Mezzanine financing blends equity and debt, with lenders
providing subordination loans over traditional ones. When a
business needs funding for a significant acquisition or project,
creative financing options like mezzanine loans can help to fill
that need. Understanding mezzanine financing can be difficult since
it differs slightly from traditional loans.
What Is Mezzanine Financing?
This financing level is a capital resource between the less
risky senior debt and the more risky equity. Mezzanine financing is
a type of junior capital with equity and debt features. Many
companies use mezzanine financing to reach funding goals that
traditional lenders will not extend. Often, established companies
want to preserve their future senior debt capacity or have already
maximized their borrowing capacity. Mezzanine financing is the last
stop in the capital structure where companies can raise large
amounts of liquidity without selling a substantial stake in the
business.
Mezzanine-level financing can take the structure of subordinated
debt, preferred stock, or convertible bonds. Sometimes, these loans
may offer participation rights to the common equity, which is less
dilutive than other types of equity. While mezzanine loans are more
expensive to borrow than typical senior debt, they carry a longer
term until their final maturity, typically seven to eight years.
Also, these loans are interest-only with no amortization before the
maturity date. With these favorable terms, businesses can have more
time to process shareholder activity and can build their senior
capacity, which may help with refinancing the mezzanine capital
over time. Mezzanine finance options are not considered a permanent
solution to capital. Instead, these terms are for solution-oriented
capital that serves a particular interest of the company. Later,
other types of cost capital may replace the mezzanine level
loan.
Subordinated Debt and Preferred Equity
Subordinated debt is an unsecured loan or bond that ranks below
senior securities and loans. In the case of borrower default, the
subordinated debt holder must wait while the senior debt holders
receive their payments after foreclosing under Article 9 of the
Uniform Commercial Code (UCC), according to the American Bar Association. The company promises
to pay all unsecured subordinated debt when there is no credit or
liens that can support it. However, businesses can secure mezzanine
debt with a lien on the underlying property. These payments are
made monthly based on a floating or fixed rate. At the maturity
date, the remaining balance is due.
Preferred equity is considered an equity investment in a
property-owning entity. This subordinated equity is under a typical
mortgage loan, but mezzanine loans are senior to common equity.
Preferred equity is deemed a higher risk than mezzanine debt
because of the lack of collateral and increased risk to the
investor.
Mezzanine Terms
Compared to senior debt, mezzanine financing costs more, but it
costs less than equity, according to the Commercial Real Estate Development Association
(NAIOP). Mezzanine level loans are a hybrid financial
instrument ranking below senior debt, with the maturity occurring
one year after senior debt. Terms for mezzanine loans include
several contractual interest options, such as payment-in-kind
(PIK), cash, or nominal equity (warrant). Generally, mezzanine
finance options include a lump sum payment at maturity with no
amortization throughout the loan’s life.
Companies use their capacity for senior debt for refinancing the
mezzanine loan before it matures, reducing the debt capital costs.
Due to the lack of amortization and the longer maturity terms,
mezzanine loans allow businesses the capital structure to process
an upcoming financing need, which can include an acquisition.
Mezzanine Financing Uses
Usually, companies can use equity or senior debt to fulfill
their capital needs, but mezzanine financing is sometimes a more
attractive option. Since mezzanine loans are considered a
“patient” source of financing that allows businesses to
reach growth goals, these options provide an opportunity for
companies to improve infrastructure to acquire other assets.
Mezzanine loans provide leverage to assist in various transactions,
including:
- Leveraged buyouts
- Acquisitions
- Recapitalizations
- Management buyouts
- Growth capital
- Shareholder buyouts
- Balance sheet optimization or restructuring
- Refinancing
Mezzanine financing may help to secure intellectual property
rights or raise capital with those IP assets.
Advantages of Mezzanine Level Financing
Like any financing option, mezzanine loans can have advantages
and disadvantages. Any business considering adding this type of
loan to its balance sheet must understand the terms to determine
whether a mezzanine loan would be the best choice to increase
capital.
Recapitalization led by a mezzanine loan allows the business
owner to retain most of the control of the company. He or she can
also control the management team and the board of directors. These
financing options provide more flexibility than standard bank
loans. Companies have fewer restrictions and loose financial
covenants. Also, the business can often achieve goals to extend its
eligibility for senior debt. As mentioned, mezzanine loans are
considered “patient,” meaning that they support long-term
growth with no amortization. Mezzanine finance options provide an
alternative capital resource, and these loans are not as dilutive
as direct equity.
Disadvantages of Mezzanine Loans
Most types of financing have pros and cons, and the mezzanine
loan is no exception. Businesses must understand that
mezzanine-level financing costs more than standard senior debt.
Usually, this type of financing requires equity dilution. While
small equity dilution may be structured as an attached warrant,
many times, the mezzanine loan terms include creditors’ rights
or financial covenants. Additionally, there may be a penalty for
prepayment during a specific period.
The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.