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What is 'Mezzanine Financing'

Mezzanine financing is a hybrid of debt and equity financing that gives the lender the rights to convert to an ownership or equity interest in the company in case of default, after venture capital companies and other senior lenders are paid. Mezzanine financing, usually completed with little due diligence on the part of the lender and little or no collateral on the part of the borrower, is treated like equity on a company's balance sheet.

BREAKING DOWN 'Mezzanine Financing'

To attract mezzanine financing, a company usually must demonstrate a track record in the industry with an established reputation and product, a history of profitability and a viable expansion plan for the business, such as through expansions, acquisitions or an initial public offering (IPO).

A typical interest rate for mezzanine financing is 12 to 20%, making it a high-risk, potentially high-return debt form. Mezzanine financing typically replaces part of the capital that equity investors would otherwise have to provide a company. For example, a private equity firm is purchasing a $200 million business. Senior lenders agree to provide $150 million. The private equity company secures mezzanine financing for $20 million and puts in $30 million of its own funds for the buyout. By using mezzanine financing, the purchasing company leverages its return while contributing less of its own capital.

Pros and Cons of Mezzanine Financing

Mezzanine financing may result in lenders gaining equity in a business or warrants for purchasing equity at a later date. This may significantly increase an investor's rate of return (ROR). In addition, mezzanine financing providers receive contractually obligated interest payments monthly, quarterly or annually. For example, Triangle Capital Corporation earns up to 19% annually on each of its mezzanine financing investments. This ROR is much higher than the interest rates U.S. Treasury notes pay annually, which are typically around 2%.

Borrowers prefer mezzanine debt because the interest is tax-deductible. For example, with a standard corporate tax rate of 35%, a pretax interest rate of 20% is reduced to 13% after taxes. Also, mezzanine financing is more manageable than other debt structures because borrowers may figure their interest into the balance of the loan. If a borrower cannot make a scheduled interest payment, some or all of the interest may be deferred. This option is typically unavailable for other types of debt. In addition, quickly expanding companies grow in value and restructure mezzanine financing into one senior loan at a lower interest rate, saving on interest costs in the long term.

However, when securing mezzanine financing, owners sacrifice control and upside potential due to the loss of equity. Owners also pay more in interest the longer mezzanine financing is in effect.

Example of Mezzanine Financing

In May 2016, Silicon Valley Bank provided IPG, a leader in surgical and implantable device management solutions, with $15 million in mezzanine financing. The funding replaced a $10 million facility with more favorable terms. IPG gained more working capital for bringing additional products to the marketplace and lowering healthcare costs for clients and their networks.

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