Loading the player...

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, 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.

RELATED TERMS
  1. Equity

    Equity is the value of an asset less the value of all liabilities ...
  2. Debt Financing

    Debt financing occurs when a firm raises money for working capital ...
  3. Subordinate Financing

    Subordinate financing is debt financing that is ranked behind ...
  4. Financing

    Financial institutions and banks are in the business of providing ...
  5. Special Finance

    Special finance is a lending option in the auto sales industry ...
  6. Corporate Finance

    Corporate finance is the division of a company that deals with ...
Related Articles
  1. Small Business

    The basics of financing a business

    From debt financing to equity financing, there are numerous ways to fund a business startup. Find out which one is the best funding model for your company?
  2. Small Business

    Is Equity Financing the Right Choice for Your Business?

    Discover the benefits and drawbacks of equity financing for a small business, and learn when equity financing should be used instead of debt financing.
  3. Small Business

    Explaining Cost Of Capital

    Cost of capital is the cost of funds used to finance a business.
  4. Investing

    The difference between finance and economics

    Learn the differences between these closely related disciplines and how they inform and influence each other.
  5. Tech

    Oaktree Capital Management: Investment Manager Highlight (OAK)

    Learn about the key executives and investment professionals who guide the alternative investment management firm, Oaktree Capital Management.
  6. Investing

    13 Pre-Issue Corporate Bond Questions For Businesses

    When a company needs more funding, there are many options. Corporate bonds is just one of them.
  7. Investing

    Target Corp: WACC Analysis (TGT)

    Learn about the importance of capital structure when making investment decisions, and how Target's capital structure compares against the rest of the industry.
  8. Insights

    The Fuel That Fed The Subprime Meltdown

    Take a look at the factors that caused this market to flare up and burn out.
RELATED FAQS
  1. How are mezzanine loans structured?

    Discover what a mezzanine loan is and how it is structured, along with reasons why companies consider this alternate form ... Read Answer >>
  2. What are the benefits for a company using equity financing vs. debt financing?

    Learn what some of the principal advantages are for a company that chooses to utilize equity financing in preference to debt ... Read Answer >>
  3. What are the benefits and shortfalls of the Herfindahl-Hirschman Index?

    Learn about the differences between equity and debt financing and how they impact financials. Find out how businesses determine ... Read Answer >>
  4. How does a company's capitalization structure affect its profitability?

    Learn about capitalization structure and how the combination of debt and equity a company uses to fund operations can affect ... Read Answer >>
  5. Which financial ratio best reflects capital structure?

    Learn about the debt-to-equity ratio and why this metric is widely considered the most useful reflection of a company's capital ... Read Answer >>
Hot Definitions
  1. Diversification

    Diversification is the strategy of investing in a variety of securities in order to lower the risk involved with putting ...
  2. Intrinsic Value

    Intrinsic value is the perceived or calculated value of a company, including tangible and intangible factors, and may differ ...
  3. Current Assets

    Current assets is a balance sheet item that represents the value of all assets that can reasonably expected to be converted ...
  4. Volatility

    Volatility measures how much the price of a security, derivative, or index fluctuates.
  5. Money Market

    The money market is a segment of the financial market in which financial instruments with high liquidity and very short maturities ...
  6. Cost of Debt

    Cost of debt is the effective rate that a company pays on its current debt as part of its capital structure.
Trading Center