Mezzanine Debt: Definition, Overview & How It Works
Taking on debt is always a risk.
Debt can be incredibly helpful for companies. It can increase their capital and allow them to make changes that will enhance the business and help them build a stronger revenue stream and cash flow.
However, businesses always need to balance the amount of debt they take on so that they never overextend. This can lead to high-interest rates that could potentially adversely affect the business’s financial health.
There are many different forms of debt. One high-reward, but high-risk form of debt is mezzanine debt. But what exactly is mezzanine debt, and how does it work? We’ll take a closer look in the following article.
Table of Contents
KEY TAKEAWAYS
- Mezzanine debt happens when a debt issue is subordinated to another debt issue. And both of the debts come from the same issuer.
- It has equity instruments attached that are embedded. These increase the value of the subordinated debt. It also allows great flexibility when dealing with any bondholders.
- Mezzanine debt is common in the field of buyouts and acquisitions.
- Mezzanine debt investors tend to demand a higher perspective return. This is in comparison to secured senior debt investors.
- It is a form of debt that has one of the highest risks attached. But the flip side of this is that it can offer incredibly high returns.
What Is Mezzanine Debt?
Mezzanine debt happens when a debt issue is subordinated to another debt issue. This is known as a hybrid debt issue. Both of the debts come from the same issuer. Mezzanine debt has equity instruments attached that are embedded. These increase the value of the subordinated debt. It also allows great flexibility when dealing with any bondholders. This is known as having warrants. Mezzanine debt bridges the gap between debt and equity investments.
Mezzanine debt is common in the field of buyouts and acquisitions. It is used to change the priority to new owners instead of the existing owners if bankruptcy occurs.
It is a form of debt that has one of the highest risks attached. But the flip side of this is that it can offer incredibly high returns. Especially when compared to other types of debt. Mezzanine debt often gets a rate of between 12% and 20% per year. Mezzanine debt investors tend to demand a higher prospective return. This is in comparison to secured senior debt investors.
The Different Types of Mezzanine Debt
Mezzanine debt can include many different types of equity. Some examples of these embedded options are stock call options, warrants, and rights. This means that mezzanine debt actually acts more like a stock than a debt. This is because these embedded options can potentially make the conversion of any debt into a stock a very attractive option.
A hybrid security classification is dependent on how the embedded option is influenced by the debt. This is under the U.S. Generally Accepted Accounting Principles (GAAP). There may be a scenario where the structure of the debt influences the act of exercising the embedded option. In this case, then both the debt and the embedded equity option must be classified in two places. This is on the liability and the stockholders’ equity sections of the company’s balance sheet.
What Is Mezzanine Debt Used For?
Mezzanine debt is a useful funding tool for growing businesses as well as acquisitions. As such, there is a fairly high demand for mezzanine debt as a form of debt financing. Some form of mezzanine debt is commonly used in the following ways:
- A leveraged buyout
- A management buyout
- A shareholder buyout
- A company acquisition
- Recapitalizations
- Growth capital
- Refinancings
- Balance sheet restructuring
Advantages And Disadvantages Of Mezzanine Debt
Advantages
There are a number of advantages of mezzanine debt. Here are some of the more common ones:
- It costs less than equity
- There is more patient capital and no loan amortization
- You have the ability to retain a majority control of your business
- There is more flexibility involved when compared to senior debt
- It works as an alternative source of capital with a higher level of risk
Disadvantages
Whilst this is a good source of funding, there are some downsides too. Here are some of the common ones:
- It costs more than senior debt
- Through equity warrants, there is a chance that it may create slight equity dilution
- The borrower will need to adhere to financial covenants
- There may be some prepayment penalties that have to be paid
Different Ways To Invest In Mezzanine Debt
There are two main ways to invest in mezzanine debt. They are:
- By entering into directly negotiated agreements with a business or its owners
- By contributing to a pooled, private-fund structure that specializes in mezzanine loan investments
An Example of Mezzanine Debt
The structure of mezzanine debt is common in leveraged buyouts. So for example, let’s say that a private equity firm is looking to purchase a larger company for $50 million with debt. But the lender doesn’t want to put up the full amount, so it only goes for 80% of the value. So the lender only offers $40 million. The private equity firm isn’t willing to put up the extra $10 million from its private funds. Instead, they will look for a mezzanine investor as an additional debt financing option. The mezzanine investor will finance $8 million, then they’ll top up the $2 million.
The combined debt financing will equal $48 million. This means that the company owners only have to invest $2 million of their own money to make up the money left over from the debt portion. This is in order to meet the $50 million price. As the company investor used mezzanine debt, they’ll have the option of converting the debt to equity. But this can only happen when certain requirements are met.
By using this method of financing, the buyer’s potential return is leveraged. And the amount of initial capital the firm had to use is minimized.
Reasons To Invest In Mezzanine Debt
As we touched on earlier, there are a number of advantages that favor both the borrower and the lender.
Where an investor wants to be on the risk/return spectrum for a particular project ultimately determines whether they should invest in mezzanine debt or equity. Mezzanine debt gives a lesser risk and lower return than equity, although equity offers a better return.
Summary
While mezzanine debt is useful, it’s important to note the high cost of this form of debt. This puts it into the highest-risk form of debt category. Anyone who is looking to borrow should do their research first. This is to check if there is any cheaper source of financing available. If there isn’t, then the borrower needs to make sure that they can service the debt, and it won’t plunge them into further financial uncertainty. As well as put their capital structures under strain.
But having a capital structure with a combination of mezzanine debt and bank borrowings can lead to attractive returns.
FAQs on Mezzanine Debt
As with any loan or debt, the interest rate will vary depending on which provider is offering it. A business borrower would have to do their own research. However, the cost of mezzanine debt is typically priced at anything between 15% and 20% throughout the mezzanine debt market. Anything priced below 15% would be considered an incredible interest rate.
A mezzanine lender is known as such because of the placement of the level of risk. It sits at a midway point between secured loans by lenders such as banks, and venture capital given by equity investors. This comes from the Italian word mezzo, which translates to “half”.
Mezzanine loans from a mezzanine lender differ from more traditional lenders or debt types such as a mortgage. A mortgage is secured by real property. Whereas mezzanine debt investors’ loans are secured through a pledge of equity investments interests. This is in an entity that owns real property. It is governed by the Uniform Commercial Code (UCC).
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