Mezzanine Financing: Everything You Need to Know

A hybrid of equity and debt, mezzanine financing is a creative financing instrument that serves as an alternative to traditional loans. In this article, we are going to cover the basics of this financing vehicle, its structure, and important advantages and disadvantages to consider.

Highlights/ Key Takeaways

• Mezzanine financing is a type of business loan that combines equity and debt financing.
• Borrowers often use mezzanine financing as expansion capital, taking advantage of flexible repayment terms and interest-only regular payments.
• Mezzanine financing is unsecured and has a relatively low priority in the capital structure. Because the loan is riskier for the lender, it often has higher interest rates.
• Mezzanine funding is listed under “equity” on a company’s balance sheet. As such, it affects a company’s Debt-to-Equity ratio.

What Is Mezzanine Financing?

Mezzanine financing is a non-traditional type of business financing, which combines elements of both equity and debt. Recall that:

• Debt financing involves borrowing funds from an external source, with a promise to repay the principal along with the agreed-upon rate of interest.
• Equity financing involves selling company shares to investors in order to raise capital.

Being a mix of both types of financing, mezzanine financing gives the lender a right to convert the debt to an equity interest in case of a loan default. This type of financing is structured either as unsecured debt or preferred stock and is commonly used to fund growth prospects, including acquisitions and business expansion.

Some common examples of mezzanine financing instruments include convertible preferred stock, convertible high-yield bonds, bonds or preferred stock with warrants, and more.

“Mezzanine financing gives the lender a right to convert the debt to an equity interest in case of a loan default.”

How Mezzanine Financing Works

Companies are often required to raise capital for their operations - either in the form of debt capital or equity capital. The exact mix of debt and equity on a company’s balance sheet represents its capital structure, with mezzanine financing being a part of that structure.

Note that mezzanine financing is typically not a long-term source of capital - instead, it is used as short-term funding for companies with a specific purpose.

Understanding the Capital Structure

All types of financing within a company’s capital structure can be ranked based on the priority of repayment: the higher the ranking, the more likely that borrowed money will be repaid if the company fails. Moving from the highest to lowest priority, financing sources include:

1. Senior debt. Senior debt includes any borrowed amounts that will be repaid as first if the company goes out of business. As compared to other types of debt, senior secured debt carries a lower risk and higher priority for repayment, which makes it attractive to lenders.
2. Subordinated debt. Subordinated debt includes unsecured loans and bonds that rank below more senior types of debt in terms of repayment priority. In the case of borrower default, lenders who have issued subordinated debt will only be paid out once the senior debt is paid in full.
3. Preferred equity. Preferred stock is a class of equity with higher dividend payments and a higher ranking in the capital structure as compared to common equity.
4. Common equity. Finally, common equity is the most basic form of equity that represents ownership in a corporation. In the event of liquidation, common shareholders will only be paid after senior and subordinated debtholders, as well as preferred shareholders, are paid in full.

Where Mezzanine Financing Fits into the Capital Structure

Mezzanine financing consists of subordinated debt, preferred equity, or a combination of the two. This makes it a junior form of debt financing, which ranks below senior debt but above common equity in a company’s capital structure.

However, the term “mezzanine financing” most often refers to riskier forms of financing that rank just above common stock - as opposed to all other, safer, subordinated debt. Note that the higher risk of mezzanine financing leads to higher associated interest rates.

“Mezzanine financing … ranks below senior debt but above common equity in a company’s capital structure.”

How Mezzanine Financing Is Structured

The two basic components of mezzanine financing are subordinated debt and preferred equity. Recall that subordinated debt includes unsecured loans and bonds that rank after senior debt in terms of repayment priority. Preferred equity is a type of equity investment, which is superior to common stock in terms of dividend payments and its ranking in the capital structure.

Common Structures of Mezzanine Financing

Within mezzanine financing, the debt and equity mix can be structured in various ways. For example, common mezzanine financing structures include:

• Subordinated debt without equity
• Subordinated debt plus an equity co-investment
• Subordinated debt plus an “equity kicker” (warrants to purchase common stock)
• Convertible debt
• Preferred stock

The most common structure of mezzanine financing is a subordinated, unsecured term loan in combination with warrants. Such an equity warrant gives a lender the right to purchase a specified quantity of stock or a percentage of a company at a set price per share.

How are Mezzanine Financing Lenders Compensated?

Because mezzanine financing is unsecured, lenders take on higher risk when extending the funding to borrowers. Naturally, they expect to be compensated for the risk with higher returns.

When issuing mezzanine financing, lenders are often compensated in several of the following ways:

• Arrangement and exit fees. Most mezzanine financing products come with an arrangement and an exit fee of 1% to 2% of the total amount of funds borrowed.
• Cash interest. Mezzanine loans have significantly higher interest rates as compared to other forms of financing, ranging from 20% to 30%.
• Equity participation or ownership. The term simply refers to the ownership of stock in a company. Mezzanine lenders often require warrants or another equity kicker to achieve their target return on investment.
• Payment-in-Kind (PIK) interest. PIK interest is a periodic form of payment, in which the interest charges translate into an increase in the principal amount of the security rather than cash interest payments.

Uses for Mezzanine Financing

A mezzanine loan rarely serves as a long-term source of capital. Instead, it is meant to provide companies with the capital necessary for a specific growth initiative in the short term. Some potential uses of mezzanine financing include growth capital, buyouts, acquisitions, refinancing, and diversification.

Growth Capital

Mezzanine financing is often used by companies that have established themselves but require additional capital for further growth. Cheaper than equity and more flexible than senior debt, mezzanine capital can be used to support growth-related capital expenditures such as research and development, increased capacity, new market expansions, and more.

Buyouts

Mezzanine capital is also frequently used in various buyout transactions, including shareholder buyouts, management buyouts, and leveraged buyouts.

• Shareholder buyouts. If a company needs to repurchase stock from a retired founder, passive investor, family member, or unhappy investor, it often uses mezzanine capital to complete the transaction. Effectively, equity will be replaced by debt in the company’s capital structure.
• Management buyouts. In a management buyout, a firm’s management acquires control of the business from investors or a parent company. Because management teams often have limited amounts of equity, mezzanine financing can be an important element of the capital structure.
• Leveraged buyouts. Mezzanine capital is also often used by private equity funds to reduce the amount of equity they invest in a transaction. If the investment is successful, the higher financial leverage due to the use of mezzanine financing will increase its rate of return.

Acquisitions

Mezzanine capital is also frequently used to finance acquisition transactions. Acquisitions, in turn, can enable access to additional products, customers, or technologies. They can also facilitate entry into new geographic markets and distribution channels, effectively supporting business expansion.

Refinancing

For refinancing applications, funds obtained through mezzanine financing can be used to repay maturing debt. Alternatively, this money can be used to prepay existing debt in order to take advantage of better terms or lower interest rates.

Diversification

Mezzanine financing can also be used to diversify a company’s capital structure. For example, mezzanine capital can be reinvested in other types of investments to create a more tax-advantageous structure or protect the company’s finances from potential market risks.

Repaying a Mezzanine Loan

Without a doubt, flexible repayment terms are one of the biggest advantages of obtaining financing through a mezzanine loan. 

The exact repayment schedule can vary based on the terms of the financing agreement, but, in most cases, borrowers have a few years before they need to start making principal payments. This is to allow the company to successfully transition through its growth phase and establish a consistent cash flow before starting to repay the loan.

At this point, the loan can be repaid in one of the three ways:

• Refinancing. If a company has grown in size and increased the value of its tangible assets, a mezzanine loan can often be refinanced through a bank. The assets can be used as collateral for a traditional loan.
• Cash flow. If a company has expanded and increased its cash flow significantly, current earnings can be used to make principal payments on the mezzanine loan.
• Sale of the company. If the timing is right, the owner of a company can choose to sell it and repay the mezzanine loan from the proceeds.

The Advantages and Disadvantages of Mezzanine Financing

Mezzanine financing presents an excellent alternative to raising equity and is one of the most flexible ways of obtaining growth capital. However, unlike equity, mezzanine debt requires regular interest payments, and the principal must be repaid at the end of the loan term.

All in all, mezzanine financing has its advantages and disadvantages - just like any other type of financing.

Advantages

Lenders that offer mezzanine financing can benefit from regular interest payments and potentially higher returns on investment. In addition, because mezzanine loans often include an equity component, investors are able to take control of the company via the equity kicker.

On the borrower side, companies often choose mezzanine financing for its flexibility in terms of repayment terms. While mezzanine loans have relatively high interest rates, they are still cheaper than equity financing and do not require posting collateral.

Disadvantages

As a rule of thumb, higher-risk investments come with higher borrowing costs or interest rates. Because mezzanine loans are non-collateralized and have a relatively low capital structure ranking, lenders have to carry the risk of default with potentially no compensation.

On the other hand, borrowers are faced with high interest rates and additional payments like the arrangement and exit fees. The mezzanine loan may also come with restrictive covenants and may lead to loss of control through the equity stake offered to the investor. When mezzanine capital is used to fund a growth initiative, there is always a risk of the initiative failure, - in either case, the mezzanine loan will need to be repaid in full.

Choosing a Lender

The right mezzanine debt lender can provide you with a continual stream of capital for the company, if need be. However, choosing the wrong one can cause a lot of headaches, consume a lot of time, and put your business at risk.

Lenders that Offer Mezzanine Financing

When choosing a lender to obtain mezzanine financing from, consider the following types of organizations:

• Hedge funds. A hedge fund presents an actively managed pool of investments, with dedicated fund managers making investment decisions on behalf of their clients.
• Private equity funds. A private equity fund is another pooled investment vehicle, where fund managers take control of the fund’s investment decisions. However, private equity funds typically focus on longer-term investments, with an investment time horizon of 10 or more years.
• Small business investment companies (SBICs). An SBIC is a privately-owned investment company that specializes in providing small companies with both debt and equity financing.
• Business development corporations (BDCs). A BSC is an organization dedicated to investing in small- to medium-sized businesses, as well as businesses in distress. The goal of a BDC is to help the business grow and expand in the initial stage of its development.

Tips for Choosing the Right Lender

The key to finding the right mezzanine debt lender is to look for a time-tested, legitimate, and high-character organization.

• Look for a lender with a reliable track record. Funds comprised of recent graduates or people with little industry experience will not be reliable lending partners.
• Evaluate the lender’s current portfolio. If the lender has a problem credit in the portfolio, they might become overly skeptical of the rest of the companies in the portfolio.
• Look for transparency. If a fund is lacking transparency, they likely serve as an intermediary, getting money from another fund. This can lead to delays and difficulties in the approval process.
• Evaluates the lenders’ approval process. Choose a lender with a highly organized, streamlined, and transparent approval process. Avoid working with funds that have multiple people involved in the approval decision.

Applying for Mezzanine Financing

Mezzanine financing is one of the most flexible sources of growth capital, - but it might not be available to every company. To qualify for a mezzanine loan, a business must meet the following criteria:

• The business is an established company (not a startup).
• The business does not belong to an industry where business models rapidly change.
• The business is in need of additional growth capital.
• The business is generating consistent cash flow.
• The business displays top-line revenue growth (increase in revenue a company earns through its core business activities).

How to Use Mezzanine Financing in Real Estate?

While the senior mortgage is the main type of debt used in real estate, many borrowers choose to include mezzanine debt as a part of the capital needed to pay for development projects or acquisitions.

For example, mezzanine bridge loans can be used to cover the cost of a development project or a property purchase that is not covered by senior debt. Such mezzanine financing helps to increase the total amount of money borrowed without the ownership dilution that would result from issuing a significant amount of equity. Instead, real estate mezzanine loans will appear as equity on the balance sheet, which may make it easier to qualify for further financing.

On the lender side, mezzanine loans for real estate offer very high rates of return as compared to low interest rates of traditional real estate financing. As an additional bonus, the lender might be able to obtain some equity or control over the business.

Final Word

Mezzanine financing is a non-traditional type of business loan that blends debt and equity. While it is only one of several debt financing options available to companies, many businesses choose to pursue mezzanine financing for its flexible repayment terms, interest-only payments, and no need for collateral.