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A mezzanine loan is finalizedMezzanine financing is a type of corporate debt that includes an equity component. It offers advantages to both borrowers and lenders that are not available through issuing stock or conventional debt, such as bonds. Established companies often use mezzanine financing to pay for an acquisition or launch a major project. Lenders participate for its higher interest rate and the possibility of part ownership in the borrower. Retail investors add it to their portfolios for higher yields than bonds and lower risk that stocks, as well as steady income. 

The word “mezzanine” comes from a Latin term meaning “middle.” In the financial world, mezzanine debt takes priority between senior debt, to which it is subordinate, and common stock as well as preferred stock, to which it is superordinate. If a company goes bankrupt and assets are sold off, senior debt holders are paid first, then mezzanine debt holders and, lastly, stockholders.

Features of Mezzanine Financing

Mezzanine financing can take the form of subordinated debt, preferred equity or a combination of the two. As subordinated debt, it takes second position to senior debt. As preferred equity, it provides lenders with the right to interest payments, unlike common shares.

Mezzanine financing usually carries a fixed, relatively high interest rate. Lenders may be compensated with a mix of cash interest payments, warrants convertible into equity or an increased amount of the principal. Lenders also receive fees for participating.

Often payments include interest only, without any amortization of the principal. Instead, the entire principal is paid off on maturity, which is typically five to eight years. Unlike senior debt or asset-based financing, mezzanine financing is not secured. Instead, in the event of default, lenders will be able to convert their loans into equity shares.

One special aspect of mezzanine loans is that senior lenders may be able to stop interest payments on the mezzanine debt in the event of the company being placed under financial stress. This is to protect the senior lenders, who are receiving a lower return than the mezzanine lenders, who are taking on more risk.

Uses For Mezzanine Financing

There are several scenarios when mezzanine financing is often used. They include when a company is:

  • Acquiring another company
  • Expanding by adding production or launching a major project
  • Recapitalizing or refinancing existing debt
  • Being bought out by management or shareholders
  • Pursuing a leveraged buyout

Ownership transition is a common example of when mezzanine financing is used. It allows privately held business owners to raise capital without diluting their ownership. It can also allow existing owners to increase their percentage ownership of a company, solidifying control.

Pros and Cons for Borrowers

Two puzzle pieces coming together

Mezzanine financing has many advantages. For one, it’s less costly than equity and in allowing owners to maintain or increase percentage ownership, mezzanine financing is obtainable with fewer restrictions. Because lenders don’t expect return of the balance for several years, it allows companies to focus on the long term.

Also, since there is no amortization, it has less effect on cash flow. And, while mezzanine financing is carried on a company’s balance sheet as equity, the interest payments are tax-deductible as if it were debt.

The disadvantages include that it’s more costly than senior debt, because lenders have no recourse to collateral in case of default. Mezzanine financing does present the potential for some equity dilution. If the borrower defaults, the lenders will be able to exercise the right to turn their warrants into equity, reducing the percentage held by existing owners.

Also, mezzanine financing requires borrowers to refinance the principal by the maturity date or come up with a large amount of cash. Typically, borrowers use new senior debt to pay off the mezzanine financing when it matures.

Another limitation of mezzanine financing is that it is usually reserved for established and profitable companies. This is because lenders have no recourse other than equity participation, so they want to see solid cash flow and the opportunity to own part of a growing company.

Pros and Cons for Lenders

Mezzanine financing, which is often described as expensive debt or cheap equity, typically offers returns from 12% to 20% to lenders – and their investors – greater than senior debt but less than equity.

It also appeals to lenders because it provides lenders with the option of an ownership stake in the borrower, through warrants or other provisions for converting debt to equity. That can be appealing if the borrower becomes much more successful. Lenders are guaranteed specific, periodic payments, something to which stockholders are not entitled.

However, lenders and their investors must wait years for pay back. Also, mezzanine debt is illiquid, since it normally cannot be traded as stocks and bonds are.

The Bottom Line

Mezzanine loan documentsMezzanine financing is a blend of equity and debt financing that has features of both and a risk profile midway between the two. It resembles a second mortgage, except that the loan is secured with stock rather than a house. It is used by companies engaged in acquisitions, expansions or buyouts that lack the collateral to take on additional, less costly senior debt, but want to avoid diluting existing owners’  holding or can’t meet the higher return expectations of equity investors. Lenders and their investors like the higher return and flexible payback terms.

Tips for Investing

  • Consider asking a financial advisor if adding a fixed income alternative investment with high yields to your portfolio makes sense. Finding the right financial advisor who fits your needs doesn’t have to be hard. SmartAsset’s free tool matches you with financial advisors in your area in five minutes. If you’re ready to be matched with local advisors who will help you achieve your financial goals, get started now.
  • A corporate bond with a high rating offers dependability and certainty but its lower risk tends to mean lower return. That’s why bonds don’t offer the kinds of returns you’ll get if you invest in mezzanine debt or stock. Just be mindful of the bond issuer’s credit rating and the bond’s duration.

Photo credit: ©iStock.com/SDI Productions, ©iStock.com/mikdam, ©iStock.com/designer491

Mark Henricks Mark Henricks has reported on personal finance, investing, retirement, entrepreneurship and other topics for more than 30 years. His freelance byline has appeared on CNBC.com and in The Wall Street Journal, The New York Times, The Washington Post, Kiplinger’s Personal Finance and other leading publications. Mark has written books including, “Not Just A Living: The Complete Guide to Creating a Business That Gives You A Life.” His favorite reporting is the kind that helps ordinary people increase their personal wealth and life satisfaction. A graduate of the University of Texas journalism program, he lives in Austin, Texas. In his spare time he enjoys reading, volunteering, performing in an acoustic music duo, whitewater kayaking, wilderness backpacking and competing in triathlons.
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