What is Mezzanine Financing? (Benefits and Structure)

By Indeed Editorial Team

Published 2 August 2022

The Indeed Editorial Team comprises a diverse and talented team of writers, researchers and subject matter experts equipped with Indeed's data and insights to deliver useful tips to help guide your career journey.

The mezzanine finance method is a combination of debt and equity financing. It incorporates mezzanine debt and loan instruments that increase subordinate debt values and bondholder flexibility while allowing businesses to raise substantial capital with no collateral requirements. By exploring the mezzanine finance structure, you can identify how it works and its uses in the financial industry. In this article, we define mezzanine financing, define important terminology to understand, outline the mezzanine finance structure and discuss its benefits.

What is mezzanine financing?

The answer to the question 'What is mezzanine financing?' is that it's a hybrid between debt financing and equity financing. It incorporates mezzanine loans and mezzanine debt instruments. Regarding a business's capital structure, mezzanine debt is under senior debt and usually refers to subordinated debt. The reason businesses may choose a mezzanine loan is that it has no collateral. There are no repayments required on the loan until several years into the agreement, depending on the conditions of the loan. Instead of collateral, the lender receives warrants or options that they convert into equity in the event of default.

An example of mezzanine finance may be a business owner who wants to increase their capital. If they decide on debt finance, it means they take a traditional loan with interest repayments. If they choose equity finance, they sell securities and company ownership to raise capital. When neither of these finance options is viable, they may choose a mezzanine finance approach. They take a mezzanine loan with no repayment requirements for an agreed period but offer warrants and options in the event of default. If the business experiences default, the lender gains equity interest.

Related: 21 Essential Finance and Business Terms for Professionals

Important terminology to understand

Below, you can explore several terminologies and their relation to mezzanine finance, which can help you understand the mezzanine finance model:

Debt financing

Debt financing usually refers to a traditional loan. If you're financing through debt, you take a loan, which means you receive money from a third-party lender. The loan agreement usually states you pay the loan over a specific period with interest. Debt financing often includes collateral, which refers to assets you offer the lender who may claim them if you can't pay the loan before the agreed date. Mezzanine finance is similar, in that you receive a loan from a third-party lender. The difference is that you don't offer assets as collateral, but rather equity interest.

Related: How to Become a Debt Collector: A Comprehensive Guide

Equity financing

In equity financing, you raise capital by selling shares. For example, if the business requires $100,000 to expand its operation in a time-sensitive environment, you might sell $100,000 worth of equity. This means you're selling ownership of the business valued at $100,000. Mezzanine finance incorporates elements of equity financing because you offer equity to the lender, but only in the event of default. This makes the mezzanine finance model a hybrid of equity and debt financing.

Related: What Is Private Equity? (Including Related Careers)

Senior debt

Most companies have a structure of debt that outlines the priority of repayments in the event of bankruptcy. This debt structure typically comprises tiers of priority. Senior debt is the top tier in this structure, meaning if the business becomes bankrupt, the senior debt is the first debt they repay. Senior debt usually includes debt with associated collateral. If the business cannot repay its senior debt, lenders may likely seize its assets. This is usually why senior debt takes priority. Mezzanine debt is under senior debt, meaning it's less of a priority to repay.

Related: How to Become Investment Banker (With Steps Guide)

Subordinated debt

Subordinated debt is essentially the opposite of senior debt. In the debt priority structure, subordinated debt is typically the lowest priority for repayments. This doesn't necessarily mean there's no collateral. Subordinated debt usually has collateral, but its stake in the business may not be as high as collateral associated with senior debt. Businesses utilising a mezzanine finance approach typically categorise mezzanine debt as subordinated debt, meaning they repay this debt after they pay senior debts.

Default

This is a business terminology that refers to an individual or organisation who fails to pay their loan or interest. Most financing contracts have default conditions that stipulate the consequences of default. These consequences are typically collateral in the form of assets. Also, the default is usually equity interest when regarding a mezzanine loan.

Related: 5 Common Risk Management Roles (With Salaries and Duties)

Mezzanine debt

Mezzanine debt is the debt incurred from a mezzanine loan. Businesses typically categorise this debt as unsecured subordinated debt. Unsecured debt refers to debt that has no asset collateral, but the lender still has a legal claim if the business can't pay this debt. In mezzanine finance, this legal claim is the lender's right to exercise warrants and options, which essentially provide them with equity interest.

Equity interest

Equity interest typically refers to the ownership of an organisational entity, usually through the ownership of securities. In mezzanine finance, if the business defaults on its mezzanine loan, the lender claims equity interest. Rather than claiming assets, the lender can convert the remaining balance of the loan into proportionate ownership of the business. For example, a business worth $1,000,000 has a mezzanine loan with $100,000 debt remaining. The business defaults and the lender receives $100,000 in equity interest. The lender now has 10% ownership of the business through equity.

Related: What Does a Stockbroker Do? (Full Career Guide With Salary)

What is the mezzanine finance structure?

The mezzanine finance structure essentially refers to its position within a business's capital structure. Many businesses may refer to the mezzanine structure as unsecured subordinated debt. The debt has no lien, meaning the lender has no asset claim in the event of default. This structure can depend on the industry. In real estate, property investment firms might consider mezzanine finance secured subordinated debt because the equity interest provided to the lender partly represents assets as property. This is technically indirect asset collateral. How a business structures its mezzanine finance within the capital structure can depend on its financial strategies.

Related: How to Become a Real Estate Investor (With Steps and Skills)

How does mezzanine finance work?

Below, you can explore a guide on how mezzanine finance works:

  • Discuss conditions with a mezzanine lender. The first step involves discussing the conditions of the loan with a mezzanine lender. These conditions refer to the default consequences and loan amount.

  • Receive mezzanine loan. Once both parties agree on the loan conditions, you receive the loan and start paying interest. It's usually a good idea to ensure the loan provides a high rate of return.

  • Pay mezzanine debt. Depending on the agreed loan conditions, you may eventually reach the date where full loan repayment is a requirement. If you can't repay the loan amount, you default on the loan.

  • Issue options or warrants in the event of default: If you default on the loan, you provide the mezzanine lender with equity interest proportionate to the remaining value of the loan. The mezzanine lender now owns a relative proportion of the business through gained equity.

Related: What Does a Credit Analyst Do? (Key Responsibilities)

Benefits of mezzanine finance

Below, you can review some benefits of increasing capital through mezzanine finance:

  • Retain majority ownership: As an alternative source of capital to equity financing, mezzanine finance only requires the selling of business ownership in the event of default. Assuming the business can repay the mezzanine loan, it can keep all or part of its ownership, depending on other equity finances.

  • Gain large amounts of capital: Mezzanine finance can usually provide a business with substantial equity with no collateral. When compared to debt financing, businesses can usually gain larger amounts of capital through mezzanine finance.

  • Minimise stock dilution: As an additional benefit of retaining majority ownership through mezzanine finance, the business usually has minimal stock dilution. Stock dilution usually decreases the individual price of securities.

  • Alternate source of capital: If large companies with positive cash flows require more capital than debt and equity financing can provide, they may also gain capital through mezzanine finance. If a company has enough assets and equity, it can secure capital through multiple financing methods.


Explore more articles