Mezzanine Financing

What Is Mezzanine Financing?

Mezzanine financing is a hybrid of debt and equity financing that gives the lender the right to convert to an equity interest in the company in case of default, generally, after venture capital companies and other senior lenders are paid.

Mezzanine debt has embedded equity instruments attached, often known as warrants, which increase the value of the subordinated debt and allow greater flexibility when dealing with bondholders. Mezzanine financing is frequently associated with acquisitions and buyouts, for which it may be used to prioritize new owners ahead of existing owners in case of bankruptcy.

How Mezzanine Financing Works

Mezzanine financing bridges the gap between debt and equity financing and is one of the highest-risk forms of debt. It is senior to pure equity but subordinate to pure debt. However, this means that it also offers some of the highest returns when compared to other debt types, as it often receives rates between 12% and 20% per year, and sometimes as high as 30%.

Companies will turn to mezzanine financing in order to fund growth projects or to help with acquisitions with short- to medium-term time horizons. Often, these loans will be provided by the long-term investors and existing funders of the company's capital. A number of other characteristics are common in the structuring of mezzanine loans, such as:

Advantages of Mezzanine Financing

Mezzanine financing may result in lenders — or investors — gaining equity in a business or warrants for purchasing equity at a later date. This may significantly increase an investor's rate of return (ROR). In addition, mezzanine financing providers receive contractually obligated interest payments monthly, quarterly, or annually.

Borrowers prefer mezzanine debt because the interest is tax-deductible. Also, mezzanine financing is more manageable than other debt structures because borrowers may figure their interest in the balance of the loan. If a borrower cannot make a scheduled interest payment, some or all of the interest may be deferred. This option is typically unavailable for other types of debt.

Disadvantages of Mezzanine Financing

However, when securing mezzanine financing, owners sacrifice control and upside potential due to the loss of equity. Owners also pay more in interest the longer mezzanine financing is in place.

For mezzanine lenders, they're at risk of losing their investment in the event of bankruptcy. In other words, when a company goes out of business, the senior debt holders get paid first by liquidating the company's assets. If there are no assets remaining after the senior debt gets paid off, mezzanine lenders lose out.

Example of Mezzanine Financing

For example, Bank XYZ provides Company ABC, a maker of surgical devices, with $15 million in mezzanine financing. The funding replaced a higher interest $10 million credit line with more favorable terms. Company ABC gained more working capital to help bring additional products to the market and paid off a higher interest debt. Bank XYZ will collect 10% a year in interest payments and will be able to convert to an equity stake if the company defaults.