What is Mezzanine Financing?
Mezzanine financing is a layer of financing that fills the gap between senior debt and equity in a company. It can be structured either as preferred stock or as unsecured debt, and it provides investors with an option to convert to equity interest. Mezzanine financing is usually used to fund growth prospects, such as acquisitions and expansion of the business.
A gap between senior debt and equity financing exists due to the following common reasons:
Inventory, accounts receivable, and fixed assets are discounted at higher rates for fear of non-recognition of their value.
There is a substantial volume of intangible assets recorded on the balance sheets.
To address the rise in defaults and regulatory pressure, banks impose limits on the total debt that a business can acquire.
Mezzanine Financing Rate of Return
The basic form of mezzanine financing is unsecured debt and preferred stocks. As mezzanine financing is unsecured, it carries higher risks, and investors require a higher rate of return than secured lenders. Typically, it pays an investor 12-20%, which is higher than the rate of return on ordinary debt.
Mezzanine investors can earn returns from the following available sources:
Cash interest
Based on the portion of the outstanding mezzanine funding balance, investors receive cash periodically. The interest rate may either be set or may fluctuate over the loan period.
Payment in Kind (PIK) interest
It is also a periodic method of payment. However, the interest amount is not paid in cash. Instead, it is added to the principal sum of the security, and the total amount is paid at the end of the loan period. For example, a $50 million bond with a 10% PIK interest rate will amount to $55 million at the end of the period, and there will be no cash interest payment.
Ownership
Similar to a convertible bond, mezzanine financing often includes an equity interest in the form of a conversion feature or warrant. Usually, the PIK interest or the cash interest follows the ownership portion of the securities.
Hence, the mezzanine layer reduces the equity requirement and helps to secure more total capital.
Reduction of capital cost and an increase in equity returns
Equity is the costliest source of capital, and it dilutes the current shareholders. Therefore, mezzanine debt may be an attractive alternative for accessing much-needed capital. Companies use an appropriate combination of senior debt, mezzanine debt, and equity to reduce the true cost of capital and increase asset returns.
To the Investor
Attractive and safe investment
The mezzanine investor enjoys the advantages of equity investment in the form of high returns and a diverse portfolio. In the case where the borrowing company becomes successful, the mezzanine investor can exercise the equity option and receive the benefits.
In addition, even in the worst case, the mezzanine investor gets at least the interest payment. The interest received for mezzanine financing outperforms the one received against traditional financing.
Warrant option
Mezzanine financing often includes warrants or convertible equity options that a mezzanine investor can exercise to earn a stake in the company.