Mezzanine Financing

What is Mezzanine Financing?

Mezzanine financing is a layer of financing that fills the gap between senior debt and equity in a company. It can be structured either as preferred stock or as unsecured debt, and it provides investors with an option to convert to equity interest. Mezzanine financing is usually used to fund growth prospects, such as acquisitions and expansion of the business.

A gap between senior debt and equity financing exists due to the following common reasons:

• Inventory, accounts receivable, and fixed assets are discounted at higher rates for fear of non-recognition of their value.
• There is a substantial volume of intangible assets recorded on the balance sheets.
• To address the rise in defaults and regulatory pressure, banks impose limits on the total debt that a business can acquire.

Mezzanine Financing Rate of Return

The basic form of mezzanine financing is unsecured debt and preferred stocks. As mezzanine financing is unsecured, it carries higher risks, and investors require a higher rate of return than secured lenders. Typically, it pays an investor 12-20%, which is higher than the rate of return on ordinary debt.

Mezzanine investors can earn returns from the following available sources:

1. Cash interest

Based on the portion of the outstanding mezzanine funding balance, investors receive cash periodically. The interest rate may either be set or may fluctuate over the loan period.

2. Payment in Kind (PIK) interest

It is also a periodic method of payment. However, the interest amount is not paid in cash. Instead, it is added to the principal sum of the security, and the total amount is paid at the end of the loan period. For example, a $50 million bond with a 10% PIK interest rate will amount to $55 million at the end of the period, and there will be no cash interest payment.

3. Ownership

Similar to a convertible bond, mezzanine financing often includes an equity interest in the form of a conversion feature or warrant. Usually, the PIK interest or the cash interest follows the ownership portion of the securities.

4. Participation payout

In place of equity, investors may take a return on equity in the form of a percentage of the company’s performance as measured by net sales or EBITDA, or profit.

5. Arrangement fee

Mezzanine investors are also required to be paid an arrangement fee upon closing the transaction.

Benefits of Mezzanine Financing

To the Issuer

1. Increase in total capital

Mezzanine financing can help a company secure more capital and circumvent the under-capitalization of the business. The interest payment on mezzanine funding is also tax-deductible.

Let us assume you want to start your own business and you need $15 million. You plan to raise $5 million through equity and approached a bank seeking a loan of $10 million. However, a bank will usually deem it as unreasonable and will lend only 75% of the required loan. It leaves you with an option to raise $7.5 million through equity.

Suppose a mezzanine investor proposes to lend you $5 million. Since the bank considers mezzanine as equity and sees a trusted partner with the mezzanine component, the bank will ultimately lend you the originally requested amount of $10 million. Therefore, the total capital raised with and without mezzanine will be:

Hence, the mezzanine layer reduces the equity requirement and helps to secure more total capital.

2. Reduction of capital cost and an increase in equity returns

Equity is the costliest source of capital, and it dilutes the current shareholders. Therefore, mezzanine debt may be an attractive alternative for accessing much-needed capital. Companies use an appropriate combination of senior debt, mezzanine debt, and equity to reduce the true cost of capital and increase asset returns.

To the Investor

1. Attractive and safe investment

The mezzanine investor enjoys the advantages of equity investment in the form of high returns and a diverse portfolio. In the case where the borrowing company becomes successful, the mezzanine investor can exercise the equity option and receive the benefits.

In addition, even in the worst case, the mezzanine investor gets at least the interest payment. The interest received for mezzanine financing outperforms the one received against traditional financing.

2. Warrant option

Mezzanine financing often includes warrants or convertible equity options that a mezzanine investor can exercise to earn a stake in the company. The rights can be exercised at a given date or the occurrence of any specific event, as outlined in the agreement.

Mezzanine Financing Limitations

For the Issuer

1. Probability of failure

Mezzanine financing, though readily available, demands high interest rates. In case the project fails to take off, the creditor will need to pay back the extremely costly loan.

2. Potential loss of control and freedom

When creditors take mezzanine debt, they sacrifice freedom and control, as conversion to equity is always a possibility. Moreover, the equity option, when exercised, results in the dilution of EPS, triggering a negative reaction from existing shareholders.

For the Investor

1. High risk

Mezzanine financing is provided without collateral, and the investment is mostly made in high-yield but risky, projects. Thus, investors are exposed to the risk of losing the investment in case the company goes bankrupt.

2. Long time-period for return on investments

Companies usually seek mezzanine financing for the growth or expansion process. Such ventures require some time before they can produce returns. Mezzanine financing is not intended for investors who are looking to make quick money. It is why mezzanine financing agreements specify the interest commencements after a period, not immediately.

Key Takeaways

• Mezzanine financing produces higher returns than traditional debt, and investors can earn returns through cash interest, PIK interest, ownership, and payout as a percentage of the company’s performance.
• It helps a business secure more capital, lower the cost of capital, increase the rate of return, and save tax on interest payments.
• Mezzanine financing includes a convertible option or warrant that provides investors with a right to earn a stake in the business. It, however, results in the existing owners being diluted by the issuance of additional shares.

Additional Resources

CFI offers the Commercial Banking & Credit Analyst (CBCA)® certification program for those looking to take their careers to the next level. To keep learning and advancing your career, the following resources will be helpful:

• Cost of Capital
• Pro-Rata Participation Rights
• Rate of Return
• Series A Financing
• See all commercial lending resources