans or bonds in which the lender agrees that senior or
secured creditors will be fully paid before any interest or principal is paid.
288. Subordinated loans (or junior debt) are unsecured loans where the lender’s claim for repayment
in the event of bankruptcy ranks behind that of providers of senior debt but ahead of equity investors.
Subordinated loans usually carry a specific rate of interest, which is independent of the state of the firm’s
finance. The provider of financing is entitled to this payment under all conditions, subject only to the
condition that senior debt holders must be paid in full before any payment is made to subordinated debt
holders. Principal is usually repaid in “bullet” form, i.e. at the end of the loan. In some instances, the
facility may provide for payment in kind (PIK) in which both interest and principal are paid at the loan’s
maturity. In this case, it carries a higher interest rate than one where interest is paid throughout the course
of the loan.
289. Subordinated bonds are unsecured bonds that offer the investor periodical interest payments
(coupons) and full redemption at maturity. In the event of liquidation or bankruptcy, the claims of
subordinated bond holders are inferior to those of senior creditors, but are superior to those of
shareholders, because their bond coupons have to be honoured before any share dividends can be
distributed by the firm. The interest rate tends to be significantly higher than that of non-subordinated
bonds, to compensate for the higher risk

6.2 Participating loans
290. Participating loans are loans whose remuneration is contingent upon the results of the debtor firm
rather than being fixed. The remuneration can be linked to the firm’s sales or turnover, profits or share
price. On the other hand, participating loans do not share losses. In the event of bankruptcy, providers of
participating loans share in the results of the liquidation in the same way as other loan creditors.
291. Sales or turnover participation rights provide the investor receives with a payment based upon
the performance of the firm, in terms of revenue, turnover, or earnings. Both the interest rate and the
capital repayment can be linked to this performance and the payment can take the form of PIK, i.e.
received at the maturity of the loan. 

292. Profit participation rights are equity investments that entitle the holder to rights over the
company’s assets (e.g. participation in profits or in the surplus on liquidation, subscription for new stock).
The owner of the profit participation right is not a shareholder of the company and is not entitled to
ownership rights, including voting rights and the right to attend the company’s shareholders’ meeting.
However, profit participation rights are not defined by law and can therefore to a large extent be negotiated
and designed to suit the parties. They can be designed to resemble borrowed capital by contractually agreeing on minimum interest payments which are independent of the company’s profits or resemble
equity capital if they grant the right to participate in the company’s profits and/or liquidation proceeds.

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