A mezzanine loan is a form of financing often used by corporations or real estate investors for acquisitions and buyouts. These loans combine features of both debt and equity, making them a unique form of financing. If a borrower defaults, lenders can convert the debt into an equity interest in the company. Mezzanine loans present a higher risk to lenders than senior debt but less risk than equity.
To grow a business, companies usually need money — and lots of it. That’s where mezzanine loans come in. Mezzanine loans are a type of financing that can help businesses grow by providing the extra cash they need to expand. This type of financing can also be a great way to acquire capital without putting up collateral.
In this article, we’ll discuss mezzanine loans, explore what makes them different from other types of financing options, along with the pros and cons for borrowers and lenders alike.
What is mezzanine financing?
Mezzanine financing is a combination of debt and equity financing that sits between senior secured debt and preferred or common equity in terms of risk. It provides companies and real estate investors with the additional capital they need to grow their business and can finance activities such as acquisitions, expansions, and working capital needs.
Mezzanine loans are junior to senior debt concerning priority. This means mezzanine lenders only get repaid after senior lenders are paid off if the company goes bankrupt. However, it also means they can be riskier for lenders, which is why they often have higher interest rates.
What is the difference between senior and mezzanine debt?
Senior debt and mezzanine loans are two popular financing options that offer different benefits and drawbacks for both lenders and borrowers.
- Senior debt. This is the most secure form of lending because it has preference over equity in a company’s liquidation value — assets available for distribution. It’s usually secured by liens on a company’s collateral such as inventory, equipment, real estate, etc.
- Mezzanine debt. This is a unique form of subordinated debt that includes features of equity and ranks below senior debt but above equity in a company’s liquidation value. Mezzanine debt usually has a higher interest rate than senior debt because it is riskier for the lender. However, the loan may have other features that make it attractive to the lender, such as warrants or convertible debt.
Are mezzanine loans secured?
Mezzanine financing can be unsecured or secured. Real estate mezzanine loans are usually secured directly or indirectly by property.
You could argue that also mezzanine loans are secured by an ownership interest in the company, but this is of limited value since mezzanine loans are pretty low in the pecking order when it comes to repayment in case of default. Mezzanine loans can be a great way for companies to get the capital they need to grow their business without giving up a large part of their equity. This is why these types of financing are typically only available to profitable companies that have strong cash flow.
How do mezzanine loans work?
Mezzanine financing can exist in a company’s balance sheet as either subordinated debt, preferred equity, or a combination of both. However, it’s more common to see mezzanine loans as a form of unsecured subordinated debt.
Unsecured subordinated debt ranks below senior loans in terms of priority. This means that in the event of bankruptcy, senior debt is repaid first using a company’s assets. Only after all senior debt is paid do the company’s assets pay off unsecured subordinated debt.
Pricing and payment structure
Generally, mezzanine loan lenders prefer to work with companies that have successful track records because they’re less likely to default on the loan. However, since there’s still a high degree of risk, lenders usually charge interest rates that are in the double digits (typically 15% to 20%). They will also likely take equity warrants of 1% to 5% in the business. Equity warrants entitle the lenders to participate in a company’s equity and receive a benefit if there’s an increase in its value.
Regarding payment, mezzanine loans are usually structured to include a mix that can include cash, payment-in-kind, as well as equity participation rights.
The majority of mezzanine loans mature within five years or more and typically require only interest payments with no principal payments prior to maturity. This “patient” nature of the debt affords businesses the time to grow, repay the loan, and take on less expensive and more senior debt.
Why are mezzanine loans risky?
As with any investment, there is always a risk that the borrower will not repay their loan in full or on time. By definition, mezzanine loans rank below senior secured debt in a company’s capital structure. So if the company goes bankrupt, mezzanine lenders are among the first to lose money. That’s why mezzanine loan financing is often structured with more equity than traditional bank lending terms to protect the lender from risk if there’s an investment loss
In short, mezzanine financing is riskier for lenders due to the lack of collateral and possibility of default. However, the potential rewards — interest payments and equity interest — may be worth the risk for some investors.
What are the pros and cons of mezzanine loans for borrowers?
The mezzanine loan can be an alternative to the traditional business bank loan, providing borrowers with additional financing beyond what a bank would lend. However, just like any financing option, there are pros and cons.
Here is a list of the benefits and drawbacks to consider.
- Avoid unnecessary dilution from new equity investors. Mezzanine financing is often much cheaper than raising equity in terms of the overall cost of capital. When a company raises money by issuing new shares, it must give up a slice of ownership to its new investors. Because of this, mezzanine financing can be an attractive option for companies that don’t want to dilute their shareholding by issuing shares in return for access to capital through venture capitalists, angel investors, or banks.
- Flexible repayment options. Mezzanine financing provides flexible repayment options. Depending on the terms of the agreement, borrowers can pay interest charges through different options. This includes paying with cash, adding the interest to the loan balance if cash flow isn’t available, or providing equity-like instruments to the lender.
- Deductible interest payments. Borrowers often find mezzanine debt an attractive financing option because the interest they pay is a tax-deductible business expense. This essentially reduces the total cost of debt and helps save companies money.
- Tedious negotiation process. The mezzanine loan process can be tedious, as it often involves a lot of back-and-forth negotiation between the lender and the borrower. This often leads to delays in starting the financing process.
- Sharing control of the company with lenders. In some cases, mezzanine loan agreements might include restrictive covenants that limit the borrower’s ability to secure additional funds or refinance senior debt. Sometimes, there may be restrictions on payouts to key employees as well as limits on financial ratios.
- Financial consequences associated with debt. When you take out a mezzanine loan, you’re basically putting your business at risk. If your business can’t make the payments on the loan, you can accrue significant debts and end up putting your business in a difficult financial situation.
Are mezzanine loans my only option?
As a business owner, you have to make sure you consider the pros and cons of your financial opportunities carefully. If you don’t like the risks associated with mezzanine financing, there are plenty of alternatives.
Before signing on the dotted line, be sure to compare the rates and offers from multiple business lenders.
What are the pros and cons of mezzanine loans for lenders?
Borrowers aren’t the only ones who experience advantages and disadvantages when it comes to mezzanine debt. This type of financing option has pros and cons for lenders as well.
Here is a list of the benefits and drawbacks to consider.
- Interest payments. Mezzanine loans are considered to be riskier than other types of loans. As a result, they usually come with a higher interest rate, which helps to offset the additional risk that the lender is taking on. By charging interest payments on a monthly, quarterly, or annual basis, lenders can also maintain a sense of control over how quickly borrowers repay loans.
- Equity and participation rights. Mezzanine loans usually come with warrants or other equity participation rights that give the lender an opportunity to share in any future appreciation in the company’s stock. This means lenders will have the potential to make more money if the company is successful, making it a high-risk, high-reward investment.
- Low seniority and priority. Mezzanine loans are a type of loan that is junior to the primary or senior debt in a company’s capital structure. This means that mezzanine lenders have a lower priority and seniority in the repayment of their loans in the event of bankruptcy or liquidation. This can be a disadvantage for lenders, as they may not be repaid as quickly or in full as they would like.
- Risk of default. Mezzanine loans are risky for lenders because they are unsecured. This means if the borrower defaults, the lender’s loss will not be offset by any collateral that secured the loan. For this reason, lenders need to conduct thorough due diligence on any potential borrowers before signing on the dotted line.
- Mezzanine loans are often used to finance expansions, acquisitions, or other types of growth initiatives.
- Mezzanine debt is subordinate to senior debt financing and therefore has a higher risk for lenders. But it also provides higher potential returns.
- The most common structure for mezzanine financing is unsecured subordinated debt. However, this could also exist as preferred equity or a combination of the two.
- Mezzanine loans are typically quite expensive, with interest rates in the 15% to 20% range. However, they are also more patient, meaning no payments toward the principal are due before maturity.
- This type of financing can be attractive to borrowers because of its minimum equity dilution, flexible repayment options, and tax-deductible interest payments.
- Lenders receive high-interest rates as well as potential equity and participation rights.
- Mezzanine loans are usually not secured by tangible collateral but by a pledge of equity. However, some mezzanine loans are secured by real estate.
View Article Sources
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- Investment Capital — Small Business Administration
- 44-5143. Real Estate Mortgages — Nebraska Legislature
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