The Function and Uses of Mezzanine Financing
Mezzanine financing combines equity and debt. In the event of a default, it allows a lender the choice to convert debt into ownership in the company. This conversion typically takes place following payment to senior lenders, such as venture capital firms. In terms of exposure, mezzanine financing has a risk profile that falls in the middle of senior debt and equity. Equity tools, sometimes known as warrants, are a regular part of this type of financing.
The subordinated debt is worth more because of these warrants. Additionally, they provide more adaptability while interacting with bondholders. In acquisitions and buyouts, mezzanine financing is frequently employed to offer new owners a higher priority than current owners in the event of bankruptcy. It allows businesses to generate funds for specific projects or to support acquisitions by combining loan and equity financing.
Instead of backing new businesses or their early phases of growth, these loans are usually utilized to expand already existing ones. Mezzanine funds, which are pooled investments with characteristics of mutual funds and are accessible to well-qualified businesses, also employ mezzanine finance.
Mezzanine financing is more profitable for investors than other corporate lending products, often paying returns of 12 to 20% each year. If the market interest rate drops sufficiently, mezzanine loans might be replaced by lower-interest financing options.
Mezzanine financing fills a critical void.
Many firms find mezzanine finance very beneficial since it fills the gap between debt and equity funding. But it also carries one of the highest risks of any kind of debt. It is ranked lower than pure equity but higher than pure debt.
Mezzanine finance, however, is well-liked by debt investors because it offers better returns than other forms of debt. In general, mezzanine financing gives a business additional access to finance while increasing its financial returns on equity.
These loans may have been funded by both short- and long-term investors in the business. If this is the case, their investment amount is regarded as preferred equity, and the company is not compelled to return it. The firm has to grow and expand. Therefore, the corporation now has more readily available capital.
A mezzanine loan borrower is only liable to pay interest that accrues before maturity. The business owner now has more money at his/her disposal to invest in the company’s growth.
Mezzanine Loan Characteristics
Currently, the bulk of mezzanine loans made to company owners share the following:
Although they are rated higher than both preferred and common stock, these loans are regarded as junior to senior debt.
- Mezzanine loans provide better returns than conventional financing.
- These are usually unsecured loans.
- A mezzanine loan’s principle is not amortized.
- These loan types may have a mix of fixed and variable interest rates.
Mezzanine Financing Structure
Mezzanine finance is a financial tool used inside a company’s capital structure. Under the guises of subordinate debt, preferred equity, or a combination of the two, it resides between senior debt and the common stock. Although, most businesses use unsecured subordinated debt for mezzanine funding.
What Exactly Is Sub-Debt?
A sub-debt is a loan or bond that is insecure and not secured by a lien or another kind of credit. When used to get support from the company’s assets or income, it has a lower rating than loans or securities with a higher standing. Sub-debt holders do not get paid out if a sub-debt borrower defaults until the senior debt holders have collected the whole amount owed to them.
Subordinate debt is unsecured debt that only has the company’s promise to pay it as a guarantee. Other kinds of mezzanine debt are secured loans that are backed by liens against certain pieces of real estate. Repayments are usually needed monthly, depending on whether the rate is fixed or changing. The remainder is payable on the maturity date.
Priority distributions are used to distribute funds before any payouts to shareholders of common stock. Negotiations are open to investors who want to obtain more money. The principle is paid back on the designated redemption date, generally following the settlement of a mezzanine loan. The sponsor could be permitted to extend the payback deadline in specific situations. Preferred equity investors could have stronger corporate approval powers since preferred equity is not subject to any lender obligation.
Maturity, Redemption, and Transferability
The typical maturity period for mezzanine finance is five years or longer. However, depending on the issuer’s ability to finance the debt, the maturity date is frequently influenced by the maturities of any other debt that is already outstanding. A defined maturity date is often absent from preferred equity. The issuer, nevertheless, has the option to change it later on. Typically, redemption is done to take advantage of reduced market rates so that debt and equity may be called in and reissued at lower rates.
The full authority to transfer these debts often rests with the lenders providing mezzanine finance. If the loan is set up to provide future dividends or advances, it is possible to negotiate a qualified transferee requirement. The borrower’s rights to move money may be affected by this. In contrast, the conditional transfer of the buyer’s ownership stake in the corporation may apply to preferred equity. The company may permit transfers once the preferred equity contribution has been fully made.
Benefits and Drawbacks of Mezzanine Financing
Benefits
Lenders. Lenders or investors who participate in mezzanine financing may get immediate ownership in a particular firm or rights to purchase stock in the future. It could significantly increase an investor’s rate of return (ROR). Additionally, per the terms of their contracts, mezzanine finance providers are paid interest on a monthly, quarterly, or yearly basis.
Borrowers. Borrowers often choose mezzanine finance because the interest paid is a tax-deductible business expense. It can significantly lower the cost of the debt. Furthermore, mezzanine finance is easier for borrowers to manage than other types of debt because it permits them to add interest to the loan total.
A borrower may have part or the entire interest payment postponed if they have an inability to pay it on time. Under other forms of loan structuring, this benefit is typically not available. Rapidly growing companies gain value and may convert mezzanine loans into senior loans with a single, lower interest rate. It lowers interest payments over the long term.
Investors. Lenders typically get incentives, increased equity interests, or the option to acquire these interests while acting as investors (or warrant). These benefits may become highly profitable if a business endeavor is a great success. Mezzanine debt may provide a substantially higher rate of return than other financing options while being classified as a low-interest rate financing option. Mezzanine financing further produces regular, guaranteed payments. In contrast, the preferred stock provides prospective but not guaranteed dividends.
Drawbacks
Owners. Because of the loss of equity, owners that employ mezzanine financing could have less control and upside potential. For loans with a longer period, they could also be assessed at higher interest rates. The capacity of the borrower to take on new debt or refinance senior debt may be restricted by stipulations in the loan agreements. Payouts to top employees may also be restricted.
Lenders. Mezzanine lenders could lose money on their investment if a borrowing firm goes bankrupt. Senior debt holders are paid off first when a firm ceases operations by selling off its assets. The senior loan may be repaid before any assets are left, in which case the mezzanine lenders could not get anything.
Additionally, it is crucial to keep in mind that the negotiation and setup process for mezzanine loan debt and equity might be lengthy. The completion of this procedure frequently takes three to six months.
The Benefits and Drawbacks of Mezzanine Financing
The following are some key benefits and drawbacks of mezzanine financing:
Benefits
- Long-term creditors and debt
- Less expensive than fundraising
- Adaptable architecture
- No decrease in stock value of the corporation
Cons
- High-interest-rate subordinated debt
- Slow or difficult to organize at times
- may impose limitations on receiving more credit
- Loss of some ownership control over the transaction
Mezzanine loans often cost between 15 and 20 percent, which is pricey in general. Since principle payments are deferred until the maturity date, they are referred to as “patient” debt. A business may develop and increase its capacity for loan repayment while also enhancing its ability to take on less expensive, more senior debt.
Final Thoughts
Bridge loans are provided through mezzanine finance to pay costs associated with real estate purchases or development projects that are not otherwise covered by senior debt. These loans are unsecured, but if a default occurs, equity may be used to replace them. With mezzanine finance in place, the loan’s lending capacity may be increased without diluting ownership. The necessary issuance of preferred or ordinary shares might result in ownership dilution in the absence of mezzanine financing.
You may receive major benefits from acquiring a mezzanine loan by doing due diligence and knowing all elements of mezzanine financing. Before applying for this sort of flexible, “patient” funding option, it is usually a good idea to talk with a reputable and knowledgeable financial counselor.
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