The nature of mezzanine financing is often confusing for a lot of people and this article attempts to break it down with an example for a better understanding. What is mezzanine finance, exactly? Beginning with the term itself, “mezzanine” essentially means “in the middle” or “intermediate,” which helps in understanding its placement within the capital structure.
With the above in mind, a mezzanine finance falls in between equity and senior debt and can actually come in several forms. For example, junior debt, preferred debt, convertible debt, and participating debt are all forms of mezzanine financing.
The primary purpose of mezzanine financing is to displace a portion of capital that would otherwise be the responsibility of the equity investor. While mezzanine financing is usually the highest risk as far as debt goes, borrowers find it attractive due to its potentially high returns. Rates for a mezzanine loan typically fall somewhere in between 12 and 20 percent.
Mezzanine financing means that the borrower doesn’t need to put up as much initial capital and if the value of the business is expected to rise rapidly, the high interest rates may be less of a concern and the borrower may have the opportunity to refinance at a lower interest rate in the future.
Say you want to buy a restaurant, for example, that the current owners are willing to sell for $1 million. You obviously don’t have this so you acquire a senior lender that puts up $600,000 of the one million, leaving you to pay the additional $400,000.
The mezzanine investor intends to reduce this amount by offering an additional $200,000, for example, and they usually take into account the business’s annual profits as well your annual payments toward your senior loan.
While interest rates are higher, the borrower would have to keep in mind that the initial investment is significantly lower. Interest payments toward your mezzanine loan will almost always be contractually mandated whether you make them monthly, quarterly, or annually.
Mezzanine financing is most commonly found in highly leveraged buyouts and new real estate.
Mezzanine financing, while subordinate to first mortgages, is prioritized over the equity of the property owner. For the borrower, mezzanine finance for property means limiting the dilution of equity and maintaining control of the assets.
Mezzanine finance for property developments will be funded before the senior loan for construction and repaid afterward. While mezzanine loans typically don’t require collateral, they often do, however, entitle the investor to buy equity at a later date and may only warrant a purchase if under a default situation.
As with any investing institution, mezzanine finance providers typically prefer companies with an attractive track record, namely one that demonstrates an established (preferably good) reputation and a history of profitability as well as a clear potential for future profitability. Some finance providers may also look at the viability of your company’s expansion plans, among other things that demonstrate stability and control.