When a company requires more cash to undertake expansion possibilities or shareholder engagement and its senior debt financing power has been exhausted or it wishes to protect foreseeable senior debt capacity, the two alternatives it normally has are raising external shares or using mezzanine financing.

Given that senior debt obtained via financial institutions has a lower interest rate than mezzanine finance, it could be viewed as either costly debt or affordable equity. Mezzanine finance is significantly less costly than stock in terms of overall cost of capital, nonetheless.

In contrast to issuing more shares to satisfy a capital demand, mezzanine financing allows current shareholders to maintain control while remaining less accretive. Mezzanine capital is a form of long-term financing that allows enterprises to take advantage of possibilities they otherwise wouldn’t have.

What Is a Mezzanine Loan Financing?

Mezzanine finance is a type of junior capital that lies between senior debt and equity, so named because of its position in the capital framework. It enables businesses to obtain funding above and beyond what they may acquire on a senior basis.

The third level of the capital framework is mezzanine finance, which enables business owners to obtain huge sums of money without having to sell a sizable percentage of their company.

Mezzanine normally takes the manner of “subordinated debt” or “preferred equity,” with a pre set payment or dividend and sometimes certain involvement entitlement in the common stock of a corporation, but it is relevantly less dilution-inducing than common equity.

How Does Mezzanine Loan Financing Work?

Mezzanine financing, which straddles the divide between debt and equity financing, is one of the riskiest kinds of debt. It comes before pure equity but after pure debt. Moreover, when contrasted to other loan kinds, it provides some of the best returns for debt investors, with rates of 12 to 20 percent annually, and on rare occasions as high as 30 percent.

Mezzanine financing can be compared to either very costly debt or less costly equity because it has a larger interest rate than senior debt provided by banks but is less expensive than equity in terms of total cost of capital.

Additionally, it decreases the corporation’s stock value. Last but not least, mezzanine financing enables an enterprise to raise extra cash and raise return on equity.

In the near to medium term, mezzanine finance will be utilized to assist enterprises in funding particular expansion initiatives or acquisitions. These loans are frequently financed by preexisting cash sources and long-term investors.

Structure of Mezzanine Loan Financing

Subjugated debt, favored equity, or a mixture of both can be utilized for mezzanine financing, which is a kind of financing that comes after a firm’s primary debt and before its public inventory. Mezzanine financing that is not backed by security is most common.

When a bond or loan is referred to as “sub-debt,” it means that it is an unsecured bond or loan with a weaker precedence than more senior bonds or securities in grounds of its capacity to assert an allegation opposing the company’s assets or revenue. 

If the debtor defaults, sub-debt holders won’t be rewarded till all senior debt holders have received full payment. Unsecured sub-debt is debt that is solely supported by the company’s promise to make payments on it.

So, neither a lien nor another kind of credit secures the loan. A lien on the underpinning asset is utilized to secure some mezzanine loans. Monthly payments for debt service, dependent normally on a preset or changeable rate, are normal, with the remaining sum due at maturity.

Mezzanine Loan Financing: Pros and Cons

Mezzanine finance, like any other complicated monetary product or service, has upsides and downsides for both creditors and debtors to contemplate.

Pros

  • In most mezzanine-led recapitalizations, the existing owner retains majority control of the company, including control of the board of directors, management, and so on.
  • Traditional bank loans offer less flexibility (looser financial covenants, lower amortization, fewer restrictions) than mezzanine finance, which permits enterprises to fulfill goals that require funds beyond that available via senior debt.
  • It is less costly and dilutive than a direct stock offering (institutional equity typically has a 20%+ return expectation).
  • Enterprise may utilize mezzanine financing as a substitute to senior debt and equity.
  • Mezzanine is “patient” capital that promotes long-term growth with only interest and no amortization for up to seven or eight years.
  • Unlike traditional minority private equity, there are fewer control provisions.

Cons

  • Senior debt is less expensive than mezzanine debt.
  • A small amount of stock may be diluted as a result of mezzanine financing; this dilution can take the form of paired warrants or another framework.
  • A mezzanine loan’s conditions include monetary restrictions and creditor rights.
  • Normally, there is a prepayment penalty for a time following issuance.

Is Mezzanine Loan Financing Secured?

A mezzanine loan is a subordinated, unsecured loan that usually contains a warrant. This kind of loan has a larger interest rate because it is subordinated and unsecured. There is nothing to back it up. In the event of debtor default, only common shareholders’ interests take precedence over mezzanine creditors’ claims. 

Mezzanine financing can therefore be utilized to support growth-oriented enterprises or to supplement other forms of debt in a leveraged buyout.

Mezzanine financing also includes a document outlining the loan’s terms, like other debt instruments do. The contract contains information about the principle repayment deadline, interest rate, and interest payment schedule, as well as whether or not a conversion facility is offered.

If the loan permits it, certain interest settlements may be accrued during the loan’s term and paid along with the principal when it comes due. A benefit of payment-in-kind is this.

Compared to other forms of borrowing, mezzanine loans have substantially greater interest rates. This is to make up for the risk the creditor assumed while issuing the subordinated and unsecured loan.

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