What Is a Mezzanine Loan?
Between Debt and Equity Financing
When a business needs funds for a significant project or acquisition, traditional lenders may be unwilling to provide all of the money required. But creative financing approaches like mezzanine loans might be able to fill the gap.
What Is a Mezzanine Loan?
A mezzanine loan is a form of financing that blends debt and equity. Lenders provide subordinated loans (less-senior than traditional loans), and they potentially receive equity interests as well. Mezzanine loans typically have relatively high-interest rates and flexible repayment terms.
Debt, or equity? : Mezzanine loans are a hybrid of both. Depending on the terms of the agreement and how events unfold, the arrangement can provide an equity interest to lenders. But borrowers often want to obtain debt financing without diluting the existing owners’ equity.
Subordinated loans: Mezzanine debt typically has a lower priority than senior debts when borrowers go bankrupt. For example, if you lend money to a business that goes belly up, the business may need to sell assets like buildings and equipment to generate cash. But if there’s not enough money to pay everybody, those “creditors” get in line. Banks and senior bondholders are usually near the front of the line, giving them a better chance of receiving payment in a liquidation. Plus, their interests may be secured by collateral.
Mezzanine loans are typically farther back in line (but above common equity).
Higher rates: Because of their low priority, mezzanine loans come with higher costs. Interest rates in the double-digits are common, or lenders may demand equity exposure to supplement interest income.
Existing business: Mezzanine lenders usually work with companies that have a successful track record. For example, you might use a mezzanine loan to acquire an existing business or expand operations for a business that’s already profitable. That said, experienced entrepreneurs might be able to find financing, including funds to purchase real estate.
Flexible payment: Depending on the terms of an agreement, borrowers may have several options for repayment. If cash flow isn’t available—or if the business wants to reinvest instead of pay interest—businesses can capitalize interest charges, known as a payment in kind.
Pros and Cons
- Access to capital: The primary advantage is that borrowers get the money they need for a purchase or expansion.
- Leverage: Borrowers don’t need to invest as much of their own money, so they earn a higher return on equity, assuming all goes well.
- Equity: Instead of trading a substantial amount of equity for capital, borrowers can minimize their equity dilution while borrowing more than traditional banks want to lend.
- Capital structure: Mezzanine financing often appears as equity on the balance sheet, enabling borrowers to show lower debt levels and more easily qualify for financing.
- Deductible expense? Interest payments may be deductible to the business, but check with a CPA to verify the details before doing anything.
- Repayment options: Borrowers can potentially pay interest charges with cash, add them to the loan balance, or provide equity-like instruments to the lender.
But everything comes at a cost. Borrowers need to be mindful of several risks, including (but not limited to):
- Leverage: Leverage (borrowing money with the hope of earning back more than you borrowed — plus interest) is always risky. Borrowers may face significant debts and other consequences if things don’t work out as planned.
- Equity loss: If borrowers default on loans, they may have to provide equity interests to lenders.
- Loss of control: Mezzanine lenders may set specific criteria that borrowers must maintain. For example, lenders could specify limits on financial ratios or make other demands.
Pros and Cons of Mezzanine Loans for Lenders
Lenders find mezzanine loans appealing for the following reasons:
- Interest income: Mezzanine financing has relatively high-interest rates to compensate lenders for the high level of risk.
- Potential upside: Lenders can potentially receive equity, allowing them to participate in a business’ success—assuming there is any. For example, warrants may be part of the lender’s compensation, or lenders may receive equity when borrowers default.
Lenders always risk losing money to default, and that’s especially true with mezzanine debt:
- Low seniority: These loans might not be secured by any physical collateral. For example, there might not be liens on property, equipment, or other company assets. When the business pays senior debtors, they may deplete any available funds before the mezzanine lenders receive payment.
Mezzanine Loan Example
Assume you want to buy a company worth $100 million, and you ask a lender to finance your entire purchase. The lender is hesitant to do so, but they are willing to provide $50 million in financing. To fill the gap, you pursue mezzanine financing, but you can only find funding of $25 million—leaving a shortfall of $25 million. You provide the remaining $25 million, and you’re able to complete the purchase. The result is:
- $25 million of owner’s equity
- $50 million bank loan
- $25 million mezzanine financing
The mezzanine lender charges an interest rate of 20%, compared to a single-digit interest rate on your bank loan. However, instead of paying interest charges each year, you can add those costs to your loan balance and pay off the entire amount with a balloon loan at the end of the loan’s term.