A mezzanine debt facility is a financing option that combines characteristics of equity and debt financing giving the lender of a loan the option to convert to an equity stake. The conversion can only happen after senior lenders and venture investors have been paid since a mezzanine debt facility ranks behind senior debt. However, mezzanine debt comes ahead of equity investors and trade creditors.
Mezzanine loans are the highest risk debt but offer better returns typically 12% – 20% annually. This type of financing is applied in start-ups, real estate developments and leveraged private equity buyouts. It is a costlier option to the borrower in comparison to senior or secured debt.
Common Features Of Mezzanine Loans
1. Higher risk to the investor hence demand a higher interest from the borrower of about 12% – 20% per year.
2. In payment order, they rank behind senior debt but come ahead of common equity.
3. No amortization of the principal.
4. A portion of the return on a mezzanine debt facility is fixed and thus does not dilute shareholding as equity stock offerings do.
5. Consists of interest payments and warrants to buy equity in future.
6. Increases return on equity since interest on the mezzanine debt is tax-deductible.
Advantages Of Mezzanine Debt Facility To Investors
1. Potential to buy equity in a successful business in future.
Most mezzanine debt facilities include clauses that allow the lender to acquire an equity stake by exercising options (warrants) that allocate them a slice of equity ownership in the business at a future date. If a borrower’s business can use debt to grow quickly these warrants can earn the lender multiples on their debt.
2. Guaranteed interest payments before returns to equity investors
Due to the significant risks of this form of debt mezzanine investors have regular interest payments that are contractually enforced. An equity investor ranks last in priority and is not guaranteed any dividend or return on their investment.
Why Borrowers Like Mezzanine Debt
1. Interest is tax-deductible
Borrowing at 12% – 20% per year may appear like an illogical decision for a borrower. However, mezzanine debt financing compensates the borrower for the higher rates as the interest is tax-deductible. The pre-tax interest rate comes at the lower end after taxes are considered.
2 Debt servicing is manageable
Unique characteristics of mezzanine debt allow the borrower to service the debt conveniently. In some cases, mezzanine financing facilities can be structured containing payment-in-kind (PIK) toggles where the issuer defers interest payment by adding it to the loan balance and the borrower agrees to pay a higher coupon in future. Thus if a company is experiencing cash flow problems it can defer all or a portion of the scheduled interest payment. This feature is not available in senior debt.
3. Can be refinanced to a lower interest loan
Businesses that are growing at a blistering pace do not have to pay high interests forever. As the business grows its value appreciates too. In this scenario, the company can refinance its entire debt structure into senior loans that offer a lower interest rate.
In conclusion, a mezzanine debt facility is a hybrid option that has some debt and equity elements. Generally, owners risk losing control of their ownership of their company by adopting this financing method. Also, over the long run, interest payments are higher as compared to other debt options but the owners enjoy a tax-deductible financing option.