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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 financing tends to be completed with little due diligence on the part of the lender and little or no collateral on the part of the borrower. It is treated as equity on a company's balance sheet.

BREAKING DOWN 'Mezzanine Financing'

Mezzanine financing is generally offered to companies that have a track record in their industry, 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.

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.

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 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.

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