Mezzanine Financing

Mezzanine financing is a form of funding that combines debt and equity. It provides the lending entity the right to convert a loan into equity in the case of a default. 

Through this financing, the lender will only receive the equity after all other senior debts are paid off first. For example, venture capital (VC) companies and other senior lenders must be paid first before the lender of mezzanine debt. 

Mezzanine debt has warrants attached, which are embedded equity instruments. These warrants raise the value of the subordinated debt and increase flexibility when working with bondholders. 

Usually, mezzanine financing is used for acquisitions and buyouts to prioritize new owners over existing owners in the case of potential bankruptcy. This method of financing is a way for firms to fund specific projects through a hybrid of both debt and equity financing. 

Also, this type of financing is usually used for company expansion, as opposed to funding start-ups or early-stage companies. 

Mezzanine funds are pooled investments (like mutual funds) that provide highly qualified businesses with mezzanine financing. 

Investors typically see generous returns through financing with mezzanine debt compared to typical corporate debt. This type of financing often pays between 12% and 20% per year. 

Like preferred equity, mezzanine financing is subject to being called in and taken over by lower-interest financing, especially if there is a significant drop in the market interest rate. 

what is mezzanine financing? 

It merges debt and equity financing. It is one of the riskiest debt structures. In terms of seniority, it is above pure equity but below pure debt. This means that it also provides investors with higher returns compared to other debt types. 

This type of financing may be viewed as very expensive debt or as cheaper equity because of the higher interest rate mezzanine funding carries. 

The interest rate is higher than the senior debt that companies would instead have through their banks. At the same time, the interest rate is lower than equity regarding the overall cost of capital. 

Additionally, compared to equity, it is less dilutive of the share value of a company. 

The overall objective and result of mezzanine financing are to allow a business to build more capital and increase its return on equity. 

Typically, if a company has short- to mid-term growth projects that need funding, it will turn towards this type of financing. The usual investors in this type of financing are a company’s long-term investors and some existing capital funders. 

A mezzanine loan leaves a company with some free capital to use because it only requires interest payments before maturity.

Mezzanine Financing Structure

As mentioned, mezzanine debt exists between senior debt and common stock in a company’s capital structure. It exists as either subordinated debt, preferred equity, or a combination. Most often, the structure for mezzanine financing is unsecured subordinated debt.

Subordinated debt is debt owed to an unsecured creditor. The debt can only be paid after secured creditors are first paid. It stands below more senior debts or securities in terms of its capacity to recover a company’s assets or earnings. 

If a borrowing company defaults, the holders of subordinated debt are not paid until all senior lenders are fully paid. Essentially, unsecured subordinated debt is only backed by a company’s promise to pay the lender. 

1. Maturity

The typical maturity is five or more years. The maturity date of any debt or equity is usually heavily dependent on the debt maturity dates that already exist in a borrowing company’s financing structure. 

2. Redemption

Loan redemption is the full repayment of a loan on or before its maturity date. A company may exercise redemption if there are lower market rates that would allow the company to call in and re-issue debt and equity at lower interest rates. 

3. Transferability

Usually, mezzanine lenders have full transfer rights to their loans. On the other hand, preferred equity typically has restrictions on transferability.

when to use mezzanine financing?

Mezzanine financing is a type of financing that is often used in growth capital, acquisition funding, and Shareholder liquidity and intergenerational transfer.

1. Growth capital

Using a mezzanine structure to raise capital is especially useful for certain companies that may not have access to commercial paper or the extensive funding resources of larger companies. 

Using mezzanine debt to finance capital expenditures (like research and development or market expansion) is advantageous because it is cheaper than equity and is more flexible than senior debt. 

2. Acquisition funding

For acquiring companies, mezzanine capital is a cost-effective alternative to financing M&A expansion through raising outside equity. 

In regards to funding an acquisition, mezzanine financing has several benefits. First, lenders of mezzanine debt rarely put a ceiling on their loan amounts. Also, mezzanine loans are typically more accessible because assets do not secure them. 

Since mezzanine debt does not amortize, the principal does not have to be paid down. This frees up cash flow for the borrowing company to pay off senior loans and other business expenses. 

3. Shareholder liquidity and intergenerational transfer. 

Using mezzanine debt, owners of private companies can gain liquidity and diversify their financing structure without having to sell the business.

An intergenerational transfer is a transfer of ownership from one shareholder to another current company shareholder. Since mezzanine debt is less dilutive and expensive than equity, there are fewer capital requirements and shareholder restrictions. 

Advantages and disadvantages of Mezzanine Financing

Like any other product or financial service, both lenders and borrowers must consider the advantages and disadvantages of mezzanine financing.

Advantages

The advantages associated with this type of funding are as follows:

1. Immediate equity: Lenders (or investors) can gain immediate equity in a company or obtain warrants to purchase equity in the future. This has the potential to increase a lender’s rate of return significantly. 
2. Contracted interest payments: Lenders of mezzanine debt are contractually obligated to receive scheduled interest payments that are either issued monthly, quarterly, or annually. 
3. Tax-deductible interest: Borrowers of mezzanine debt benefit from paying interest that is a tax-deductible business expense. Because the interest is tax-deductible, it significantly decreases the total cost of the debt. 
4. Manageability: This method of financing is relatively manageable compared to other debt structures. This is because borrowing companies can move their interest to the balance of the loan. Essentially, a borrower can defer interest if they cannot make a scheduled payment. 

Disadvantages

The disadvantages associated with this type of funding are as follows:

1. Loss of equity: Using mezzanine financing, business owners may have to forfeit some control of the company and upside potential due to loss of equity. 
2. Potential activist investors: It is possible that lenders may have long-term goals for the company they are investing in and could potentially demand a board presence. 
3. Increasing interest: Borrowing companies have to pay more interest the longer they use mezzanine financing. 
4. Restrictive covenants: Mezzanine loan agreements often limit the borrowing company’s ability to borrow additional funds or refinance senior debt. They may also set financial ratios the borrowing company must meet. 
5. Bankruptcy: If the borrowing company were to go bankrupt, mezzanine lenders risk losing their investment because senior debt holders receive payments first through liquidating the borrower’s assets. 

Example of Mezzanine Financing

An example would be if Bank X provides Company Y, a producer of water bottles, with $20 million in mezzanine loan financing. The funding replaced a higher interest $15 million credit line with more favorable terms.

Company Y gained more working capital to bring more water bottles to the market and paid off higher-interest debt. 

Bank X will collect 5% per year in interest payments and can convert the debt into an equity stake if Company Y defaults. Additionally, Bank X was also able to prevent Company Y from borrowing any additional funds and enforced specific financial ratio standards. 

We can contrast this example of mezzanine financing with an example of equity financing:

In a preferred equity example, Company A issues Series B 5% preferred stock with a value of $250. The stock will pay scheduled dividends when funding is available until the maturity date.

Mezzanine Financing Example in Real Estate

Suppose you want to buy commercial real estate valued at $1.5 million.

1. You could finance using a traditional bank, which would offer you $800,000. The bank might offer that loan with an interest rate of 5% per year. 
2. To buy the property, you must put up $300,000 of your cash. 
3. Assuming the property will earn you $250,000 per year, $50,000 of that would go back to the bank in interest payments.
4. This leaves behind a profit of $200,000. After taxes, your profit will be around $120,000, which would be a return of 40% on your $300,000 investment. 
5. To lower the amount of equity you put into the property, you can use a mezzanine investor to add an additional $100,000 at 15% per year. 
6. This would leave you with $200,000 in equity. The bank would continue to get $50,000 in interest payments. However, the mezzanine investor would get $15,000, making your after-tax profit $105,000. 

Ultimately, that would be $105,000 from a $200,000 investment. That is a return of 52.5%, which is exceedingly high. 

Researched and authored by Rachel Kim | LinkedIn

Reviewed and edited by James Fazeli-Sinaki | LinkedIn

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