Mezzanine Financing: Its Purpose and Function
Mezzanine financing is a fusion of debt and equity financing. It enables a lender to convert debt into equity interest in a business if default should occur. This conversion typically takes place after senior lenders like venture capital companies are paid. The degree of risk involved in mezzanine financing is between the risk factors of senior debt and equity. This type of financing has inherent equity tools, often called warrants.
These warrants raise the value of the subordinated debt. They also permit more flexibility in working with bondholders. Mezzanine financing is often used in acquisitions and buyouts to give greater priority to new owners than to existing owners if bankruptcy should occur. It provides a method for companies to raise funding for specified projects or for supporting an acquisition via a combination of debt and equity financing.
These loans are frequently used for expanding established companies rather than for funding start-up companies or the early stages of business development. Mezzanine funding is also used in pooled investments called mezzanine funds, which have similarities to mutual funds, available to well-qualified companies.
More lucrative for investors than most corporate debt instruments, mezzanine financing typically pays returns of 12 to 20 percent annually. Yet if the market’s interest rate falls considerably, mezzanine loans may be replaced by lower-interest financing instruments.
Mezzanine Financing Bridges an Important Gap
Mezzanine financing serves to bridge the gap between debt and equity financing, which is very useful to many businesses. However, it is also among the forms of debt with the greatest risk. While it is superior to pure equity in ranking, it ranks below pure debt.
Yet it gains high approval from debt investors since mezzanine financing can yield higher rates of return than other types of debt. Overall, mezzanine financing enables a company to access more capital while boosting its monetary returns on equity.
The funders of these loans may be current and long-term investors of the company. If so, the amount of their funding is considered preferred equity, and the company is not obligated to repay this capital. This gives the company more liquid funds for developing and growing the business.
The borrower of a mezzanine loan is required to pay only interest amounts that accrue before maturity. This also gives the business owner more capital to use for the benefit of the company.
Common Characteristics of Mezzanine Loans
Characteristics that are common to the majority of mezzanine loans that are issued to business owners today include the following:
- These loans are considered subordinate to senior debt, yet they have higher ratings than both preferred and common stock.
- Mezzanine loans offer greater returns than ordinary debt.
- These loans are typically unsecured debts.
- The loan principal of a mezzanine loan is not subject to amortization.
- These loan structures may include a combination of partially fixed and partially variable interest rates.
Structure of Mezzanine Financing
Mezzanine financing is a financial instrument within the capital structure of a company. It exists between the senior debt and the common stock in the forms of subordinate debt, preferred equity or a hybrid of the two. However, mezzanine financing in the majority of companies is in the form of unsecured subordinated debt.
What Is Sub-Debt?
Sub-debt is an unsecured loan or bond that is not supported by a lien or other type of credit. It has a lower ranking than loans or securities that have more senior standing to use to obtain backing from the company assets or revenues. If a sub-debt borrower should default, the sub-debt holder does not receive a payout until the senior debt holders have received the total payout due.
As unsecured debt, sub-debts are backed simply by the company’s promise to repay. Other types of mezzanine debt is backed by a lien on specific property and is secured debt. Repayments are typically made on a monthly schedule according to a fixed or floating rate. The remaining balance is due on the maturity date.
Payments are issued via priority distributions prior to any distributions to common equity holders. Investors may negotiate to receive additional profits. On the set redemption date, the principal is repaid, typically after repayment for a mezzanine debt. Under certain circumstances, the sponsor may be granted a date extension for repayment. Since preferred equity does not carry any aspects of lender liability, its holders may have more corporate approval rights.
Aspects of Maturity, Redemption and Transferability
Mezzanine financing generally matures within five years or more. Yet the maturity date is often dependent on the maturity dates of any existing debt within the financing capacity of the issuer. Most preferred equity lacks a fixed maturity date. However, it may be set by the issuer at a time after its issue. Redemption is typically used to gain benefit from lower market rates for calling in and reissuing debt and equity at lower rates.
In general, mezzanine financing lenders have the complete rights to transfer these loans. If this type of loan is structured to issue future distributions or advances, a qualified transferee standard may be negotiated. This can limit the borrower’s transferring rights. In comparison, preferred equity may be subject to conditional transferring of the buyer’s interest in the entity. After the completed contribution of the preferred equity, the entity may allow transfers.
Mezzanine Financing Advantages and Disadvantages
Advantages
- Lenders. In mezzanine financing, lenders, or investors, may attain immediate equity in a specific company or obtain warrants for buying equity at a later time. This can boost an investor’s rate of return (ROR) considerably. Also, providers of mezzanine financing receive interest payments under contract that are issued on a monthly, quarterly or annual schedule.
- Borrowers. Generally, borrowers choose mezzanine debt since the interest charged is a business cost that is tax-deductible. This can lower the cost of the debt significantly. In addition, mezzanine financing can be more easily managed by borrowers than other types of debt since they are permitted to transfer interest to the loan balance.
If a borrower in unable to make an interest payment as scheduled, part or the balance of the interest may be deferred. Generally, this advantage is not offered under other types of debt structure. Rapidly expanding businesses increase in value, and they may restructure a mezzanine loan as a single senior loan with a lower rate of interest. In the long run, this cuts the costs of interest.
- Investors. In the role of an investor, the lender frequently obtains an incentive, more equity interest or the choice of obtaining this interest (or warrant). If a venture proves to be very successful, these advantages can become quite lucrative. Although mezzanine debt is categorized as a low interest rate financing option, it can produce a much greater rate of return than other financing choices. In addition, Mezzanine debt generates periodic payments that are guaranteed. This is in contrast to potential but not guaranteed dividends provided by preferred equity.
Disadvantages
- Owners. With mezzanine financing, owners may have less control and upside possibilities because of equity loss. They may also be charged higher interest rates for longer-term loans. There may be restricting clauses in the loan agreements that place limitations on their ability for additional borrowing or senior debt refinancing. There may be restrictions placed on key staff member payouts as well.
- Lenders. If a borrowing company experiences bankruptcy, mezzanine lenders may lose their investment. When a company closes business operations, senior debt holders are paid first via the liquidation of the company assets. Unless there are remaining assets following the repayment of the senior debt, the mezzanine lenders may receive nothing.
It is important to remember, too, that mezzanine loan debt and equity can take some time and negotiating to set up. Many times, this process may require three to six months to finalize.
Pros and Cons of Mezzanine Financing
Major pros and cons of mezzanine financing are the following:
Pros
- Long-term lenders and debt
- Less costly than raising funds
- Flexible structure
- No negative effect on company equity
Cons
- Subordinated debt at high interest rates
- Sometimes slow or difficult to arrange
- May place restrictions on obtaining additional credit
- Loss of some owner control on deal
In general, mezzanine loans are expensive, within the range of 15 to 20 percent. However, they are known as “patient” debt since there are no payments due on the principal until the maturity date. A company can grow and expand its ability to repay the loan while strengthening its capacity for more senior debt, which is less costly.
Concluding Thoughts
Mezzanine financing offers bridge loans to cover the expense of a property purchase or development project that is not covered otherwise by senior debt. Although these loans are not secured, they may be replaced with equity if a default should occur. With mezzanine financing in place, the loan can increase the amount of funding while avoiding ownership dilution. Without mezzanine financing, the necessary issuing of preferred or common equity could cause ownership dilution.
By performing due diligence and understanding all of the aspects of mezzanine financing, you can gain significant advantages from obtaining a mezzanine loan. It is always advisable to consult a respected and experienced financial advisor before you apply for this type of flexible, “patient” funding option.