how mezzanine financing works
mezzanine financing bridges the gap between debt and equity financing and is one of the highest risk forms of debt it is senior to pure equity but subordinate to pure debt however this means that it also offers some of the highest returns to investors in debt when compared to other debt types as it often receives rates of 12 to 20 per year and sometimes as high as 30 mezzanine financing can be considered as very expensive debt or cheaper equity because it carries a higher interest rate than the senior debt that companies would otherwise obtain through their banks but is substantially less expensive than equity in terms of the overall cost of capital it is also less diluting of the company s share value in the end mezzanine financing permits a business to own more capital and increase its returns on equity 12companies will turn to mezzanine financing in order to fund specific growth projects or to help with acquisitions having short to medium term time horizons often these loans will be funded by the company s long term investors and existing funders of the company s capital in the case of preferred equity there is in effect no obligation to repay the money acquired through equity financing since there are no mandatory payments to be made the company has more liquid capital available to it for investing in the business even a mezzanine loan requires only interest payments prior to maturity and thus leaves more free capital in the hands of the business owner a number of characteristics are common in the structuring of mezzanine loans including mezzanine financing structuremezzanine financing exists in a company s capital structure between its senior debt and its common stock as subordinated debt or preferred equity or some combination of these two the most common structure for mezzanine financing is unsecured subordinated debt sub debt as it is also called is an unsecured bond or loan that ranks below more senior loans or securities in its ability to claim against the company s assets or earnings in the case of a borrower default sub debt holders are not paid out until all senior debt holders are paid in full unsecured sub debt means that the debt is backed only by the company s promise to pay in other words there is no lien or other credit that supports the debt other mezzanine debt is security by a lien on the underlying property and is therefore secured payments are usually made with monthly payments of debt service based on a fixed or floating rate and the balance due at the maturity date preferred equity rather than being a loan that may be unsecured or secured by a lien is an equity investment in a property owning entity it is generally subordinate to mortgage loans and any mezzanine loans but is senior to common equity it is generally deemed to be a higher risk than mezzanine debt because of increased risk and the lack of collateral payments are made through priority distributions before any distributions to holders of common equity some investors negotiate to receive additional profit participation the principal is repaid at the stated redemption date usually after that of mezzanine debt the sponsor may sometimes negotiate for an extension of this date a preferred equity investor may however have broader corporate approval rights because it does not have lender liability issues maturity redemption and transferabilitymezzanine financing typically matures in five years or more 3 however the maturity date of any given issue of debt or equity is frequently dependent on the scheduled maturities of existing debt in the issuer s financing structure preferred equity generally does not have a fixed maturity date but may be called by the issuer as of some date after its issue redemption is usually exercised to take advantage of lower market rates to call in and reissue debt and equity at lower rates generally the lender in mezzanine financing has the unrestricted right to transfer its loan if the loan involves future distributions or advances the borrower may be able to negotiate a qualified transferee standard as a limitation on the borrower s right to transfer preferred equity in contrast is often subject to restrictions or conditions on transferring the purchaser s interest in the entity once all the preferred equity has been contributed the entity may permit transfers advantages and disadvantages of mezzanine financingas with any complex financial product or service mezzanine financing has advantages and disadvantages to consider for lenders and borrowers mezzanine financing may result in lenders or investors gaining immediate equity in a business or acquiring warrants for purchasing equity at a later date this may significantly increase an investor s rate of return ror in addition mezzanine financing providers are scheduled to receive contractually obligated interest payments made monthly quarterly or annually borrowers prefer mezzanine debt because the interest they pay is a tax deductible business expense thus substantially reducing the actual cost of the debt also mezzanine financing is more manageable than other debt structures because borrowers may move their interest to the balance of the loan if a borrower cannot make a scheduled interest payment some or all of the interest may be deferred this option is typically unavailable for other types of debt in addition quickly expanding companies grow in value and may restructure mezzanine financing loans into one senior loan at a lower interest rate saving on interest costs in the long term as an investor the lender often receives an incentive an additional equity interest or option to obtain such interest a warrant sometimes if the venture is highly successful the little add ons can end up hugely valuable mezzanine debt also generates a much higher rate of return which is important in what is still a low interest rate environment mezzanine debit also offers guaranteed periodic payments in contrast to the potential but not guaranteed dividends on preferred equity 