Mezzanine loans are a combination of debt and equity finance, most commonly utilized in the expansion of established companies rather than as start-up or early-phase financing. This type of financing is similar to debt capital in that it provides the lending party the right to adjust terms to access ownership or equity interest in the company if the loan is not paid back fully and on a timely basis. These types of loans are made available in short periods of time and usually only require minimal collateral from the borrower. Mezzanine loans command significantly higher interest rates, typically within the range of 20% to 30%.
Mezzanine financing is the part of a company's capital that exists between senior debt and common equity as either subordinated debt, preferred equity or a combination of the two. A number of characteristics are common in the structuring of mezzanine loans, such as:
- In relation to the priority with which they are paid, these loans are subordinate to senior debt but senior to common equity.
- Differing from standard bank loans, mezzanine loans demand a higher yield than senior debt and are often unsecured.
- No principal amortization exists.
- Part of the return on a mezzanine loan is fixed, which makes this type of security less dilutive than common equity.
- Subordinated debt is made up of a current interest coupon, payment in kind and warrants.
- Preferred equity is junior to subordinated debt, causing it to be viewed as equity coming from more senior members in the structure of capital financing.
Companies commonly seek mezzanine financing to support specific growth projects or acquisitions. The benefits for a company in obtaining mezzanine financing include the fact that the providers of mezzanine capital are often long-term investors in the company. This makes it easier to obtain other types of financing since traditional creditors generally view a company with long-term investors in a more favorable light and are therefore more likely to extend credit and favorable terms to that company.
Mezzanine loans assist in generating more capital for a business in addition to allowing it to increase its returns on equity and show a higher bottom-line profit. Mezzanine loans typically do not require payment during the term of debt, only at the end of the term. This enables a company to improve its cash flow. The company can also use the additional available funds to pay off other existing debt, invest working capital, develop products or finance market expansion. The company may also wish to hold onto the additional cash and allow it to accumulate on its balance sheet while seeking potential future opportunities to put the funds to their best possible use.