Meaning of Mezzanine Financing
In real-life instances, companies look forward to reaping the maximum benefit through their financial transactions. They look forward to opportunities that benefit them more than the previous alternative they chose. One of the better alternatives chosen by companies that need capital but do not want to dilute their ownership or control is mezzanine financing.
The word mezzanine comes from the Latin for “middle”. We can say mezzanine financing is a hybrid that incorporates the features of equity and debt in them. In mezzanine finance, the lender is given the right to convert the debt to equity in case of default after venture capital companies and other senior lenders are paid. Mezzanine Finance bridges the gap between debt and equity and is mainly used in acquisitions.
Mezzanine finance is usually preferred by borrowers when all the existing sources of financing have been exhausted. This is usually used by well-established companies as the companies that use mezzanine finance should have a high-risk tolerance.
It usually fills the gap between senior debt and equity in a company. Mezzanine loans are subordinate to senior debt and are often unsecured debts. They have a priority over both preferred and common stock and carry higher yields than ordinary debt.
There are many benefits to mezzanine financing it is a tax-deductible business expense, is more manageable than other debt structures, and generates a much higher rate of return. The foremost advantage is that they provide more generous returns to investors compared to typical corporate debt, often paying between 12% and 20% a year.
Types of Mezzanine Finance
There are generally two types of mezzanine financing – mezzanine debt and Preferred equity. Each type of mezzanine finance has its unique features and benefits, and the choice of which type to use will depend on the specific needs and goals of the company and the investor.
This occurs when the hybrid issue of one debt is subordinate to another issue from the same issuer. They bridge the gap between debt and equity by being subordinate to pure debt but superior to equity. In real-life instances, they possess the characteristics of stocks rather than equity as it is convertible to equity. Mezzanine debt offers the highest returns as compared to other forms of debt. The interest in it ranges from 12% to 20%.
It is generally structured as a loan that is secured by a lien on the property. It is normally an unsecured obligation of the borrower. It usually holds a position in the capital stack ahead of equity. It is a risk mitigation play for the investors as a whole. Mezzanine debt providers are considered lenders and their rights differ from equity holders.
There are different types of mezzanine debt:
- Subordinated Debt + Equity Kicker as Warrants:
This is the most popular type as they ensure the debt is converted into equity. In this type, it gives the holder a right to purchase a specified number of shares of the company’s stock at a predetermined price. This usually gives an increase in the return potential of the investor.
- Subordinated Debt + Co-investment Tag in Equity:
They provide the company with the benefits of both debt and equity financing. They possess the benefits of repayment before equity and allow the investor to convert that debt into equity at a pre-determined price. They allow the company to retain protection and ownership. From the investor’s point of view, they are the best option for whoever is willing to participate in the potential size of the company but are risk averse. This type of debt protects the investors. The decision to use subordinated debt and co-investment tag in equity together will depend on the specific needs and goals of the company and the investor.
- Subordinated Debt without a Share in Equity:
In this form of mezzanine financing the investor provides a loan to the company, but does not receive an ownership stake in the form of equity. This type is most preferable for investors who companies that want to maintain ownership and control while they raise additional capital. The choice of this type of debt is mainly done after considering the long-term capital goals of the company. They are not diverse as investors sometimes step back in investing because of the lack of ownership right offered to them. They have a higher rate of interest as the risk invested in them is high.
- Convertible Debt Option:
This option is when the investors can convert the debt into equity on a future date. This conversion will be done solely at the option of the investor. From the company’s point of view, they can raise capital without diluting the ownership. This conversion usually takes place on the happening of specified events that will benefit both the company and the investor. The long-term perspective of the company is the main consideration while we exercise this option of financing. They are structured in a way so that they act as a cap on the conversion price or interest rate, which can provide additional protection for both the company and the investor.
This type of mezzanine finance is usually placed between senior debt and common equity in terms of priority of payment and risk. They possess superior power than common equity shareholders in terms of repayment but do not possess the right to ownership like normal equity shareholders. They have a fixed income in terms of dividend but is not subject to the risk or volatility associated with common equity investments. The investors are allowed to customize the investment to their specific needs and goals like, put option, call option, etc. They have a priority of repayment at the time of dilution of the company. They are the second preference just backing the traditional debt holders.
The choice between the above two will depend on the specific needs and goals of the company, the terms and conditions of the financing, and the preferences of the investors. Both options are suitable for companies that need to raise capital but want to possess both the advantages of debt and equity. In the current scenario of reaping high profits and optimally utilizing resources, mezzanine financing is the best option put forward.