Mezzanine Finance- an effective form of business capital

Mezzanine Finance in the United States

What is Mezzanine Finance?

Mezzanine capital is any subordinated debt or preferred equity instrument that represents a claim on a company’s assets which is senior only to that of the common shares. As a hybrid capital model, mezzanine financings can be structured either as debt (typically an unsecured and subordinated note) or preferred stock.

Mezzanine financing is a form of subordinated debt. It is typically used by middle-market companies and real estate projects in the US to bridge the funding gap beyond their borrowing capacity from traditional banking sources.

Mezzanine capital is often a more expensive financing source for a company than secured debt or senior debt. The higher cost of capital associated with mezzanine financings is the result of its being an unsecured, subordinated (or junior) obligation in a company’s capital structure (i.e., in the event of default, the mezzanine financing is only repaid after all senior obligations have been satisfied). Additionally, mezzanine financings, which are usually private placements, are often used by smaller companies and may involve greater overall levels of leverage than issues in the high-yield market; they thus involve additional risk. In compensation for the increased risk, mezzanine debt holders require a higher return for their investment than secured or more senior lenders.

How are Mezzanine Financing structured?

Mezzanine financings can be completed through a variety of different structures based on the specific objectives of the transaction and the existing capital structure in place at the company. The basic forms used in most mezzanine financings are subordinated notes and preferred stock. Mezzanine lenders, typically specialist mezzanine investment funds, look for a certain rate of return which can come from (each individual security can be made up of any of the following or a combination thereof):

• Cash interest: A periodic payment of cash based on a percentage of the outstanding balance of the mezzanine financing.
• Ownership: Along with the typical interest payment associated with debt, mezzanine capital will often include an equity stake in the form of attached warrants or a conversion feature similar to that of a convertible bond.

Comparison of Mezzanine Finance with Senior Debt and Equity

For many businesses, the mezzanine is not viewed as permanent capital, but instead solution-oriented capital that serves a specific purpose, and can later be replaced with lower-cost capital, i.e. senior debt.

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Mezzanine financing is ultimately a way for companies to grow faster than they could otherwise on a senior basis alone and also execute an ownership or management transition in a way that allows existing stakeholders to increase their ownership interest.

What are the purposes of Mezzanine Financing?

In many situations where senior debt or equity might ordinarily be used, companies can instead turn to mezzanine financing to fulfil their capital needs. It is a patient source of financing that enables businesses to accomplish their goals for growth, whether it is building a larger production facility or accomplishing an acquisition that can’t be completed with all senior financing.

Mezzanine financing provides incremental leverage to facilitate a wide variety of transactions, including the following:

• Recapitalizations
• Real Estate Financing
• Leveraged buyouts
• Management buyouts
• Growth capital
• Acquisitions
• Shareholder buyouts
• Refinancings
• Balance sheet restructuring or optimization

What are the advantages of Mezzanine Financing

For a company considering introducing mezzanine financing to their balance sheet, it’s wise to weigh the pros and cons. This is to best determine whether the mezzanine is the right fit for their business.

Advantages

• A mezzanine-led recapitalization often results in the existing owner retaining majority control of the company, controlling the board, management, etc.
• Mezzanine financing provides more flexibility (looser financial covenants, reduced amortization, fewer restrictions) than traditional bank loans. It allows companies to achieve goals that require capital beyond senior debt availability
• It is less costly and less dilutive than a direct equity issuance (institutional equity typically has a return expectation of 20%+)
• With mezzanine capital, companies have an alternative capital resource to senior debt and equity
• Mezzanine is ‘patient’ capital that supports long-term growth. It is interest-only for up to seven or eight years and no amortization
• There are fewer control type provisions than typical minority private equity
• The interest on mezzanine debt is a tax-deductible expense as against dividend. Thus, at a standard corporate tax rate of 35%, a pretax interest rate of 20% is really only 13% after taxes are taken into consideration.
• Mezzanine lenders will occasionally include features like so-called “PIK (Payable in Kind) toggles,”. Such features allow the borrower to “pay” its interest by rolling it into the loan balance. Thus, if the company can’t make an interest payment as normally scheduled, it can defer some or all of the interest for a period of time. You won’t find this feature on senior debt.
• Fast-growing firms often find that they won’t need to pay sky-high interest rates for very long. If the company grows, its value should grow, too. Thus, it’s likely that the company will be able to refinance the entirety of its senior and mezzanine debt into a single senior loan at a lower interest rate in the future.

What are the disadvantages of mezzanine finance?

• Mezzanine financing is more costly than senior debt
• Mezzanine financing may involve some equity dilution, which is typically small, and maybe in the form of attached warrants or some other structure
• Terms for a mezzanine financing include financial covenants and creditor rights
• There is often a prepayment penalty for a period following issuance

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