Mezzanine Financing: A Hybrid Debt Solution
Mezzanine financing provides companies with the ability to raise funds for specific projects or for the selective acquisition by offering a form of debt and equity financing. Beyond this, mezzanine financing is also embedded in mezzanine funds. The latter represent a sort of pooled investment, again like a mutual fund, granting financing under the guise of mezzanine financing with significantly qualified businesses. This form of financing can provide greater returns to investors than corporate debt, which may pay as much as 12% to 30% per annum. Mezzanine loans are most commonly utilized in the growth expansion of existing businesses and not as start-up or early-stage capital. Both mezzanine financing and preferred equity can be taken out and retired with lower-interest financing if the market interest rate declines significantly.
How it works:
Mezzanine financing fills the gap between debt financing and equity financing and is considered one of the highest risk forms of debt. It ranks higher than pure equity but lower than pure debt. But this also means that it can offer some of the highest returns to investors in debt, since it often enjoys rates from 12% to 20% a year, and sometimes as high as 30%. Mezzanine finance is also considered very expensive debt or cheaper equity, as it carries a higher interest rate than the senior debt that companies would otherwise obtain through their banks but is substantially less expensive than equity in terms of the overall cost of capital. It also impacts the company's share value less than equity does. Ultimately, mezzanine financing lets a business own more capital and thus increase its returns on equity.
Structure of Mezzanine Financing:
Mezzanine financing provides a place within a company's capital structure between the senior debt and its common stock, represented either as subordinated debt or preferred equity, or some form of both. Subordinated non-cash collateralized debt is the most typical mezzanine financing structure. It, known as sub-debt, is an unsecured bond or loan that ranks below the higher-ranking loans or securities in its ability to claim against company assets or earnings. Sub-debt holders are not paid out before all other senior debt holders are paid in the event of a borrower default. This being an unsecured sub-debt means that the debt is only backed by the promise to pay by the firm.
Maturity and transferability:
In general, Mezzanine financing has maturity in more than five years.
The maturity date of any particular issue of debt or equity, however, is usually determined by the scheduled maturities of outstanding debt in the issuer's financing structure.
Generally, the lender under mezzanine financing has an unfettered right to transfer its loan. However, when future distributions or advances are part of the loan, the borrower may be able to negotiate a qualified transferee standard as a limitation on the borrower's right to transfer.
Advantages:
Mezzanine financing may involve lenders, or investors, acquiring direct equity in a business or warrants to buy equity in the future. This can also significantly boost an investor's rate of return (ROR). Lastly, mezzanine financing providers are scheduled to receive contractually obligated interest payments made monthly, quarterly, or annually. The main interest of borrowers in mezzanine debt is the interest they pay. It's a tax-deductible business expense, so the actual cost of the debt is much lower. Furthermore, mezzanine financing is much easier on other debt structures. Borrowers can restructure their interest to the balance of the loan. Some or even the entire interest may be left out if a borrower cannot make his scheduled interest payment. This is typically not the case for other types of debt.
Disadvantages:
Owners lose some control and potential upside in mezzanine financing due to the loss of equity. Lenders may also have a longer-term view and require a seat on the board. Owners pay more in interest the longer that mezzanine financing is in place. Loan agreements will also often include restrictive covenants that limit the borrower's ability to obtain further financing or to refinance senior debt and may also establish the debtor-specific financial ratios that a borrower must attain. Payout restrictions on major employees and even owners are also not unusual.
Conclusion:
Mezzanine financing is a combination of debt financing and equity financing. In the event of default, it allows a lender to convert debt to an equity interest in the company. The general manner this works is normally besides being paid in full by venture capital companies and other lenders considered to be senior lenders. It is situated in terms of risk between senior debt and equity.
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