Mezzanine Debt: What it is, How It Works, Pros, Cons & Examples
Debt is often necessary for businesses to grow and thrive. There are several different types of debt available, and it’s important to choose the right one for your company’s goals.
Mezzanine debt is a hybrid of debt and investment that helps companies bridge the gap between senior debt and equity. Accessing mezzanine debt can help with making major purchases, retaining asset control, and accessing funding when traditional debt and equity aren’t available.
This article will explore different types of mezzanine debt, how mezzanine financing works, and the advantages and disadvantages to help you determine whether mezzanine capital is the right fit for your business.
Table of Contents
KEY TAKEAWAYS
- Mezzanine debt happens when a debt issue is subordinated to another debt issue. And both of the debts come from the same issuer.
- It has equity instruments attached that are embedded. These increase the value of the subordinated debt. It also allows great flexibility when dealing with any bondholders.
- Mezzanine debt is common in the field of buyouts and acquisitions.
- Mezzanine debt investors tend to demand a higher perspective return. This is in comparison to secured senior debt investors.
- Mezzanine financing works by filling the gap between equity and senior debt.
- It is a form of debt that has one of the highest risks attached. But the flip side of this is that it can offer incredibly high returns.
What Is Mezzanine Debt?
Mezzanine debt is a type of financing that sits below senior debt and above equity. It’s intended to bridge the gap between equity and debt, allowing businesses to access additional capital without having to sell more equity.
However, the equity is still attached to the mezzanine debt, and in the event of a default, the lender has the right to recoup that loan in the form of taking equity.
Mezzanine bridge loans are usually used in buyouts and acquisitions when an established company wants to expand. It’s rare to use mezzanine debt for start-ups since it’s a high-risk, high-reward style of financing that has major impacts in the event of a default.
Because of its high-risk style, mezzanine debt also usually carries shorter terms and higher interest payments. However, since it doesn’t involve selling off common equity, some businesses find that mezzanine debt is worth the higher rates since retaining equity can mean a greater payoff in the long run.
Types of Mezzanine Debt
Mezzanine debt links equity to the debt so that lenders have something to recoup in the event of a default by the borrowing company. However, different types of equity can be embedded with mezzanine debt. These types include:
Call Options
Call options allow investors the ability to purchase stocks and bonds at a set price within a specific time limit as part of the debt contract. They’re not obliged to purchase, but this gives them a right to buy at the set rate if they so choose.
Rights
Rights are issued for each share of stock and may be traded together or separately with the stock. These give existing owners and shareholders a way to hang on to a component of corporate ownership.
Warrants
Warrants also allow shareholders to buy stock at a set price, though they typically operate on a longer term. When investors hold warrants, they wait for the market stock price to rise above the warrant price, then use the warrant to purchase stock if they choose.
What Is Mezzanine Financing?
Mezzanine financing is a way for companies to raise capital without having to offer collateral. It combines debt and equity financing adapted to a company’s cash flows.
In some ways, mezzanine financing can be considered either a very expensive debt or a very cheap equity. It’s expensive compared to bank debt because it carries very high interest rates but cheap compared to equity because it allows companies to retain long-term asset control.
How Mezzanine Financing Works
Mezzanine financing works by bridging the gap between equity and senior debt so companies can access more capital. It also provides mezzanine lenders with high rewards for their high-risk investments. Mezzanine funding is considered high-risk because companies don’t provide any collateral, leaving lenders to assume a large level of risk in the event of a default. In return, lenders ask for a high interest rate to cover the risk.
Mezzanine financing is most often used when companies want to raise money for a specific project, such as real estate acquisition. If the project is costly and they don’t want to provide up-front collateral or offer preferred equity, they can opt for mezzanine financing and retain long-term equity control.
Mezzanine financing is also an option for businesses that are struggling to access higher levels of senior debt and seeking an alternative capital source.
What Is Mezzanine Debt Used For?
Mezzanine debt is a useful funding tool for growing businesses as well as acquisitions. As such, there is a fairly high demand for mezzanine debt as a form of debt financing. Some form of mezzanine debt is commonly used in the following ways:
- A leveraged buyout
- A management buyout
- A shareholder buyout
- A company acquisition
- Recapitalizations
- Growth capital
- Refinancings
- Balance sheet restructuring
Advantages and Disadvantages of Mezzanine Debt
There are several benefits and drawbacks of mezzanine debt to consider:
Pros of Mezzanine Debt
There are several advantages of mezzanine debt. Here are some of the more common ones:
- It costs less than equity
- There is more patient capital and no loan amortization
- You have the ability to retain a majority control of your business
- There is more flexibility involved when compared to senior debt
- It works as an alternative source of capital with a higher level of risk
Cons of Mezzanine Debt
Whilst this is a good source of funding, there are some downsides too. Here are some of the common ones:
- It costs more than senior debt
- Through equity warrants, there is a chance that it may create slight equity dilution
- The borrower will need to adhere to financial covenants
- There may be some prepayment penalties that have to be paid
Different Ways To Invest In Mezzanine Debt
There are two main ways to invest in mezzanine debt. They are:
- By entering into directly negotiated agreements with a business or its owners
- By contributing to a pooled, private-fund structure that specializes in mezzanine loan investments
An Example of Mezzanine Debt
The structure of mezzanine debt is common in leveraged buyouts. So, for example, let’s say that a private equity firm is looking to purchase a larger company for $50 million with debt. However, the lender doesn’t want to put up the full amount, so it only goes for 80% of the value. So, the lender only offers $40 million. The private equity firm isn’t willing to put up the extra $10 million from its private funds. Instead, they will look for a mezzanine investor as an additional debt financing option. The mezzanine investor will finance $8 million; then, they’ll top up the $2 million.
The combined debt financing will equal $48 million. This means that the company owners only have to invest $2 million of their own money to make up the money left over from the debt portion. This is in order to meet the $50 million price. As the company investor used mezzanine debt, they’ll have the option of converting the debt to equity. But this can only happen when certain requirements are met.
By using this method of financing, the buyer’s potential return is leveraged. And the amount of initial capital the firm had to use is minimized.
Reasons To Invest in Mezzanine Debt
As we touched on earlier, there are a number of advantages that favor both the borrower and the lender.
Where an investor wants to be on the risk/return spectrum for a particular project ultimately determines whether they should invest in mezzanine debt or equity. Mezzanine debt gives a lesser risk and lower return than equity, although equity offers a better return.
Summary
While mezzanine debt is useful, it’s important to note the high cost of this form of debt. This puts it into the highest-risk debt category. Anyone who is looking to borrow should do their research first. This is to check if there is any cheaper source of financing available. If there isn’t, then the borrower needs to make sure that they can service the debt and it won’t plunge them into further financial uncertainty. As well as put their capital structures under strain.
However, having a capital structure that combines mezzanine debt and bank borrowings can lead to attractive returns.
FAQs About Mezzanine Debt
The cost of mezzanine debt is typically priced at anything between 15% and 20% throughout the mezzanine debt market. Anything priced below 15% would be considered an incredible interest rate. As with any loan or debt, the interest rate will vary depending on which provider is offering it. A business borrower would have to do their own research.
A mezzanine debt is known as such because of the placement of the level of risk. It sits at a midway point between secured loans by lenders such as banks and venture capital given by equity investors. This comes from the Italian word mezzo, which translates to “half.”
Mezzanine loans from a mezzanine lender differ from more traditional lenders or debt types such as a mortgage. A mortgage is secured by real property. Whereas mezzanine debt investors’ loans are secured through a pledge of equity investments interests. This is in an entity that owns real property. It is governed by the Uniform Commercial Code (UCC).
The main difference between mezzanine debt and senior debt is that mezzanine debt is a hybrid loan investment, whereas senior debt is a pure loan. Senior debt comes from banks, and the senior loan is the priority debt in the capital hierarchy.
Mezzanine debt is a mix of loan and investment, whereas equity is primarily investment-based. Mezzanine debt sits above equity investment in the capital hierarchy. Equity investors also usually make decisions involving the company’s direction, whereas mezzanine investors are not entitled to company control.
A landlord might choose mezzanine debt over preferred equity for two reasons: they’re struggling to raise enough equity, or they want to retain company control. Mezzanine debt offers a bridge between equity and debt and doesn’t automatically entitle the lender to equity control.
Yes, mezzanine debt can be converted to equity if the right circumstances are met. In some cases, certain equity elements are tied to mezzanine debt, so lenders may have access to rights and warrants. If the borrower defaults on the mezzanine debt structures, however, the lender may also have the right to recoup in the form of equity.
Mezzanine debt is more expensive because it is a high-risk, high-reward form of debt. Because the debtors are receiving no up-front collateral and assuming a greater level of risk, they typically charge significantly higher interest rates than traditional bank loan senior debt.
Mezzanine financing is considered risky for lenders because they don’t receive any up-front collateral. If the investment fails, they may receive equity, but there is still significant risk without collateral. In return, they typically demand high interest rates to compensate for the risk.
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