What Is Mezzanine Financing
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Mezzanine financing is a structured loan that is granted against company stock, or an ownership interest rather than real property.
It is a hybrid of debt and equity financing that allows business owners to borrow a larger portion of their capital needs than a conventional loan.
In case of loan default, the lender has the right to convert the debt to an equity interest in the business.
This type of financing is often associated with acquisitions and buyouts. Mezzanine loans have high interest rates and flexible repayment terms.
It can be useful for funding large projects, management buyouts or growing businesses. This form of financing does not require payment during the term of loan.
How Mezzanine Financing Works
Mezzanine financing bridges the gap between debt and equity financing.
It is one of the highest-risk forms of debt. It is senior to equity but subordinate to debt.
It offers some of the highest returns when compared to other types of debt.
Interest rates range between 12 percent up to 30 percent per year.
A mezzanine lender is often brought into a buyout to displace some of the capital from an equity investor.
It is a business loan where the debt becomes an equity share after a predetermined time limit.
If the company cannot pay back the funding, the lender gets a share of equity.
Business equity is used as security for the loan.
Mezzanine finance combines debt and equity by offering a share of profit as well as interest payments.
Loan terms range from 1 year up to 10 years.
Mezzanine financing is often used when a business has maxed out its asset-based loans or bank loans.
Business owners can invest less equity into a deal upfront by using a mezzanine loan.
Mezzanine lenders prefer to work with companies that have successful track records.
This type of finance is used to fund large projects and the money borrowed is to be repaid through profit gained.
The loan is offered as cash with the company’s equity used as collateral.
For property development, a mezzanine lender can cover up to 90 percent of project costs with the developer contributing the remaining 10 percent.
Property developers have to prove their experience.
They also have to provide full and detailed planning consent, and personal guarantees.
Mezzanine lenders are paid after ‘senior debt’ holders, but before common equity holders.
Mezzanine loans are subordinate to senior debt but have priority over preferred and common shares.
They carry higher yields than ordinary loans.
They are often unsecured loans.
There is no amortization of loan principal.
It may be structured as part fixed and variable interest.
Mezzanine finance is secured by a second charge.
It has a higher Loan-to-Value and is more expensive than senior loans. Loan arrangement fees usually begin at 1 percent.
Interest rates vary on a case-by-case basis and range from 10 percent up to 30 percent per year.
The interest rate is determined by deposit, market demand, location and amount of financing required.
Lending Criteria For Mezzanine Financing
Not every business will qualify for a mezzanine loan. A mezzanine lender will do less due diligence than in a senior debt deal.
The lender will want a business that is established and profitable.
A lender will also want to know the company’s business plan.
Established businesses with large growth plans may want to consider mezzanine financing.
The most common mezzanine loan term is 5-years during which, the borrower makes interest-only payments.
At the end of the term, the loan amount will be paid in full.
This type of funding is not suited for business startups, since they do not have enough cash flow.
It is preferred for large profitable business deals.
Uses For Mezzanine Financing
Mezzanine financing is a form of junior capital that sits between senior debt and equity.
Business owners can raise funds with this form of financing without selling a large stake in their company.
Here are some popular uses for mezzanine financing:
This involves raising funding to restructure the debt and equity mixture on a company’s balance sheet.
It can be used in situations where a group of shareholders are looking for partial or full liquidity, while others seek to remain involved in the business.
Leveraged Management Buyouts
Leveraged buyouts are used by businesses seeking to raise large amounts of funds to support an ownership transition or significant growth.
This is when mezzanine financing is used by the management team of a business to buy out current owners, such as private equity or other investors, and regain control of the business.
Mezzanine financing can be used to help businesses meet their growth targets such as raising significant capital expenditures, or constructing a large quantity of facilities.
It can also be used to exit or enter new markets by developing new products and company subsidiaries.
It can be used to raise funds for acquisition of other businesses with the goal of growing and responding to customers’ needs much more quickly.
Acquisitions can help companies to access new markets as well as diversify their customers.
This can be used by family-owned businesses to repurchase shares from other non-family shareholders in order increase their ownership stake.
It can be used to pay off or replace existing business debts to take advantage of lower interest rates and better terms.
Refinancing can help with acquisitions and shareholder buyouts.
Mezzanine financing can used to help fulfill debt requirements for transactions such as acquisitions and management buyouts, while giving the business time to recover from those expenses.
It can also be used to pay off a senior lender’s requirement, or create additional senior debt for a company.
Advantages Of Mezzanine Financing
Access to funding: Borrowers get funds for a purchase or business expansion.
Reduce equity dilution: Borrowers can minimize their equity dilution.
Interest deduction: Interest payments may be deductible to the company.
Multiple repayment solutions: Borrowers can pay interest charges with cash or provide equity instruments to the lender.
Lower debt levels: Borrowers can lower debt levels and more easily qualify for other types of financing.
Interest income: It has relatively high interest rates to compensate lenders for the high level of risk.
Equity and participation: Lenders can get equity and participate in managing the business when a borrower defaults.
Easy loans: Mezzanine financing is easy to get.
Flexible loans: The borrowers can access loans from multiple lending sources.
Tax-deductible interest: Interest paid on mezzanine debt may be tax deductible.
Leverage: Borrowing less money implies a higher return on equity
Disadvantages Of Mezzanine Financing
Leverage risks: If the deal does not work out, the business may find itself in too much debts.
Loss of business equity: If a borrowers defaults on a loan, they may have to give up equity as interest to the lenders.
Equity limits: A lender may set limits on financial ratios or make other equity demands.
High loan default risks: Lenders face huge risks of losing money due to default.
Low debt seniority: The loans may have no liens on property, equipment, or other company assets.
The company has to pay senior debtors first, and funds may get depleted before mezzanine lenders get paid.
Restrictive loan terms: The loans are unsecured and lenders include restrictive conditions such as warrants, options of partial ownership, and not to borrow additional loans.
Higher interest rates: Borrowers need to pay a high interest rate.
Loss of business control: Loan terms and conditions tend to be very detailed with many lenders stipulating certain criteria borrowers must maintain.