Last Updated: March 17, 2023
Want to know all about mezzanine financing and how it works? You’re in the right place!
Read on to find out all about it, including how it ranks compared to other forms of financing, and what are its advantages for the borrowers and lenders.
We’ve also included a useful example that will give you a practical layout of the overall cost and return in case you’re considering this option.
Let’s dig in!
What Is Mezzanine Finance?
When companies need to raise funds to finance a company expansion or achieve some other goal, they have a couple of options at their disposal.
Depending on the stage of business that the company is in, its industry, the amount of money it needs, the possibility to take a loan, different companies can choose different solutions.
In this article, we will explain one of the available options.
So, what is mezzanine debt?
It’s a term used to describe a hybrid debt that is subordinated to other types of debt, both from the same issuer (borrower).
It’s often associated with buyouts and acquisitions. In these cases, it’s used to give an advantage to the new owners ahead of the existing ones in case of bankruptcy.
This form of debt involves embedded equity instruments, entitling the lenders to convert their debt into equity.
Because it’s subordinated to traditional debt, it is associated with high risk. On the other hand, it also has generous returns.
Mezzanine finance is a hybrid of debt and equity financing. This implies that the lenders may turn their debt into an equity interest in case of default. Sometimes, the terms of the loan may also state that part of the debt is to be paid in equity.
|Did you know: This type of financing is often used when companies need additional capital and they exceed their senior lenders’ capacity. To further understand this relation, read more about what is senior debt.|
How Does Mezzanine Financing Work?
This type of financing has the features of both traditional debt and equity, and it stands in between them in the company’s capital structure. It’s subordinated to senior debt, but it has a higher priority than both common and preferred stock.
You can look at it as a higher costing debt, due to higher interest rates compared to senior debt, or as cheaper equity because it comes with less dilution and less overall cost of capital.
It’s also favorable because it allows existing owners to maintain control over the company.
Mezzanine loans are often seen as a more patient form of capital compared with senior loans. This is due to the extended period until they reach maturity, which is usually 5 but can take up to 7-8 years. Also, these loans don’t have any amortization prior to maturity. Until the loan reaches maturity, you would only need to pay off the interest.
What also sets this loan apart is the possibility of senior lenders pausing the interest payments in case the company faces some liquidity constraints.
Considering that these types of loans carry a more significant amount of risk, the lenders have a higher rate of return (RoR), usually from 12% to 20% a year.
You could also come across mezzanine funds – pools of capital created to invest in mezzanine forms of financing for recapitalization, growth, acquisitions, management, or leveraged buyouts.
In case of default, this type of financing includes subordinated loans with higher interest rates, flexible terms of repayment, and a possibility to convert into equity. But in case of bankruptcy, they’re among the last ones to get paid.
That said, this financing option does come with high interests as well as with warrants – a stake in the company’s shares which is typically included in the mezzanine plan, referred to as mezzanine equity. This means that in a case of default, the debt can be converted into an equity. In some cases, it may imply an equity stake over time along with the money paid out.
In Which Cases Does Someone Turn to This Form of Financing?
Let’s say you would like to buy a local business that makes $300,000 a year. The price that the owner is willing to sell out for is $2 million.
That’s quite an investment.
The good news is that you don’t have to provide all the funds by yourself. Let’s assume you get a senior loan of $1,5 million at an interest rate of 8%. That leaves you with a $500,000 investment.
In case you want to additionally lower the sum you’re going to invest, you may reach out to mezzanine finance companies. Let’s assume such a company provides you with an additional $300,000 at an interest rate of 20%.
Sounds like a lot, but this would leave you with a $200,000 in equity investment. Now it sounds better, right?
But let’s break it down and see what it means for you. Here is a calculation based on this mezzanine financing example (assuming that the tax rate is 35%).
|Annual return on the investment||39%|
If everything goes smoothly, the calculation above shows that you can have a significant return with a minimum investment.
|Did you know: Interest rates with this loan are tax-deductible, so you would only pay taxes for the amount you have left after paying the interest. To make sure you’re applying for a loan with a reputable company, find out how to check if a loan company is legitimate.|
Characteristics of Mezzanine Debt and Financing
Let’s break down exactly how this funding works:
The mezzanine has qualities of both a traditional loan and an equity, thus it is often referred to as a hybrid debt.
- In practice, this hybrid debt behaves more like a stock. Also, there is the option for the debt to convert to an equity.
- Due to often being an unsecured debt that is subordinated to other types of loans, mezzanine lending involves higher risks for the lenders. In case that the company goes bankrupt and there aren’t enough funds to repay all of its investors, this is the loan that gets repaid last, if there is money left.
- It’s no surprise that these types of loans have high-interest rates that vary between 12% to 20% a year or even higher.
- These loans usually reach maturity in 5 years or even later. Until that time, only interest is paid on a monthly, quarterly, or yearly basis, depending on the terms agreed. But in case that the mezzanine investment happened at the same time as a traditional loan, the latter will reach maturity first.
- Unlike regular stocks and bonds, the ones used as warrants on these types of loans are not traded. This makes them less liquid and their non-transferability has to be taken into account by the managers of the funds.
|The mezzanine financing definition states that it is a hybrid between debt and equity financing.|
|In case of default, lenders are entitled to convert their debt into equity.|
|This type of financing sits in the middle in a company capital structure; it’s a subordinate debt that has priority over the stocks.|
|This type of debt is among the highest-risk ones and therefore comes with high interest rates, often as high as 20%.|
|This option is often used in leveraged or management buyouts, acquisitions, etc.|
Return Sources of Mezzanine Finance
Due to the higher risk involved and less liquidity, the investors have a greater rate of return (RoR) for this type of financing.
Here are the ways that the return of their investment can happen:
Depending on the terms of the agreement, interest can be either fixed or a floating rate. The borrower regularly issues cash payments to the lender. It can be monthly, quarterly, or yearly, depending on the agreement.
Payable in Kind Interest (PIK)
In some cases, the borrower can pay interest not by payments, but through an increase in the overall amount borrowed.
In case of default, the lender has the right to convert the debt into equity and get the agreed portion of the company’s ownership using mezzanine securities.
The lender may agree to take a percentage of the company’s performance.
Often the lenders will charge this fee upfront upon closing the transaction to cover the administrative costs of the process.
|Did you know: These loans may include the possibility for the borrowers to defer an interest payment if they can’t manage it for some reason. This is normally not an option with other forms of loans.|
This type of financing, although it involves generous returns, is not available for all companies.
For the mezzanine lender to be willing to invest, a company must be well established within its industry, with a stable cash flow, consistent profitability, and a feasible expansion plan through IPO (initial public offering) or acquisition.
Considering the above, this is a prevailing financing option for well-established companies, rather than for start-ups or early phase financing.
|Did you know: Most of these types of loans are paid off with the regular profit of the company, so it’s no surprise that the lenders choose the companies they will lend to carefully. In order to convince the lenders that your business will achieve its goals and profits, you have to know how to write a business plan. It may also be a good idea to research the best business plan software to make sure your plan looks professional.|
Benefits of Mezzanine Financing
This financing method has certain advantages both for the lenders and the companies using these funds.
When it comes to the lenders, although there is high risk involved, this type of financing has its fair share of upsides:
Consistent Generous Returns
An investment in shares doesn’t guarantee regular payments. In this case, lenders are provided with regular interest payments on the agreed schedule until the loan reaches maturity.
The Downside Risk Is Minimized
When it comes to the worst-case scenario, the potential losses are secured with the embedded equity option.
The Option to Convert to an Equity
Mezzanine debt implies that the debt can be converted to equity. This is also very appealing if the company increases in value.
For the company borrowing the money, here are some of the advantages:
It’s Cheaper Than Equity and It Doesn’t Result in the Dilution of Stakeholders
When trying to raise funds, a company that chooses this way of funding over issuing stocks saves the capital, and the stocks remain under the control of the existing stakeholders.
The Interest Is Tax-Deductible
Even though pricey, the interest on these loans is tax-deductible which lowers the overall cost.
A Company With Mezzanine Capital Is More Likely to Obtain Loans From Banks
The lender is often an institutional investor and his presence gives additional security to the banks. If you’re interested in getting a loan for your company, you should get familiar with some of the most popular business loans out there.
Flexible Repayment Terms
This flexibility and the fact that lenders are often open for negotiations with this type of loan can be extremely helpful in case you’re struggling with cash.
To sum up, deciding on mezzanine funding allows you to create a cost-effective capital structure with the minimum cost of capital and maximum equity return.
|Did you know: Due to high interest rates in these forms of loans, companies often get a refinancing loan with lower interest rates and use it for mezzanine debt financing. If this sounds appealing, check out some of the greatest debt relief solutions.|
In case your company needs to raise funds, you now have all the information to decide whether this type of financing is the right option for you.
This form of funding can result in high returns. Although this may sound appealing, don’t forget that there are high costs involved and that there’s a possibility for the lender to convert the debt to equity.
With the help of the facts provided in this article, analyze the pros and cons and make a decision based on your company’s needs and possibilities.
It’s also known as a hybrid debt because it stands between debt and equity financing. Usually, it’s brought in a buyout to reduce the capital that would have to be invested by the equity investor. It’s one of the high risk debts but yields generous returns.
When this debt reaches maturity, the principal has to be paid off. Usually, the maturity of this debt is 5 years, but it is negotiable. If a company takes this loan at the same time as a senior loan, usually the mezzanine will reach maturity later.
The place of mezzanine financing in the company’s capital structure is between senior debt and equities. In case of bankruptcy or liquidation, senior debt and other debts get paid out first, after that comes the mezzanine, and at last, equities.
It got its name based on the analogy of its place in the capital structure. This financing stands between debt and equity, the same way as the mezzanine floor stands between two main floors of a building or between the ceiling and the floor.