Mezzanine financing gets its name from the architectural term mezzanine, meaning a story or floor of a building midway between the first and second floors. This type of financing sits between equity and senior debt, having features of each. Mezzanine financing can provide capital for companies that don’t have enough senior debt capacity to meet their need and don’t want to dilute ownership by selling equity. Companies typically use mezzanine financing for specific needs, such as expanding facilities or making an acquisition.
Debt funding, capital a company receives in exchange for paying interest, may also be referred to as senior loans, security-based lending or an asset/revolving line of credit. Borrowing capital lets the company owner retain control and schedule repayments at a low, fixed or floating interest rate. On the downside, the company will use future cash flow to repay or “service” the debt and the money must be repaid if the company defaults.
Equity funding refers to the company selling ownership shares to another entity. While there is no interest paid on the amount the outside entity pays for its shares and no repayment if the company fails, such investors often seek an active role in operating the company.
Mezzanine financing bridges the gap by providing capital in exchange for a higher interest rate, lower annual debt service and sometimes the option to convert the debt into equity shares of the company defaults on the loan.
Not every company is a candidate for mezzanine financing. A company must be well established with a solid reputation, a proven product, a history of profitability and a viable expansion plan for the business.
In exchange, mezzanine lenders charge higher interest rates, typically 11% to 15%. They also sometimes have the option, if the borrower defaults, to turn the loan balance into equity in the company, which they can keep, sell or transfer. Mezzanine debt is subordinate to senior debt, meaning it is not repaid if the company fails and has no assets to offer in return.
For borrowers, mezzanine financing has several benefits beyond preventing ownership dilution. It generally has limited or no amortization, limiting annual debt service payments. Interest on mezzanine debt can sometimes be figured into the balance of the loan. If the company can’t make a scheduled interest payment, all or part of the payment can be deferred for a period of time. This kind of flexibility is typically not offered with senior debt. Prolonged or frequent payment deferrals, however, puts the company at risk of losing equity to the lender.
Mezzanine debt is said to be more “patient” than senior debt in that the term to final maturity, sometimes up to 8 years, is longer than a secured loan and there is no amortization prior to maturity. This longer term gives the company time to realize the upside of the mezzanine capital it invested and to build its senior debt capacity. Companies often refinance mezzanine loans into senior debt to reduce interest expense and protect equity. To protect their investment, mezzanine lenders often stipulate a prepayment penalty in the loan agreement to insure they generate enough interest to cover costs and maintain some margin.
Used correctly, mezzanine financing can provide companies additional access to debt capital for expansion or acquisition while allowing owners to retain control and protect their equity interest. Bridgepoint Investment Banking has expertise in structuring mezzanine funding and access to lenders interested in obtaining higher returns and the potential for ownership.