Mezzanine Debt: How This Alternative Financing Option Works
6 MIN READ
Published October 19, 2023 | Updated November 09, 2023
Mezzanine debt is a type of business debt or loan used when a company cannot secure a conventional loan due to the risk. These loans are commonly used for scale-ups or expansion, not for start-ups. It’s a non-traditional loan that combines debt and equity and has a lower priority than other debt if the business fails.
Mezzanine loans usually have high-interest rates due to the inherent risk and flexible repayment terms. Depending on the terms, lenders may set conditions for business operations or choose to receive a share in equity if the borrower defaults.
What Is Mezzanine Debt?
Mezzanine debt is a form of financing that combines debt and equity. Lenders offer subordinated loans and receive interest and equity in some cases. When a business requires funds for a significant acquisition or project, traditional lenders may be unable to provide all the funds needed.
Mezzanine loans fill the gap for these situations but may come at an interest rate of 20% to 30% due to the risk for lenders with this form of debt. They can be secured or unsecured and are offered for short periods.
How Mezzanine Debt Works
Mezzanine lenders usually work with companies with a successful track record, such as profitable businesses that want to expand operations. Unlike traditional businesses, the loans come with a higher interest rate, and lenders may also ask for equity exposure and interest.
Borrowers may have several repayment options. The loans usually do not require payment during the term, only at the end. If the business doesn’t have enough cash flow or wants to reinvest, it can capitalize on interest charges. If the business fails and the borrower goes bankrupt, mezzanine debt has a lower priority than senior debts.
Mezzanine Debt Financing Options
Borrowers have several different mezzanine debt financing options to choose from for their capital structure:
- Preferred share
- Convertible debt option
- Subordinated debt without equity
- Subordinated debt with equity
- Subordinated debt with co-investment in equity
Convertible debt allows lenders to convert the debt to an equity interest if the company defaults. A business will usually secure a major portion of its desired capital from a senior lender, but mezzanine loans have their place in the capital stack.
For example, if a company wants to raise $5 million, a senior lender may offer them $3.5 million. The company can then use a mezzanine debt lender to raise the remaining $1.5 million to reach its goal. In case of default, the senior lender gets repaid first, which makes mezzanine loans riskier.
Mezzanine Debt vs Preferred Equity
Mezzanine debt is usually structured as a loan secured by collateral, and preferred equity is an equity investment in the company. Both are hybrid financing options because they have characteristics of debt and equity instruments.
Mezzanine financing is viewed as debt because it comes next in line after senior debt in case of repayment. The recall rights are structured differently from preferred equity. Both options offer tax advantages, are less expensive than common equity, and allow borrowers to close a deal fast.
Mezzanine Debt Term Sheet
A mezzanine debt term sheet lists the key conditions and terms of the financing arrangement, some of which are listed below:
- Principal Amount: This is the amount of loan that the lender offers.
- Interest Rate: The term sheet must specify the annual interest rate and whether it’s variable or fixed.
- Maturity Date: This is the date the loan must be repaid.
- Fees: Upfront fees, transaction costs, ongoing fees, and commitment fees must be specified in the term sheet.
- Amortization: Loans may have a bullet payment structure or periodic principal repayments.
- Covenants: The term sheet should specify the lender’s operational and financial covenants.
- Equity Conversion: In some cases, lenders may have the option to convert the debt into equity at a predetermined conversion price.
- Exit Strategy: The term sheet will also outline expectations about the exit strategy, which may involve a sale or an IPO.
Why Choose Mezzanine Debt?
There are several advantages of choosing mezzanine loans as a financing option, as listed below:
- Borrowers get access to funds for expansion or purchase.
- Interest payments on mezzanine loans may be tax-deductible.
- Borrowers can minimize equity dilution while borrowing more than what traditional banks lend.
- Borrowers can choose from multiple repayment options.
- Borrowers can show mezzanine financing as equity on their balance sheet, allowing them to show lower debt levels and qualify for other financing.
“If you have a financially healthy business but need extra capital to support growth, a Mezzanine loan can be a good option,” explains Teresa Dodson, a debt expert and the founder of Greenbacks Consulting.
When To Avoid Mezzanine Debt
While there are a number of benefits of mezzanine debt, there are also a few risks that you should be aware of:
- If a business defaults on the loan, it may have to offer equity to the lenders.
- If a project fails or doesn’t work as planned, debt holders may face significant debts, bankruptcy, and other financial consequences.
- Lenders may set operational and financial criteria that the borrower must maintain, which may not be suitable for all companies.
Successful Examples of Mezzanine Debt
Let’s say you want to acquire a business and require an investment of $1 million. The business has an operating income of $250,000. A senior lender finances $700,000 at an interest rate of 8% per year.
You then get funding for an additional $200,000 from a mezzanine investor at a rate of 20% per year, and you contribute the remaining $100,000 in equity. Here’s how much it’ll cost you each year in interest:
- $56,000 for the senior loan ($700,000 X 8%)
- $40,000 for the mezzanine loan ($200,000 X 20%)
The traditional senior loan has a lower interest rate. Your profits may be lower with mezzanine funds, but your required initial investment is also lower. Instead of $300,000, you only invested $100,000 of your capital, so your return on equity rises.
Mezzanine Debt in Real Estate
Mezzanine financing works for real estate investors who want to get capital while preventing equity dilution. It helps them retain a large stake of profit and ownership. For large development projects, investors may be able to raise funds through mezzanine debt, where traditional loans don’t offer large funding.
It allows developers to fund large-scale projects, enhance returns, and leverage their capital stack. The shorter loan term, risk-sharing features, and equity conversion options also make it a beneficial tool for investors who want to retain control over the project while securing additional capital.
Mezzanine Debt in Commercial Real Estate
Mezzanine debt also has extensive application in commercial real estate because it can bridge the gap between property acquisitions and development. Due to increased leverage, investors can maximize their returns on equity.
This type of financing is also helpful if traditional debt is insufficient to cover all the costs. It allows investors to undertake larger projects. Additionally, mezzanine debt offers flexibility and can be structured to align with the project's exit strategy and cash flow.
Where To Find Mezzanine Debt Options
Mezzanine debt providers offer loans to companies that can service higher debt levels safely. Often, these private equity firms offer financing to companies they’ve previously worked with because they have a better understanding of their business. Several lenders in the U.S. currently offer mezzanine debt options, some of which are listed below:
- Edgewood Capital Advisors: Their mezzanine lending program funds transitional assets and ground-up development projects.
- NewSpring Foundation: The company offers solutions for several transaction types, such as leveraged buyouts, refinancings, and liquidity.
- FinanceBoston: This real estate capital advisory firm offers mezzanine financing to bridge the borrower’s project funding gap.
- Global Capital Partners Fund: The team offers additional and quick funding and works with borrowers with a proven track record.
- Prime Commercial Lending: The company offers several finance structures, such as equity investments and subordinated debt with or without warrants.
The Bottom Line on Mezzanine Debt
While companies can raise funds through traditional avenues, mezzanine debt can offer more leverage and a higher return. Mezzanine debt is structured to be subordinate to senior debt. Lenders charge a higher interest rate due to the risk involved and may require equity as collateral.