What is mezzanine financing?

Mezzanine financing is an unconventional type of funding that combines debt and equity participation for lenders. It ranks lower in priority than other debts in the event of business failure.

Definition and Example of Mezzanine Loan

A mezzanine loan is a type of financing that combines debt and equity participation. Lenders offer loans in subordinate ranks (less important than traditional loans), and they may also receive equity shares. Mezzanine loans often come with relatively high interest rates and flexible repayment terms.

When a business needs money for a large project or acquisition, traditional lenders may be unwilling to provide the entire required amount. Creative financing methods such as mezzanine loans can bridge that gap.

How Mezzanine Loans Work

Mezzanine loans are a blend of debt and equity participation. Depending on the terms of the agreement and how events unfold, the agreement can provide equity participation to lenders.

Lenders in mezzanine loans typically work with companies that have a successful track record. For example, you might use a mezzanine loan to acquire an existing business or expand operations for an already profitable business.

Interest and Repayment of the Loan

Mezzanine loans often come with higher costs than traditional borrowing. It is common to see interest rates in the double digits, or lenders may demand equity participation to enhance interest income.

Depending on the terms of the agreement, borrowers may have several options for repaying the loan. If cash flow is unavailable, or if the company wishes to reinvest instead of paying interest, companies can capitalize on interest costs, known as “payment in kind.”.

Subordinated Loans

Mezzanine debts typically have lower priority than senior debts when borrowers default. If the business fails, it may need to sell assets such as buildings and equipment to generate cash and pay off debts. If there is not enough money to pay everyone, these creditors line up. Banks and senior bondholders are usually at the front, giving them a better chance of receiving payment in the event of liquidation. (Their interests may also be secured by collateral.) Mezzanine loans are usually positioned further down the priority list, although they stand above common equity.

Advantages and Disadvantages of Mezzanine Loans for Borrowers

Like any type of borrowing, mezzanine loans come with benefits and drawbacks for borrowers.

Advantages

• Access to Capital: Borrowers receive the money they need for purchasing or expanding.
• Reduced Equity Dilution: Instead of trading a large amount of equity for capital, borrowers can reduce their equity dilution while borrowing more than traditional banks are willing to lend.
• Tax-Deductible Interest Payments: Interest payments may be tax-deductible for the company.
• Multiple Repayment Options: Borrowers can pay interest in cash, add it to the loan balance, or provide instruments resembling equity to the lender.
• Capital Structure Benefits: Mezzanine financing typically appears as equity on the balance sheet, allowing borrowers to show lower debt levels and qualify more easily for other types of financing.

Disadvantages

• Financial Consequences: Leverage (borrowing money in the hope of recovering more than you borrowed) is always risky. Borrowers may face significant debt and other consequences if things do not go as planned.
• Risk of Losing Equity: If borrowers default on the loans, they may have to provide equity to the lenders.
• Shared Control with Lenders: Lenders in mezzanine loans may set specific criteria that borrowers must adhere to. For example, lenders may impose limits on financial ratios or provide other claims.

Advantages and Disadvantages of Mezzanine Loans for Lenders

Lenders

They are not the only ones facing advantages and disadvantages of mezzanine loans. This type of lending structure also has advantages and disadvantages for lenders.

Advantages

• Interest Income: Mezzanine financing tends to have relatively high interest rates to compensate lenders for the high level of risk.
• Equity Participation Rights: Lenders can receive equity participation rights, allowing them to share in the success of the business. For example, warrants may be part of the lender’s compensation, or lenders may receive equity participation rights if borrowers default on the loans.

Disadvantages

• Default Risk: Lenders always face the risk of losing money due to defaults, particularly with mezzanine debt.
• Low Priority: These loans may not be secured by any tangible collateral. For example, there may be no liens on property, equipment, or other company assets. When the business pays its senior creditors, any available funds may be exhausted before mezzanine lenders receive payment.

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Source: https://www.thebalancemoney.com/what-is-a-mezzanine-loan-debt-and-equity-financing-4687180