Mezzanine Finance

The nature of mezzanine financing is often confusing for a lot of people, and this article attempts to break it down with an example for a better understanding. What is mezzanine finance, exactly? Beginning with the term itself, “mezzanine” essentially means “in the middle” or “intermediate,” which helps in understanding its placement within the capital structure.

A simple breakdown of mezzanine financing

With the above in mind, mezzanine finance falls between equity and senior debt and can actually come in several forms. For example, junior debt, preferred debt, convertible debt, and participating debt are all forms of mezzanine financing.

The primary purpose of mezzanine financing is to displace a portion of capital that would otherwise be the responsibility of the equity investor. While mezzanine financing is usually the highest risk as far as debt goes, borrowers find it attractive due to its potentially high returns. Rates for a mezzanine loan typically fall somewhere between 12 and 20 per cent.

Mezzanine financing means that the borrower doesn’t need to put up as much initial capital, and if the value of the business is expected to rise rapidly, the high-interest rates may be less of a concern, and the borrower may have the opportunity to refinance at a lower interest rate in the future.

Example of mezzanine financing

Say you want to buy a restaurant, for example, that the current owners are willing to sell for £1 million. You obviously don’t have this, so you acquire a senior lender that puts up £600,000 of the one million, leaving you to pay the additional £400,000.

The mezzanine investor intends to reduce this amount by offering an additional £200,000, for example, and they usually take into account the business’s annual profits as well as your annual payments towards your senior loan.

While interest rates are higher, the borrower would have to keep in mind that the initial investment is significantly lower. Interest payments towards your mezzanine loan will almost always be contractually mandated, whether you make them monthly, quarterly, or annually.

Mezzanine financing is most commonly found in highly leveraged buyouts and new real estate.

Exploring the advantages and disadvantages of mezzanine financing

Unveiling the perks and pitfalls of mezzanine financing reveals a nuanced landscape for both lenders and borrowers.

Advantages
Venturing into mezzanine financing might swiftly grant lenders or investors a slice of equity in a business or the promise of warrants for future equity acquisitions. This potential can substantially spike an investor’s rate of return (ROR). Moreover, providers of mezzanine financing relish the predictability of contractually mandated interest payments, flowing monthly, quarterly, or annually.

From the borrower’s realm, mezzanine debt shines as the interest becomes a deductible business expense, effectively trimming down the actual debt cost. Plus, managing mezzanine financing proves smoother compared to other debt structures, with the flexibility to roll interest into the loan balance. Should a borrower stumble on a scheduled interest payment, the option to defer some or all of it often stands—a luxury rarely extended in other debt scenarios.

Furthermore, burgeoning enterprises riding the wave of expansion may consolidate their mezzanine financing into a senior loan with a reduced interest rate, spelling long-term savings on interest outlays.

For investors, the allure lies in the added incentive of equity stakes or warrants on the table. These sweeteners, especially in the case of a soaring venture, can morph into substantial assets. Mezzanine debt also flaunts a superior rate of return, a pivotal advantage in the prevailing low-interest climate. Unlike the uncertain dividends of preferred equity, mezzanine debt pledges guarantee periodic payments.

Disadvantages
Yet, amidst the allure, mezzanine financing casts shadows. Owners grappling for this financial lifeline might find themselves relinquishing control and potential gains due to equity dilution. Lenders often harbour a long-term outlook, demanding a seat at the boardroom table. Moreover, the interest burden balloons over time with lingering mezzanine financing. Loan agreements brim with restrictive covenants, curtailing the freedom to secure additional funds or refinance senior debt while imposing stringent financial benchmarks on borrowers. Constraints on payouts to key personnel and owners are not uncommon either.

The spectre of bankruptcy looms large for mezzanine lenders, poised to swallow their investment should the borrowing company sink. In the grim event of business closure, senior debt holders leap to the front of the line, leaving mezzanine lenders empty-handed if assets fall short of clearing the debt slate.

Lastly, navigating the maze of mezzanine financing—straddling the realms of debt and equity—proves arduous and time-consuming. Such negotiations often stretch over three to six months before the ink dries on the deal.

To keep it simple:

Advantages

Long-term “patient” debt.
Cheaper than raising equity.
Structural flexibility
No diluting effect on the company’s equity.
Lenders tend to be long-term

Disadvantages

High interest rates.
Debts are subordinated.
Obtaining credit can be difficult and time-consuming, with potential limitations on future credit.
The owner must relinquish some power.

Is mezzanine financing risky?

Mezzanine loans often carry a higher risk profile compared to traditional debt financing. In terms of repayment hierarchy, they typically rank subordinate to other forms of debt, earning them the moniker “subordinate loans.” Consequently, lenders offset this heightened risk by levying higher interest rates.

Mezzanine for real estate

Mezzanine financing, while subordinate to first mortgages, is prioritised over the equity of the property owner. For the borrower, mezzanine finance for property means limiting the dilution of equity and maintaining control of the assets.

Mezzanine finance for property developments will be funded before the senior loan for construction and repair afterward. While mezzanine loans typically don’t require collateral, they often do, however, entitle the investor to buy equity at a later date and may only warrant a purchase if under a default situation.

Receiving mezzanine financing

As with any investing institution, mezzanine finance providers typically prefer companies with an attractive track record, namely one that demonstrates an established (preferably good) reputation and a history of profitability as well as a clear potential for future profitability. Some finance providers may also look at the viability of your company’s expansion plans, among other things that demonstrate stability and control.