Most people think that business loans only fall under two types: debt finance and equity financing. The former usually comes in the form of a business loan that will eventually need to be paid back; the latter, on the other hand, involves bringing in external investment in exchange for equity in a business.
Few people are aware of funding options that straddle the line between debt and equity: that’s mezzanine finance.
What is Mezzanine Finance?
Mezzanine finance, also known as mezzanine funding or mezzanine debt, is a funding option that takes up some of the financing that an investor would put in if it were an equity finance scenario. Technically, a mezzanine loan is considered the type of debt with the highest level of risk. However, it is also the one with the highest possible returns.
A company may opt to use mezzanine finance in order to fund development projects or endeavours that need more capital than what most senior lenders would be willing to give.
It is so-called because it sits right between low-risk senior debt and higher-risk equity, or a blend of both.
How does mezzanine finance work?
These characterise mezzanine funding options:
- Serves as a capital resource between senior debt and equity;
- Maximises total leverage with little dilution or even no dilution at all;
- Offers a fixed rate without amortisation.
Who uses or needs mezzanine debt finance?
One of the key issues many companies have with equity investment is the potential loss of managerial control when investors buy into their enterprise. There is no danger of this in the context of mezzanine finance.
To prevent this loss of control, a company can use mezzanine-supported recapitalisation (also known as minority capitalisation.)
Surprisingly, this actually allows a company to grow more rapidly than if a senior lender financed them. Mezzanine financing providers allow for the reinforcement of ownership or facilitate a management transition so that shareholders can increase their ownership interest in the firm.
What is Mezzanine Finance commonly used for?
Senior debt and equity are seen as the usual options for companies that require capital for their initiatives. Yet mezzanine finance is considered a viable – and certainly more patient – alternative for businesses that are poised for growth in a commercial bridging environment.
In many cases, mezzanine finance is used for funding the construction of large-scale production facilities and industrial estates. They’re also used to finalise acquisitions that cannot be completed using funds from senior financing.
Most of the time, however, this financial instrument is used for any of the following transactions and situations:
- Leveraged, management, and shareholder buy-outs;
- Capital for growth;
- Large-scale acquisitions;
- Balance sheet restructuring; and
- Balance sheet optimisation.
What are the advantages of using mezzanine finance?
Companies that take advantage of mezzanine capital usually enjoy the following benefits:
- Mezzanine-driven recapitalisation allows current or existing owners to retain majority control of their enterprise, including control of both board and management;
- A more flexible alternative to traditional bank loans or debt structures in that they have less binding financial covenants, lower amortisation, and fewer restrictions;
- Enables a company to achieve goals that call for capital beyond that offered by senior debt availability;
- Comes at a lower cost than direct equity issuance and is less dilutive to company assets;
- Long-term growth gets ample support and interest-only runs for around seven or eight years; and
- Mezzanine finance has fewer control-type provisions as opposed to equity finance.
Likewise, for investors, mezzanine finance has certain advantages. While mezzanine investors also take risks the way equity investors do, they have the perk of earning from mandated payments on a monthly, quarterly, or even annual basis. This contrasts with equity investors whose dividends are not guaranteed, nor are they entitled to regular payouts.
Are there any disadvantages to mezzanine finance and a business?
As with anything, there is a flip side to mezzanine finance, but the advantages certainly outweigh the following disadvantages when clinching a mezzanine agreement:
- As a financial instrument, mezzanine loans tend to be more costly than senior debt;
- Though not as much as an actual equity structure, mezzanine loans may involve a small measure of equity dilution as either warrants or similar constructs;
- The loan term of most mezzanine loans involve financial covenants;
- More costly than senior debt
- Mezzanine financing may involve some equity dilution, which is typically small, and may be in the form of attached warrants or a similar instrument;
- Terms for such loans often include creditor rights as well as financial covenants; and
- A mezzanine lender may charge prepayment penalties for a certain amount of time post-issuance.
Is there a standard pricing and payment structure for mezzanine finance?
We have stated previously that mezzanine finance is a financial instrument that poses the highest risks and promises the highest returns. However, we have yet to get into how much it will actually cost a company.
It should be noted that, as an in-between instrument, it costs considerably more than senior debts but is much cheaper than equity investments. As a hybrid of the two, it is subordinate to senior debt (in which case, it is referred to as subordinate debt), and maturity occurs a year after the senior debt.
As such, mezzanine finance is structured to include a varied mix of contractual interest, usually as cash, payments-in-kind (PIKs), and nominal equity in the form of warrants. During the life of the loan, it has no amortisation and has the additional benefit of bullet maturity.
In some cases, a company will utilise any accumulated senior debt capacity to refinance its mezzanine loan before it reaches maturity. This is a smart move as it reduces the total cost of their debt capital.
Note, however, that mezzanine finance’s longer maturity period and the fact that amortisation is not required further provides “patience” – essentially capital structure – for a company to process a financing event, such as integrating a recent acquisition.
In the UK, how much interest can a business incur with mezzanine finance?
Most mezzanine lenders charge between 10 to 30 per cent in terms of interest rate. This may seem steep at first, but remember that, in this context, equity is offered instead of cash to raise security to a comfortable degree. Nevertheless, it will take some time before one’s lender can convert equity to ready cash in the worst-case situations, thus the higher interest rate.
Like bridging loans, businesses prefer mezzanine finance providers for big – and certainly profitable – transactions where higher percentages in interest are welcome.
Since you mentioned bridging loans, can mezzanine finance be used for real estate?
In principle, it can be used in transactions involving commercial property. In this context, the property in questions can serve as equity or collateral. This is seen as a boon for property developers since it is instrumental for financial deals. The centrality of a property with a certified value in the real estate market is considered immediate security by most lenders who will happily approve funding for such endeavours.
Interestingly, mezzanine finance for real estate usually accords a maturity period that can run between one and five years, though this may be lengthened to a full ten years.
It’s useful for property developers because it facilitates significant finance deals while placing the investment property itself as collateral.
Are there any standard criteria for taking out mezzanine finance?
In the United Kingdom, potential borrowers need to consider the following before applying for a loan:
- Borrowers need to ensure that their finance is secured with a second charge;
- For property financing, lenders will require full planning consent;
- Property financing – either for residential or commercial purposes – are permissible for properties within England, Scotland, and Wales;
- Borrowers must submit a formal notice of personal guarantee;
- In property funding, borrowers must provide proof of experience as property developers in good standing.
Get Help for Mezzanine Financing
If you’re looking for mezzanine financing providers, your best bet is to contact us here at The Bridging Loan Company. We can find the most suitable lender for you, so enquire now here and get an indicative quote from us in 2 hours!