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Mezzanine capital is a type of financing that sits betweensenior debt and equity in a company's capital structure. It is typically used to fund growth, acquisitions, or buyouts. Technically, mezzanine capital can be either a debt or equityinstrument with arepayment priority between senior debt and common stock equity. Mezzanine debt issubordinated debt that represents a claim on a company's assets which is senior only to that of thecommon shares and usuallyunsecured. Redeemablepreferred stock equity, withwarrants or conversion rights, is also a type of mezzanine financing.[1]
Mezzanine capital is often a more expensive financing source for a company thansecured debt orsenior debt. The highercost of capital associated with mezzanine financings is the result of it being an unsecured, subordinated (or junior) obligation in a company'scapital structure (i.e., in the event ofdefault, the mezzanine financing is only repaid after all senior obligations have been satisfied). Additionally, mezzanine financings, which are usuallyprivate placements, are often used by smaller companies and may involve greater overall levels of leverage than issues in thehigh-yield market; they thus involve additional risk. In compensation for the increased risk, mezzanine debt holders require a higher return for their investment than secured or more senior lenders.
Mezzanine financings can be completed through a variety of different structures based on the specific objectives of the transaction and the existing capital structure in place at the company.[citation needed] The basic forms used in most mezzanine financings aresubordinated notes andpreferred stock. Mezzanine lenders, typically specialist mezzanineinvestment funds, look for a certainrate of return which can come fromsecurities made up of any of the following or a combination thereof:
Mezzanine lenders will also often charge an arrangement fee, payable upfront at the closing of the transaction. Arrangement fees contribute the least return, and their purposes are primarily to cover administrative costs or as an incentive to complete the transaction.
The following are illustrative examples of mezzanine financings:
In structuring a mezzanine security, the company and lender work together to avoid burdening the borrower with the full interest cost of such a loan. Because mezzanine lenders will seek a return of 14% to 20%, this return must be achieved through means other than simple cash interest payments. As a result, by using equity ownership and PIK interest, the mezzanine lender effectively defers its compensation until the due date of the security or a change of control of the company.
Mezzanine financings can be made at either the operating company level or at the level of aholding company (also known asstructural subordination). In a holding company structure, as there are no operations and hence no cash flows, the structural subordination of the security and the reliance on cashdividends from the operating company introduces additional risk and typically higher cost.
Inleveraged buyouts, mezzanine capital is used in conjunction with other securities to fund the purchase price of the company being acquired. Typically, mezzanine capital will be used to fill a financing gap between less expensive forms of financing (e.g.,senior loans,second lien loan,high yield financings) andequity. Often, afinancial sponsor will exhaust other sources of capital before turning to mezzanine capital.
Financial sponsors will seek to use mezzanine capital in aleveraged buyout in order to reduce the amount of the capital invested by theprivate equity firm; because mezzanine lenders typically have a lower target cost of capital than the private equity investor, using mezzanine capital can potentially enhance the private equity firm's investment returns. Additionally,middle market companies may be unable to access thehigh yield market due to high minimum size requirements, creating a need for flexible, private mezzanine capital.
Inreal estatefinance, mezzanine loans are often used bydevelopers to secure supplementary financing for development projects (typically in cases where the primary mortgage or construction loan equity requirements are larger than 10%).[3] These sorts of mezzanine loans are often secured by a second ranking real property mortgage (that is, ranking subordinate to the first mortgage lenders). Standard mortgage foreclosure proceedings can take more than a year, depending upon the relationship between the first mortgage lenders and the mezzanine debt lender, governed by anIntercreditor Deed.
