Mezzanine Financing If you’re part of an entity or an independent business owner, mezzanine financing may be the best bridging loan option for you.
What Is Mezzanine Financing?
Mezzanine funding 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. It’s typically offered to companies with:
- A proven track record within their industry
- An established reputation
- A history of profitability
- A viable plan for expansion of the business
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 one of the highest-risk forms of debt. 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 a high-risk form of debt, mezzanine loan lending comes with some of the highest returns. A typical rate is usually in the range of 12%-20% per year. However, junior bond finance, which is a subordinate to mezzanine financing, and carries an even higher risk than standard mezzanine funding. Therefore, the returns are often higher.
What Is The Definition Of Private Equity?
The private equity definition is simply where equity is not publicly traded or listed. This means that those who do have shares or an interest in the business are typically high net worth firms or individuals. These investors are generally part of limited partnerships that acquire and restructure companies that aren’t publicly traded.
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An Example Of Mezzanine Funding
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 financing 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 is Mezzanine Financing Appealing For Lenders?
For lenders, providing a mezzanine loan is an appealing prospect. The main reason is that interest rates tend to be higher from mezzanine lenders compared to traditional loan lenders. There are many reasons why this is:
– There’s no need for borrowers to provide collateral as part of the loan
– For business owners, a mezzanine debt would be less of a priority compared to older debts that are currently held by the business
– There is less of due diligence required in order for borrowers to obtain mezzanine financing
There is a high-risk nature with mezzanine financing, but it can still be favourable for lenders. This is because if borrowers are unable to pay back the loan within the set term, lenders can convert the outstanding balance into the ownership of the business in question. This means that lenders can gain equity in the business.
If the business becomes successful during the period when lenders have ownership in the business, a payout can be obtained by the lender. They will also be entitled to sell or transfer the stake at any time.
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 big advantages, including:
– Interest on debt is tax-deductible. This means that the interest that requires to be paid off for the debt can be less than 20% after taxes are considered.
– Mezzanine debt or junior bond finance comes with unique features which make the debt more manageable. Unlike our commercial loan rates, 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.
– 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.
– 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 Funding
It’s important to discuss the pros and cons of mezzanine financing to ensure it’s a solution for your needs. There can be many pros from obtaining a mezzanine loan:
– Borrowers prefer mezzanine debt as the interest can be deducted through tax
– The loan that’s obtained is treated as equity on business’ balance sheets, making it easier to obtain traditional financing easier in the future
– It’s 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.
– Mezzanine financing prevents business owners from giving up a large percentage of their ownership to obtain capital, in comparison to obtaining equity investors where they would need to give up a large percentage.
– Companies can restructure their mezzanine debt into one senior loan at a lower interest rate.
Mezzanine funding 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, who, by the private equity definition, are usually high net worth individuals. Mezzanine finance providers can also receive contractually binding interest payments either monthly, quarterly or annually.
On the other hand, there are downfalls to obtaining a mezzanine loan:
– During the process of securing mezzanine funding, owners sacrifice the control and potential thanks to the loss of equity.
– Compared to more traditional forms of lending, the owners would pay more in the interest the longer that the mezzanine financing is in place. This is because mezzanine financing lenders tend to look for high returns compared to traditional lenders.
How Do I Know If Mezzanine Financing Is For Me?
Here at UK Bridging Loans, we know that mezzanine or junior bond finance is useful for companies that are looking to fund a large project. If you are unsure as to whether mezzanine funding is right for you, then get in touch with our friendly and experienced team of mezzanine finance providers today. Submit your enquiry and we will aim to get back to you within 24 hours.