Debt financing — bank loans, bonds, convertibles, mezz — Financing Module 5

Debt financing creates a fixed claim on the company's cash flows in exchange for cash today. Unlike equity, lenders don't share in upside — they just expect to be repaid. Unlike equity, missing a payment can trigger default and ultimately bankruptcy. Debt is cheaper than equity (lower required return; tax shield) but riskier to the company itself.

Bank loans vs bonds — the two main forms

Bank loans: privately negotiated with one bank (bilateral) or a group (syndicated). Faster to arrange (4-12 weeks vs 12-24 weeks for bonds). More flexible (terms can be customised, covenants negotiable). Smaller (typically <KES 10bn / $100m). Relationship-driven — your house bank earns the right to lend by being responsive over time.
Public bonds: issued to many investors via the capital markets. Slower (needs prospectus, ratings, roadshow). More rigid (terms standardised; covenants set at issuance). Larger ($100m+ typically). Disclosure-driven — bondholders rely on public information.

Convertibles — debt with embedded options

A convertible bond pays a coupon like a regular bond, but the holder can convert it into a fixed number of shares of the issuer's stock at a defined ratio. If the stock rises above a threshold (the 'conversion price'), the holder benefits from equity upside; if it doesn't, they keep collecting the coupon and get principal back at maturity.

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Example: KES 1bn 5-year convertible bond
  Coupon: 5% (vs ~13% for straight bond — the 8% discount is the
          embedded option premium)
  Conversion ratio: 100 shares per KES 100,000 face
  Conversion price: KES 1,000 (vs current share price KES 800)
  Soft call: issuer can force conversion if stock trades above 130%
             of conversion price for 20+ days

For investor: bond floor (principal + coupon) + equity upside
For issuer: low cash interest + potential future dilution

Convertibles are particularly popular for growth companies with
uncertain near-term cash flows but high option value if successful.

Convertibles are bonds with an embedded equity call option. Pricing involves both bond pricing and option pricing.

Mezzanine — between senior debt and equity

Mezzanine debt sits below senior bank debt and senior bonds but above equity in the capital stack. It's typically used in: (1) leveraged buyouts to fill the gap between senior debt and equity contribution; (2) growth companies that can't borrow more senior debt but don't want to dilute equity. Structure: 10-15% interest rate, often part PIK (paid-in-kind, accruing rather than paid cash), plus equity warrants giving 1-5% of equity on conversion. Mezzanine providers expect IRRs of 15-20% inclusive of the warrant upside.

The capital stack from a lender's perspective

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Seniority      Instrument                Typical pricing (Kenya, 2026)
────────────────────────────────────────────────────────────────────
Most senior    Senior secured bank loan  T-bill + 3-5% = 16-18%
               Senior unsecured bond     T-bill + 4-6% = 17-19%
               Subordinated debt         T-bill + 7-10% = 20-23%
               Mezzanine                 18-22% all-in (cash + PIK + warrants)
               Preferred equity          20-25% IRR
Least senior   Common equity             ~22%+ Re via CAPM

Each step down the stack: higher expected return, but also higher
risk of loss. In a workout, senior debt gets paid first; mezzanine
fourth; common equity last (and often nothing).

The capital stack from a Kenyan corporate's perspective. Pricing approximations — real terms depend on the specific issuer's credit profile.

Why a company would use multiple debt layers

A typical LBO might have 50% senior bank debt at 14%, 20% high-yield bonds at 18%, 10% mezzanine at 22%, and 20% equity contribution at 25%. WACC: ~17%. If the deal returned 22% pre-financing, the equity returns ~35% IRR after debt service. The leverage is what makes the equity returns attractive. Without the multiple layers, the equity holder would either need to fund more (lower returns) or the deal couldn't close at all.

Exercise

A growth-stage Kenyan technology company has 3 years of profitability but isn't quite IPO-ready. They want to raise KES 1.5bn to accelerate. They're a thin asset business (no real collateral). What instrument would you recommend, and at what terms roughly? Compare to a convertible bond.