A Mezzanine debt is a loan that is subordinated to a senior lender. In a default scenario, the Mezzanine loan has a junior lien on the assets and will be paid back with whatever is left after the senior lender is made whole, but it is senior to pure equity. It is the debt with the greatest risk, but it also has some of the best yields; a typical rate is between 12% and 20% annually.
A Demonstration of How Mezzanine Debt Works
Suppose you want to acquire a local business in your hometown which earns $300,000 operating income annually. Let's say the owners agree to sell the business to you for $1 million. However, you don’t have $1 million of free money to invest, so you approach a senior lender who will finance this buyout with $500,000 at 8% per year. The Scenario splits from here.
Scenario 1: you accept to make a $500,000 investment to buy the business.
Scenario 2: you can find another mezzanine debt investor who agrees to contribute $300,000 for 15% per year. You only need to invest $200,000 now.
Assuming the operating income of 35%, the Capital structure and return on investment in both scenarios will look like this:
Even though the after tax income is lower, your ROE increases from 14.3% to 21.1% with the use of Mezzanine debt.
How and why Mezzanine debt is used?
Mezzanine finance offers extra leverage to make a number of deals possible, namely recapitalizations, leverage buyouts, management buyouts, growth capital, acquisitions, shareholders buyouts, refinancing, and balance sheet restructuring or optimization.
Mezzanine financing helps businesses to expand more quickly than they would be able to on a senior basis alone. It also enables ownership or management transitions to be carried out in a fashion that permits current stakeholders to enhance their ownership participation.
Mezzanine Debt Pricing & Payment Structure
Mezzanine finance is priced as a mix of senior debt debt and equity since it is more expensive than senior debt and less expensive than equity, but it is also a relative hybrid of the two.Â
The most frequent type of mezzanine debt is subordinated debt, or debt that matures one year after senior debt. Typically, it is set up to contain a combination of nominal equity, cash, and payment-in-kind (PIK). It frequently has a bullet maturity with no loan-life amortization.
Companies frequently refinance mezzanine loans before they mature using senior debt capacity that has accumulated over time, which lowers the cost of their debt capital in the process. However, the mezzanine loan's longer duration and lack of any needed amortization also give the company crucial capital structure "patience" to handle the financing event (e.g. acquisition).
Advantages and disadvantages of Mezzanine debt
Weighing the advantages and disadvantages can help a firm decide whether mezzanine finance is the best match for their organization before adding it to their balance sheet.
Advantages
Maintain ownership: In a mezzanine-led recapitalization, the existing owner frequently maintains majority control of the business, including oversight of the board, management, etc.
More flexible than senior debt and equity: compared to conventional bank loans, mezzanine financing offers more freedom (looser financial covenants, less amortization, and fewer limitations), enabling businesses to pursue objectives that call for cash that is not readily available through senior debt. There are also less control provisions when compared to private equity.
Less dilutive and expensive than equity: compared to a direct stock issuance (which normally has a return expectation of 20%+), it is less expensive and less dilutionary.
Tax deductible: Taxes can be deducted from debt interest payments. Therefore, a pretax interest rate of 20% at a normal corporation tax rate of 35% is actually just 13% after taxes.
Easier debt servicing than senior debt: Mezzanine debt frequently has special characteristics that make debt servicing easier. Occasionally, mezzanine lenders would incorporate provisions like PIK toggles, which let the borrower "pay" interest by adding it to the loan sum. As a result, if the business is unable to pay interest as usual, it may choose to postpone paying some or all of the interest for a while. This option is not available for senior debt.
“Patient” financing option: with interest only payments for up to 7 or 8 years and no amortization, mezzanine is "patient" financing that enables long-term growth.
Disadvantages
More expensive option than senior debt: mezzanine debt requires higher interest rates (up to 20%) compared to senior debt.
Might result in equity dilution: Mezzanine financing may result in a minor amount of equity dilution, usually in the form of attached warrants or another structure.
Interest payment might be blocked by senior debt: The senior lender may stop (or "block") existing interest payments on mezzanine loans if a firm experiences financial issues. Mezzanine financing is frequently chosen by first lien senior lenders in comparison to second lien loans or other debt options because these attributes generally provide a company's banks or senior lenders confidence in their senior position.
Financial covenants and creditor rights are included in the terms of a mezzanine financing.
Prepayment penalty: there is frequently a prepayment penalty for some time after issue.
