Mezzanine financing: a concise guide
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Do you have acquisition in mind? Maybe a management buyout? Do you need an injection of funds to bridge the gap between loan capital and equity? If any of these resonate with you, then mezzanine financing could be the answer you’re looking for. In this article, we’ll unpack all you need to know about it.
What is mezzanine financing?
Mezzanine financing is a specialised form of business funding that mixes debt and equity. It can work to benefit both the business owner and capital provider. Often, this is achieved by enabling the business to borrow more than then normally could by securing the lender's stake using the option to convert the loan to equity – if the borrower defaults.
This form of finance is sometimes called upon for leveraged buyouts and acquisitions, and to help fund expansion and project development. A business typically uses mezzanine finance to provide additional funding over and above any standard loans or existing equity and venture capital.
Most mezzanine debt is not secured against assets which makes it a higher risk for the lender. So, as well as giving the lender the right to convert the debt to equity at a future date, interest tends to be charged at a premium rate, which may around the 20-30% mark.
What is mezzanine debt financing?
The term mezzanine debt finance and mezzanine debt are often used interchangeably, but in reality is there’s no difference between the two.
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Mezzanine finance vs debt and equity
Classic business funding draws capital from two primary sources: money borrowed from a lender and money put up by the business owners and investors. These are typically defined as debt finance and equity finance.
Debt usually comes in the form of a loan or something like a business credit card. The interest rates and terms are usually fixed and will be put in place when the loan agreement is signed. Both the business and lender know what payments are due and when the debt will be cleared. If the business fails or defaults, the lender will be first line to recover its funds from the sale of the business assets. This is known as senior debt.
Equity can be seen as investment in future growth and value. As the value of the business grows, the value of the equity increases. The business owner can choose to sell a share of this equity and with it a corresponding share of ownership, profits and losses, and control in the future of the business. If the company goes under, equity holders (shareholders) get what's left after the senior debt has been paid off.
Mezzanine financing combines elements of debt and equity. Taking its name from the Latin word for middle, mezzanine capital sits between senior debt and shareholder equity. The structure of the loan is flexible and tailored to the business. Rather than securing the debt against business assets or a personal guarantee, mezzanine finance lenders are banking on the business' future. The agreement often includes rights to convert debt to equity at a future date or when certain conditions – such as the business defaulting – are met.
Mezzanine finance example
The best way to understand how mezzanine funding works is through an example
Let's say you're eyeing an acquisition target valued at £1 million. Your bank agrees to a standard business loan of £750,000. You need another £250,000, but you only have £100,000 available. You need another £150,000 - and you don’t want to miss out on this deal.
So, you talk to a mezzanine finance provider – who offers you the extra £150,000, at a relatively high interest rate and the condition of converting the agreement into equity if you can no longer repay the debts.
By taking on mezzanine debt for the other £150,000, you get to close the deal, rather than miss the opportunity. Mezzanine financing bridges the gap between the funding you already have through debt, and equity financing and the funding you need for a specific project or venture.
Mezzanine finance can also play a key role in helping you secure your primary sources of funding. Providers of mezzanine capital tend to be vested in the success of your business, often for the long term.
Why use mezzanine financing?
From a business point of view, mezzanine financing offers several strategic advantages.
- With mezzanine lending in the mix, business owners can leverage a higher potential return while putting up less of the capital themselves.
- Mezzanine debt may include what are called “PIK toggles” – a type of arrangement where the borrower may defer interest payments or add them to the loan balance.
- As interest on debt is a tax–deductible expense, the premium interest rates on mezzanine debt financing can be more manageable than they seem at first.
- If the extra capital can help businesses grow their value faster, enabling the borrower to to restructure the mezzanine debt into a more traditional loan at a lower rate.
Drawbacks of using mezzanine debt
Attractive as mezzanine funding can be, it's important to consider the downsides too.
- Mezzanine debt comes with agreed financial strings, such as warrants and options – are you comfortable potentially diluting your own share of equity and future value?
- If you were to default on the loan, the lender may opt to sell or transfer their stake, leaving you with new equity partners.
- As subordinated debt, mezzanine funding may include restrictions on how you manage your credit, expenditure and cashflow.
- Compared with a bank loan, mezzanine financing can be complex – it takes time and effort to arrange – and it may be weeks before you can access the cash.
Mezzanine finance alternatives
Mezzanine financing can be a good source of additional capital for an established business seeking growth through acquisition, buyout or development, and for funding major projects and new ventures.
For business owners with less aggressive growth plans, other forms of funding or alternative business finance may be more suitable.
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