What Is Mezzanine Financing?

Mezzanine financing is a hybrid of debt and equity financing that gives the lender the right to convert to an equity interest in the company in case of default, generally, after venture capital companies and other senior lenders are paid.

Mezzanine debt has embedded equity instruments attached, often known as warrants, which increase the value of the subordinated debt and allow greater flexibility when dealing with bondholders. Mezzanine financing is frequently associated with acquisitions and buyouts, for which it may be used to prioritize new owners ahead of existing owners in case of bankruptcy.

How Mezzanine Financing Works

Mezzanine financing bridges the gap between debt and equity financing and is one of the highest-risk forms of debt. It is subordinate to pure equity but senior to pure debt. However, this means that it also offers some of the highest returns when compared to other debt types, as it often receives rates between 12% and 20% per year.

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.

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 the capital financing.

Key Takeaways

  • Mezzanine financing is a hybrid of debt and equity financing that gives the lender the right to convert to an equity interest in the company in case of default, generally, after venture capital companies and other senior lenders are paid
  • It offers some of the highest returns when compared to other debt-linked financing types, as it often receives rates between 12% and 20% per year.
  • Mezzanine loans are most commonly utilized in the expansion of established companies rather than as start-up or early-phase financing. 

The 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.

Borrowers prefer mezzanine debt because the interest is tax-deductible. Also, mezzanine financing is more manageable than other debt structures because borrowers may figure their interest in 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 place.

An Example of Mezzanine Financing

For example, Bank XYZ provides Company ABC, a maker of surgical devices, with $15 million in mezzanine financing. The funding replaced a higher interest $10 million credit line with more favorable terms. Company ABC gained more working capital to help bring additional products to the market and paid off a higher interest debt. Bank XYZ will collect 10% a year in interest payments and will be able to convert to an equity stake if the company defaults.