What is mezzanine debt financing?
Mezzanine debt, also called mezzanine financing, is a type of financing that got its name due to the fact that it’s a debt-equity hybrid.
Mezzanine financing gives the lender the ability to convert to an equity interest in the company in the case of a default, which makes it a frequent option during acquisitions and buyouts.
While as a type of debt it has the highest risk, high mezzanine loan interest rates also offer the highest potential returns for lenders, though with flexible repayment terms for borrowers.
Is a mezzanine loan debt or equity?
Mezzanine loans are a hybrid of both debt and equity, which can make them a bit a difficult at first to understand.
The best way to understand them is that they’re a form of debt financing that has equity options built in, which allows it to take on the form of an equity investment if those options are exercised.
Mezzanine debt isn’t commonly used, as roughly only about 10% of debt is mezzanine debt, and therefore it’s often considered lower priority than senior debts. However, its unique qualities make it a useful option in the right situation.
How does Mezzanine debt work?
Mezzanine debt creates a new level of flexibility for borrowers and lenders that otherwise wouldn’t be possible.
Mezzanine lending is often sought-after as an aid to companies with specific acquisition goals. Mezzanine lenders also tend to be long-time investors in the company, making them a trusted partner to make those projects a reality.
Mezzanine loans often have a few unique qualities, including:
- As opposed to traditional bank loans, mezzanine loans typically have a higher return than senior debt and are often unsecured
- Mezzanine debt is subordinate to senior debt but higher priority than pure equity
- There is no principle amortization
- A portion of the return on a mezzanine loan is fixed, differing from pure equity
Explaining mezzanine financing can be a bit confusing even with a thorough explanation, so let’s look at an example.
Mezzanine financing: Example
Bill is looking to purchase a company worth $10 million, so he goes to a lender he’s hoping will finance the purchase.
Bill isn’t approved for the full amount, but he gets $5 million toward the purchase. To bridge the gap and get the remainder of the financing he needs to make the purchase, he looks to get mezzanine financing.
He acquires mezzanine financing for $4 million, making his direct investment just $1. That breaks down to:
- $5 million basic loan
- $4 million mezzanine loan
- $1 personal investment
On the repayment side, the mezzanine lender then charges a 16% interest rate as opposed to just 6% with the bank loan. However, as opposed to paying interest charges monthly or annually, Bill has the option to add those charges to the cost of his loan, giving him added flexibility.
Pros and Cons of mezzanine debt financing
With a more thorough explanation of what mezzanine debt is, let’s talk about why you might want to consider using mezzanine debt as well as the drawbacks of doing so.
Mezzanine financing has the unique ability to offer lenders a way of obtaining equity in a business, something no other type of debt financing can do. It can have a considerable impact on a lender’s rate-of-return in some cases.
However, it’s not without its cons for both lenders and borrowers. Here’s a breakdown of both the pros and cons of mezzanine debt for lenders as well as borrowers:
Pros and Cons for borrowers
The greatest pros exist in what mezzanine financing can do for borrowers. However, mezzanine loans offer their own cons as well.
Pro: Leverage
A mezzanine loan offers borrowers financing they otherwise wouldn’t have been able to acquire, giving them more purchasing power and the ability to earn a higher return on equity optimal cases.
Pro: Looks better on your balance sheet
Because mezzanine financing often appears as equity on a company’s balance sheet, it makes your debt level appear lower than it is, making it easier for you to qualify for financing.
Pro: Tax-deductible interest
Interest payments on a mezzanine loan are typically tax-deductible, which can account for a large amount of savings over the course of a year.
Pro: Flexible repayment options
Repayment options with mezzanine debt are often highly flexible, with the ability to add interest charges to your loan’s balance or even pay those charges with cash.
Con: Using a mezzanine loan for purchasing leverage is risky
While mezzanine loans have unique benefits for borrowers, they also come with their own set of cons. The primary con of mezzanine loans doesn’t inherently exist in the loan itself but in the way they’re typically used.
Using a mezzanine loan for purchasing leverage comes with a high level of risk. There’s no guarantee the company is going to be a success, or even break even on your investment, so that loan may become a significant debt.
Con: Equity interest
If you as the borrower default on a mezzanine loan, you could be required to provide equity interests to lenders.
Pros and Cons for lenders
The pros and cons of mezzanine loans for lenders are more direct and typical as they relate to lending, but they’re significant nonetheless.
Pro: Equity benefits
There are just a few pros of mezzanine lending, but they’re significant.
First, lenders can potentially gain equity, giving them the ability to take advantage of the growth of a business and the resulting equity.
Pro: Interest income
Another pro is that mezzanine loans typically have very high interest rates, which gives mezzanine financing a high potential return.
Con: Subordinate debt
Because mezzanine debt is considered subordinate to pure debt, a mezzanine debt from a lender may not be secured by any hard collateral.
If a business defaults, by the time all senior debt is paid, there may be no more collateral or cash-equivalent to pay repay the loan.
A unique type of financing
Mezzanine financing is entirely unique among the wide-ranging collection of business financing solutions.
It serves an important role that other financing vehicles can’t fill, making it a useful tool for both lenders and borrowers.
