Owners also pay more in interest the longer the mezzanine financing is in place. Loan agreements will also often include restrictive covenants, limiting the ability to borrow additional funds or refinance senior debt, as well as establishing financial ratios the borrower must meet. Restrictions on payouts to key employees and even owners are also not uncommon. Mezzanine lenders provide capital in the form of unsecured loans, which are subordinated to senior debt but have priority over equity. Mezzanine debt offers a higher interest rate than traditional bank loans due to its higher risk profile.
- Mezzanine lending most commonly is used in the expansion of established companies.
- The high interest payments mean that there has to be a solid motive (and business plan) behind the bid to obtain the financing.
- Oftentimes, management with extensive experience will consider debt alternatives throughout the entire process.
- The funding replaced a higher interest $10 million credit line with more favorable terms.
This frees up cash flow for the borrowing company to pay off senior loans and other business expenses. Mezzanine financing is a hybrid form of financing, which combines features of debt and equity. Because of its hybrid form, mezzanine financing is sometimes considered a middle ground between debt and equity, enabling the company to benefit from both, and in doing so, raise higher levels of https://personal-accounting.org/what-is-mezzanine-financing/ capital. Sub-debt, as it is also called, is an unsecured bond or loan that ranks below more senior loans or securities in its ability to claim against the company’s assets or earnings. In the case of a borrower default, sub-debt holders are not paid out until all senior debt holders are paid in full. Unsecured sub-debt means that the debt is backed only by the company’s promise to pay.
Mezzanine use cases
Sometimes, if the venture is highly successful, the little add-ons can end up hugely valuable. Mezzanine debt also generates a much higher rate of return, important in what is still a low interest rate environment. Mezzanine debit also offers guaranteed periodic payments in contrast to the potential but not guaranteed dividends offered on preferred equity. Borrowers prefer mezzanine debt because the interest they pay is a tax-deductible business expense, thus substantially reducing the actual cost of the debt. Also, mezzanine financing is more manageable than other debt structures because borrowers may move their interest to the balance of the loan.
- The private equity firm does not want to put up $20 million of its own capital and instead looks for a mezzanine investor to finance $15 million.
- The following illustration from Oaktree shows a sample capital structure of a company.
- Besides forgoing collateral, small mezzanine loans can make debt service more manageable.
- Although they are typically more expensive than senior debt, these loans offer more flexible repayment terms and less paperwork than traditional loans.
If the cost of a mezzanine loan is too high, there are other financing options you can explore. In a preferred equity example, Company A issues Series B 5% preferred stock with a value of $250. The stock will pay scheduled dividends when funding is available until the maturity date.
What Is a Mezzanine Type Loan?
Usually, banks – specifically investment banks – only provide mezzanine financing to large corporate clients with annual revenues running into the hundreds of millions. In certain situations, a majority shareholder will seek to obtain further (or full) control over the company stock by buying out other stockholders. The buyer may choose mezzanine financing as a means of achieving this, bringing enough liquidity to the business to buy out the other shareholder’s interests in the company.
Senior Debt vs. Mezzanine Debt
Mezzanine loans are a type of financing that effectively allow borrowers to achieve a higher loan-to-value ratio than typically available with conventional loans. In commercial real estate, mezzanine loans enable borrowers to make up the difference between their equity investment and the senior debt that lenders like banks or credit unions provide. When mezzanine finance combines with senior debt and equity capital, it can optimize a company’s capital structure, minimize its cost of capital, and generate significant growth. Mezzanine financing gives businesses access to capital that is not available from traditional loan sources. Loan terms are usually structured as a hybrid between debt and equity. In some cases, borrowers can even use mezzanine financing to purchase additional assets for the business.
Mezzanine Financing 101: Definition, How it Works (2023 Updated)
But what about companies looking to raise significant amounts of capital for a major growth event? Real-estate investment trusts and closed-end funds may own mezzanine debt, which they make available for investors in the form of publicly traded shares. Mezzanine financing in real estate often can provide higher returns than conventional acquisition or development loans. In addition to higher interest rates, these loans are typically short-term and may include fees for applying, underwriting or closing. Lastly, the longer-term nature of mezzanine debt, typically ranging from five to seven years, grants companies sufficient time to generate cash flows and repay the debt, aligning with their growth trajectory.
Banks have strict regulations that limit the amount of money they can lend to companies and require them to sign strict agreements. Mezzanine financing lets companies borrow more cash and offers flexible terms and structure. Mezzanine loans have longer maturity and absence of amortization requirements. These make it easier for businesses to finance an event such as the integration of an acquisition. Mezzanine loans are layered on top of conventional loans in a typical capital structure—hence the name. Equity and mezzanine debt are two distinct forms of financing with different characteristics.
Problems with Mezzanine Financing
One of the principal drawbacks of mezzanine financing – discussed in more detail below – is that it involves a higher level of risk than traditional debt financing. Under U.S. Generally Accepted Accounting Principles (GAAP), a hybrid security classification on the balance sheet is dependent on how the embedded option is influenced by the debt portion. When creditors take mezzanine debt, they sacrifice freedom and control, as conversion to equity is always a possibility. Moreover, the equity option, when exercised, results in the dilution of EPS, triggering a negative reaction from existing shareholders. Mezzanine financing can help a company secure more capital and circumvent the under-capitalization of the business.
These warrants raise the value of the subordinated debt and increase flexibility when working with bondholders. From the borrower’s perspective, who is likely undergoing an LBO or M&A-related activity, the reason for raising mezzanine financing is to raise more capital and meet the funding target. Like every kind of borrowing, mezzanine loans come with benefits and drawbacks for borrowers. For many businesses, mezzanine is not viewed as permanent capital, but instead solution-oriented capital that serves a specific purpose, and can later be replaced with lower cost capital, i.e. senior debt. Mezzanine finance is a creative alternative for companies which already have significant levels of senior debt on their balance sheet to raise capital.
For a company considering introducing mezzanine financing to their balance sheet, it’s wise to weigh the pros and cons to best determine whether mezzanine is the right fit for their business. Any company or investor seeking liquidity for a well-defined strategic purpose may do well to consider mezzanine financing. The high interest payments mean that there has to be a solid motive (and business plan) behind the bid to obtain the financing. Without it, a company which already lacks liquidity may find itself in an even worse position. The sense for mezzanine financing is that it’s a middle ground between debt and equity. Mezzanine financing is thought to be a relatively new form of financing, with origins in the 1980s.
This is where companies buy other businesses in order to grow and respond faster to customer needs. They achieve this when purchasing other businesses through acquisitions. Established businesses that have big growth plans may want to consider the mezzanine financing route. Mezzanine financing is a type of financing that is often used in growth capital, acquisition funding, and Shareholder liquidity and intergenerational transfer.