Companies in the small and medium size range generally have difficulty being approved for debt funding. As federal constraints on conventional lending have tightened, these businesses have turned to alternatives like mezzanine loans. This tool can come in handy when pursuing growth prospects or making acquisitions. So, what is mezzanine debt?
What Is Mezzanine Debt?
Mezzanine debt is an intermediate financing form that sits between equity and senior debt. It is a form of financing that combines debt and equity. However, it is not secured by the company’s assets. However, it is secured by the company’s free cash flow value.
It’s an excellent option for startups and developing enterprises to raise capital when traditional lenders cannot meet their full funding needs. When your business has established free cash flow, you may want to use this debt instead of equity. This will allow you to secure financing without diminishing your ownership stake.
How Does Mezzanine Debt Work?
Mezzanine loans combine the benefits of debt with those of equity. As a form of financing, it carries a significant level of risk. It ranks below debt in priority and above pure equity. However, compared to other forms of debt, its returns on investment tend to be among the highest (often between 12% and 30%).
Mezzanine funding can be viewed in two ways:
- Pricey debt
- Inexpensive equity
This is because the cost of capital for mezzanine financing is lower than that of equity. However, it is still greater than that of senior debt, which businesses would normally receive from their banks. Additionally, the value of the company’s shares is not diluted as much.
Mezzanine financiers like to partner with established businesses. A mezzanine loan could be used, for instance:
- To finance the purchase of an established company or
- The expansion of an established and successful company’s activities.
Mezzanine financing, in the end, allows a company to raise additional money and boost its returns on equity.
How Is Mezzanine Debt Structured?
Mezzanine financing can take the form of subordinated debt, it can also be preferred equity or a combination of both. It sits in a company’s capital structure below senior debt and above common stock. Mezzanine financing typically takes the form of unsecured subordinated debt.
Subordinated debt refers to bonds and loans secondary to other holders of the company’s debt instruments in terms of their claims on the company’s assets and earnings. For debt repayment in the event of borrower default, the sale of assets like real estate and equipment may be necessary. When there isn’t enough cash, creditors take a back seat.
It is common practice for banks and senior debt holders to receive payment before other creditors during a liquidation. Collateral may also be used to protect their interests. All senior debt holders must be compensated before subordinated debt holders get any funds.
The term “unsecured subordinated debt” refers to a debt not backed by assets other than the company’s pledge to repay. The debt is not backed by a lien or any other credit. Despite being superior to ordinary equity, mezzanine loans are often lower on the priority scale.
When to Use Mezzanine Debt
This debt form, as mentioned before, serves as a bridge between senior debt financing and the equity you must put into as one of the commercial real estate transaction steps. For instance, you want to purchase a commercial property worth $60 million. You finance 60% of the purchase with a bank loan, and then your personal equity contribution covers 20%.
You are still left with 20% of the cost to cover. Increasing your equity contribution to cover the remaining 20% is one possibility among several others. However, there are situations where a higher equity investment is just not possible. In such instances, you can use mezzanine financing with your current CRE loan to make the difference.
Even if you have enough cash in hand to pay for the remaining equity investment, you may still decide to go for a mezzanine loan. This will free up cash that would have gone toward the purchase’s equity contribution so that it can be used elsewhere. You can finance two purchases at once instead of just one if you use mezzanine financing to lower your equity investment.
Benefits of Mezzanine Debt
For both borrowers and lenders, there are pros and negatives to mezzanine finance, just like any other complicated financial product or service. Here are some of the reasons why borrowers and lenders like this debt form:
Borrowing at interest rates close to 20% per year may seem counterintuitive, however, mezzanine financing has significant benefits for the borrower as well:
- Mezzanine loans are set up to allow the current owner to keep full sway over the company’s operations and strategy. Mezzanine financiers take a back seat. Lenders typically do not get in the way of business when it comes to running the company.
- Mezzanine debt is a very flexible arrangement that can be tailored to meet the cash flow needs of any business through the structuring of coupons, amortization, and covenants. An interest payment may be postponed in whole or part if the borrower cannot pay it when due. For most forms of debt, this choice is not available.
Additionally, if the value of a rapidly expanding company rises, the option to consolidate many mezzanine finance loans into a single senior loan at a reduced interest rate may become available.
It’s not only the borrowers that enjoy benefits from mezzanine loans. There are benefits and drawbacks for lenders under this framework as well. Interest rates on mezzanine loans are higher than those on traditional bank loans because of the greater risk the lenders take on by providing this type of funding.
- Interest payments to mezzanine lenders are due on a monthly, quarterly, or yearly basis, depending on the terms of the loan agreement. This is in contrast to equity investors, who are not guaranteed any periodic payments or dividends
- Mezzanine debt returns are also more stable than equity returns
- Mezzanine loan returns are contractual and guaranteed to be paid in full, while equity returns fluctuate with market conditions. Lenders of a mezzanine loan may receive stock in the company.
For certain lenders, this might mean a huge return rate (ROR) boost.
Disadvantages of Mezzanine Debt
Despite the several benefits this debt form provides to borrowers and lenders, it equally comes with its fair share of disadvantages. Here are some of the drawbacks of this debt for borrowers and lenders:
When securing mezzanine financing, owners may sacrifice some control and upside potential due to the loss of equity. Mezzanine lenders may set specific criteria that borrowers must maintain. This may include:
- A board presence
- Specified limits on financial ratios, amongst other demands.
Leverage is always risky. Borrowers may face significant debts and other consequences if things do not work out as planned. If borrowers default on loans, they may have to provide equity interest to lenders.
Finally, mezzanine loan debt and equity can be tedious and burdensome to negotiate and put into place. Most such deals will take three to six months to finalize the deal.
The greatest disadvantage that mezzanine lenders face is the risk of losing their money. If the borrower company declares bankruptcy, the mezzanine lenders could lose their money. In the event of a company’s insolvency, the senior debt holders prioritize receiving payment from the sale of the company’s assets.
All mezzanine lenders will lose out if no assets are left over after all senior debt has been repaid.
The best way to take advantage of this debt form as a commercial real estate investor is with the help of commercial real estate experts like Si Vales Valeo Real Estate. We have experience in analyzing and handling commercial real estate investments, including how to go about this debt. We are your best shot if you want to invest in the Cincinnati MSA.
Frequently Asked Questions
What Is the Difference Between Mezzanine Debt and Senior Debt?
This debt combines aspects of a loan and an investment into a single package. Bank loans are one example of senior debt. The two are vastly different in many ways. Assets secure many senior loans since banks base their lending on the value of those assets. In contrast, mezzanine debts typically offer higher returns and are not collateralized.
What Is the Difference Between Preferred Equity and Mezzanine Debt?
To put it simply, mezzanine debt functions as debt, while preferred equity functions as equity. Both forms of funding combine features of debt and equity. However, in contrast to preferred equity, this debt form from a bank or a private lender is considered debt because it ranks below senior debt and has recall rights that are structured differently than preferred equity.
Mezzanine financing is one of the most flexible alternative financing options for borrowers in an era of bank constraints as it lets companies grow. However, not all businesses need mezzanine finance. Only profitable enterprises with a viable expansion plan can receive mezzanine finance. Depending on your financial goals and commitments, you may consider the need for mezzanine debt.