Mezzanine Financing: Definition & Overview

KEY TAKEAWAYS

• Mezzanine financing is a type of business funding that falls between senior debt and equity.
• Mezzanine financing is often used by businesses that are too small to access the equity markets but too large for traditional bank loans.
• Mezzanine financing funds a variety of costs, including expansion, acquisitions, and working capital.

How Mezzanine Financing Works?

Mezzanine financing relates to companies maxing out their borrowing capacity for senior debt. It’s also for those who want to preserve their borrowing capacity for senior debt. Moreover, those companies need to acquire additional funding. This is necessary in order to pursue their growth opportunities.

This includes sizable capital programs, acquisitions, and so on. It can also include shareholder activity, such as distributions or shareholder buyouts. When this happens, they generally have a couple of different options to pursue:

1. Gather additional equity
2. Use mezzanine financing

It’s true that mezzanine financing is sometimes seen as expensive debt (higher fixed-rate coupon basis). Or cheap equity (less dilutive). This is because mezzanine comes with a higher market interest rate than what senior debt companies can get from banks. This minimum rate is attractive to equity investors.

As such, it has more risk compared to senior debt. But it’s considerably less costly than equity financing as far as the overall capital cost goes.

What’s more, mezzanine financing isn’t as dilutive as raising additional capital to meet capital needs. Moreover, it lets existing owners retain control. Mezzanine is also known as patient capital. It’s a way for companies to seek lasting strategic opportunities that may not be possible otherwise.

Mezzanine Financing Structure

Mezzanine financing acquisitions can be more costly than senior debt. But they’re less expensive than equity. Still, it’s a relative mix of the two. It is therefore priced as a blended rate of equity and senior debt.

Most commonly, mezzanine refers to subordinated debt or senior debt with maturity one year later than senior debt. It typically includes a mix of nominal equity (form of warrants), contractual interest, payment-in-kind (PIK), and cash. The loan often has a bullet maturity that allows for no amortization over the life of the loan.

Senior debt capacity is often built up over time. As such, it’s used by companies to refinance their mezzanine loans before maturity. This reduces the cost of their ordinary debt capital. In business time, it ensures that they don’t have to pay out as much. Oftentimes, management with extensive experience will consider debt alternatives throughout the entire process.

The capital-raising process needs to entail affirmative covenants on loans to borrowers. This avoids a loss of control while funding companies.

Mezzanine loans have longer maturity and absence of amortization requirements. These make it easier for businesses to finance an event such as the integration of an acquisition.

Uses for Mezzanine Financing

The primary use of mezzanine financing is to bridge the gap between a company’s start-up capital needs and its next funding stage.

For example, let’s say a company is experimenting with new technologies and has outgrown its current lab space. It needs more space, but it only has enough money to buy a lab.

A mezzanine financing provider may let the company buy new equipment that it can use to expand its business. The equipment will cost more than the original start-up money, but it will help the company grow and ultimately make it more money in the long run.

Recapitalizations

This is a way to raise new capital to restructure debt and equity on a company’s balance sheets. They make a great use case for mezzanine capital, especially when owners wish to maintain control and partial liquidity.

Mezzanine financing is for when a group of shareholders needs partial or complete liquidity. Moreover, it’s for other shareholders who want to continue actively participating in the business. As such, they need to speak with a mezzanine lending company. As long as they have a structure for mezzanine financing, they could consider mezzanine debt.

A private equity firm often offers the cost of capital as a way to get majority ownership or complete ownership. This is especially true if existing owners do not seek full liquidity or exit. Companies may consider a mezzanine-supported recapitalization instead of seeking a majority equity owner. It’s also an ideal alternative to giving up control.

Leveraged Buyouts

A leveraged buyout often uses mezzanine financing by the buying shareholders. This is usually done by institutional groups or private equity funds to increase their borrowing capacity. But what about companies looking to raise significant amounts of capital for a major growth event? Or an ownership transition? They are most likely to complete leveraged buyouts.

Management Buyout

Mezzanine financing is useful for buying out current owners. For example, private equity or other investors. It allows them to take control of a company via management buyout. As such, it is a common method of funding common equity.

Once getting capital from a mezzanine financing provider, the management transition can proceed.

Moreover, it allows the management team to decide the direction of the company. From there, the business owner can grow the business while also gaining future equity value.

Growth Capital

Mezzanine financing for growth capital can help companies reach their organic growth goals. This includes large capital expenditures or the construction of large quantities of facilities. You can also use growth capital to expand your market reach by creating new products or subsidiaries.

Acquisitions

Mezzanine financing is available to finance acquisitions. This is where companies buy other businesses in order to grow and respond faster to customer needs. Companies can access new markets and diversify their customer base. They achieve this when purchasing other businesses through acquisitions.

Shareholder Buyouts

Shareholder Buyouts are a great option for family-owned businesses that want to repurchase shares sold to them. These transactions often use mezzanine financing.

Refinancing

Refinancing is often done with mezzanine financing. This is to pay off existing debt or to replace it. Mezzanine financing allows for more flexible sources in a company’s debt capital structure. And it better prepares them for opportunities such as acquisitions or shareholder buyouts.

Restructurings of the Balance Sheet

Mezzanine financing is a good option for balance sheet restructurings due to its upside potential. Mezzanine financing can add to a company’s balance sheet to optimize its debt capital structure.

It helps to meet debt requirements for transactions like acquisitions. Current management buyouts also apply. It can also allow the company to recover from these expenses. It’s an attractive alternative for many businesses. And it gives them a source of capital to achieve various objectives.

A key characteristic of mezzanine is that it satisfies restrictive covenants for a junior capital increase. It’s also useful for creating additional senior debt capacity.

You can combine a balance sheet restructuring with a larger transaction. For example, a complete refinance of the debt capital structure or a growth event for your business. Or you can do it as a standalone transaction.

Advantages and Disadvantages of Mezzanine Financing

Mezzanine financing comes with advantages and disadvantages. You need to be aware of these pros and cons to ensure that this financing method is right for you.

One of the main advantages of mezzanine financing is that it can help a company grow without having to start over. In other words, it’s a way to bridge the gap from the early stages of a company’s development to the later stages. This is when it can take on larger projects without worrying about failure.

However, financing a high-risk venture is risky in and of itself. So this is why mezzanine financing is sometimes called “bridge financing.” Also, because mezzanine financing can buy assets and grow a company, it can be pricey.

Let’s explore more advantages and disadvantages of mezzanine financing to help you determine if it’s a good fit for your company.

Advantages

• Mezzanine-led recapitalization often results in the current owner keeping majority control. They’ll also control management, the board, and so on.
• Mezzanine financing offers more flexible sources than traditional bank loans. This includes looser financial agreements and reduced amortization. It also lets companies reach capital requirements beyond the availability of senior debt.
• It’s cheaper and not as dilutive compared to direct equity issues. For example, institutional equity usually has an expectation of return greater than 20%.
• Companies have another capital source to equity and senior debt with mezzanine
• Mezzanine, also known as “patient capital,” is long-term capital that provides support for lasting growth. Plus, it only has interest for seven to eight years with no amortization.
• Control-type provisions are less than those for minority private equities. This is a good option for companies trying to maintain control of shares or family control.

Disadvantages

• Senior debt is less expensive than mezzanine financing
• Mezzanine financing can involve equity dilution. This is usually small and could come in the form of another structure or attached warrants.
• Creditor rights and financial agreements are part of the terms for mezzanine financing.
• Prepayment penalties are often assessed for periods following the issuance.

As you can see, there is a lot to consider. If you can afford equity dilution and you want flexibility in your loan, mezzanine may be right for you.

Example of Mezzanine Financing

Example 1

Company A decided to do a minor recapitalization. They planned to use the capital to provide partial shareholder liquidity. It also planned to include full liquidity to a retiring shareholder. It wished to fund its organic growth and potential acquisitions.

The minority recapitalization will give more ownership to the extended leadership team. This helps drive the business forward. Capital Company 1 provided mezzanine financing to Company A.

Not only that, but also senior debt, senior accordion notes, and senior promissory notes.

Company A partnered with the existing bank to continue to provide working capital financing. The company achieved its liquidity goal. It also gave the current leadership the chance to increase its ownership stake. It also increased its position in capital structure. As such, it continued to capitalize on organic and inorganic opportunities.

Example 2

Company C was seeking a financial partner in order to help them with the next stage of its growth. They determined that a leveraged buyout would be the best way to obtain the capital.

Capital Company 1 introduced Company C to Capital Company 2 as a possible equity partner to complete the financing package.

 Company 1 got mezzanine and senior debt by Capital Company 1, as well as equity capital from Capital Company 2 after the buyout. The company was able to source the capital necessary to achieve its long-term, ambitious growth goals.

Mezzanine financing is a viable option for many companies that are looking for outside funding. It can ensure that you get the operating capital you need to get your business off the ground and running.

But it’s also ideal for funding various other necessities in business. Perhaps you need to upgrade your operations and buy new equipment. You might need to restructure your company from the ground up, which requires capital.

Whatever your needs, mezzanine could provide the funding needed to realize your objectives. If not, there are always many other financing options to consider.

Summary

The bottom line is that mezzanine financing can be a high-risk, high-reward strategy that brings an equity-like stake to an investor. Therefore, you should only consider it if you’re comfortable with risk and want a large return if the venture is successful.

Company 1 got mezzanine and senior debt by Capital Company 1, as well as equity capital from Capital Company 2 after the buyout. The company was able to source the capital necessary to achieve its long-term, ambitious growth goals.

Written by Jami Gong, MPAcc, CPA

Jami Gong is a Chartered Professional Account and Financial System Consultant. She holds a Masters Degree in Professional Accounting from the University of New South Wales. Her areas of expertise include accounting system and enterprise resource planning implementations, as well as accounting business process improvement and workflow design. Jami has collaborated with clients large and small in the technology, financial, and post-secondary fields.

Written by Jami Gong, MPAcc, CPA

Jami Gong is a Chartered Professional Account and Financial System Consultant. She holds a Masters Degree in Professional Accounting from the University of New South Wales. Her areas of expertise include accounting system and enterprise resource planning implementations, as well as accounting business process improvement and workflow design. Jami has collaborated with clients large and small in the technology, financial, and post-secondary fields.