Mezzanine financing bridges the gap between debt and equity financing and is one of the highest-risk forms of debt. However, this means that it also offers some of the highest returns to investors in debt when compared to other debt types, as it often receives rates between 12% and 20% per year, and sometimes as high as 30%. In the end, mezzanine financing permits a business to more more capital and increase its returns on equity.

  • Mezzanine financing allows the loan to increase the funding without the ownership dilution that would be caused by the issuance of a significant amount of preferred or common equity.
  • This can be one of the most challenging and time consuming parts of mezzanine financing.
  • In addition, mezzanine financing providers are scheduled to receive contractually obligated interest payments made monthly, quarterly, or annually.
  • A mezzanine financing provider may let the company buy new equipment that it can use to expand its business.

Typically, borrowers use new senior debt to pay off the mezzanine financing when it matures. Also, since there is no amortization, it has less effect on cash flow. And, while mezzanine financing is carried on a company’s balance sheet as equity, the interest payments are tax-deductible as if it were debt. Since mezzanine debt does not amortize, the principal does not have to be paid down.

Loans

The borrower in this situation is usually not publicly held, and so does not have access to the public markets as a more ready source of cash. This type of financing is usually obtained from smaller lenders who specialize in mezzanine financing, rather than from more traditional banking institutions. Mezzanine financing is a blend of equity and debt financing that has features of both and a risk profile midway between the two. It resembles a second mortgage, except that the loan is secured with stock rather than a house. Lenders and their investors like the higher return and flexible payback terms.

Bank X will collect 5% per year in interest payments and can convert the debt into an equity stake if Company Y defaults. Additionally, Bank X was also able to prevent Company Y from borrowing any additional funds and enforced specific financial ratio standards. Like any other product or financial service, both lenders and borrowers must consider the advantages and disadvantages of mezzanine financing. It stands below more senior debts or securities in terms of its capacity to recover a company’s assets or earnings. Mezzanine funds are pooled investments (like mutual funds) that provide highly qualified businesses with mezzanine financing. Mezzanine debt has warrants attached, which are embedded equity instruments.

The Different Types of Mezzanine Debt

If a borrower cannot make a scheduled interest payment, some or all of the interest may be deferred. Mezzanine financing may result in lenders—or investors—gaining immediate equity in a business or acquiring warrants for purchasing equity at a later date. In addition, mezzanine financing providers are scheduled to receive contractually obligated interest payments made monthly, quarterly, or annually. Mezzanine financing allows for more flexible sources in a company’s debt capital structure.

What Is the Purpose of Mezzanine Debt?

Similar to a convertible bond, mezzanine financing often includes an equity interest in the form of a conversion feature or warrant. Usually, the PIK interest or the cash interest follows the ownership portion of the securities. Finally, the ideal provider will be willing to work in your interest, providing the best value for the amount, price, and flexibility of the debt raised. Often lenders have previously been involved with the company seeking the loan and each has experience of the other’s reliability and ability to understand the business at hand.

COMPANY

A mezzanine lender will typically do less due diligence than in a senior debt deal, but the lender will want a company that has an established business and a history of being profitable. Preferred equity represents an ownership stake in a company or property, granting the holder specific rights and priority over other stakeholders. It offers investors a more secure position with a fixed return and potential upside. Equity represents ownership in a company and entails a share of the business’ profits and losses. Investors who contribute equity take on more risk as they have the potential for significant returns if the company is successful but could also lose their investment if the business fails.

Mezzanine financing does present the potential for some equity dilution. If the borrower defaults, the lenders will be able to exercise the right to turn their warrants into equity, reducing the percentage held by existing owners. Ownership transition is a common example of when mezzanine financing is used. It allows privately held business owners to raise capital without diluting their ownership.

Interest and Repayment

A mezzanine lender is known as such because of the placement of the level of risk. It sits at a midway point between secured loans by lenders such as banks, and venture capital given by equity investors. Some examples of these embedded options are stock call options, warrants, and rights. This means that mezzanine debt actually acts more like a stock than a debt.

Mezzanine Financing Example in Real Estate

Borrowers aren’t the only ones who face benefits and drawbacks from mezzanine loans. This type of lending structure has pros and cons for lenders as well. Mezzanine loans often come with higher costs than traditional borrowing. Interest https://personal-accounting.org/what-is-mezzanine-financing/ rates in the double digits are common, or lenders may demand equity exposure to supplement interest income. Depending on the terms of the agreement and how events unfold, the arrangement can provide an equity interest to lenders.