Understanding Mezzanine Financing
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.
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
- Management buyouts
- Growth capital
- Shareholder buyouts
- Balance sheet optimization or restructuring
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.