Mezzanine Finance Mezzanine Financing is a mixture of debt and equity financing which gives the lender the right to convert to an equity interest within the company in the case of default.
What Is Mezzanine Finance?
It is a highly complex form of business funding, but it can be useful in certain situations. Mezzanine financing tends to be carried out with little to no due diligence from the lender and little to no collateral on behalf of the borrower, making it the highest-risk form of debt.
Mezzanine finance is typically offered to companies that have a proven track record within their industry or an established reputation, as well as a history of profitability and a viable plan for expansion for the business. A mezzanine lender is usually brought into a buyout situation to help displace some of the capital which would usually be invested by an equity investor.
Although it is the highest-risk form of debt, mezzanine lending comes with some of the highest returns. A typical rate is usually in the range of 12%-20% per year.
An Example Of Mezzanine Financing
It is better for mezzanine financing to be thought of as a sort of ‘top up’ for bigger projects, rather than a complete loan.
If, for example, you want to raise £10 million and you already have a loan agreed for £7 million with a standard lender then, through mezzanine finance providers, you may be able to secure another £1.5 million. This means you would only need to put in £1.5 million yourself instead of the whole £3 million. Alternatively, you could also put in the same amount but have a fund for your project of £11.5 million instead of £10 million.
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Why Do Investors Like Mezzanine Debt?
Mezzanine debt has many advantages for the investor involved. Typically, mezzanine debt investments come with a free “kicker” which is usually in the form of a small piece of ownership which entitles the debt investor to buy equity in the company in the future. If the borrower goes on to be a huge success, then the kickers can often pay out over several multiples more than the originally borrowed amount.
Mezzanine debt generates a return for the investor which is much more consistent with equity rather than a debt. Mezzanine investors take big risks, just like equity investors, but they gain the benefit of having a contractually mandated interest payment monthly, quarterly or annually. Equity investors are not guaranteed to any dividends or entitled to receive specific amounts of money on a regular basis.
Why Do Borrowers Like Mezzanine Debt?
Whilst it may seem irrational for a borrower to borrow with rates nearing 20% per year, mezzanine debt gives the borrower a big advantage. Mezzanine debt comes with unique features which make the debt more manageable. Mezzanine lenders will typically include features like “PIK toggles”, which allow the borrower to be able to pay the interest by adding it onto the loan balance.
So, if the company is unable to make an interest payment as is normally scheduled, then they can defer some, or even all, of the interest for an agreed period of time. This feature is not available on senior debt.
Fast-growing companies may find that they won’t need to be paying sky-high interest rates for long. If the company expands, then the value should grow alongside it. Therefore, it is likely that the company will be able to refinance their senior and mezzanine debt into a single senior loan set at a lower interest rate for the future.
Pros and Cons Of Mezzanine Financing
Mezzanine financing may end up with lenders gaining equity in a business or purchasing equity at a later date. This can significantly increase the investor’s rate of return. Mezzanine finance providers can also receive contractually binding interest payments either monthly, quarterly or annually.
Borrowers prefer mezzanine debt as the interest can be deducted through tax. Mezzanine financing is also more manageable than other popular debt structures as borrowers may figure the interest in the balance of the loan. If the borrower is unable to make the scheduled interest payment, then some or even all of the debt may be deferred. This option is usually unavailable for other types of debt.
Quickly expanding companies can, and often do, grow in value. These companies can restructure their mezzanine debt into one senior loan at a lower interest rate, which saves on interest costs in the long-run.
However, during the process of securing mezzanine funding, owners sacrifice the control and potential thanks to the loss of equity. The owners also pay more in interest the longer that the mezzanine finance is in place.
How Do I Know If Mezzanine Finance Is For Me?
Mezzanine finance is useful for companies that are looking to fund a large project. If you are unsure as to whether mezzanine finance is right for you, then get in touch with our friendly and experienced team today. Submit your enquiry and we will aim to get back to you within 24 hours.