Mezzanine finance is a method of raising capital that is financed by debt. It fills the gap in a company’s finance structure between equity and senior debt. This means that mezzanine financing has priority over the company’s equity but is subordinate to the debts of senior lenders. A mezzanine debt may have several specific structures such as a convertible preferred debt, private securities and second-lien debt.
Mezzanine Finance Benefits
A company must have a positive cash flow to use mezzanine financing. It is typically used to expand the company through leveraged buyouts, recapitalization and acquisitions. The common feature of these types of mezzanine financing is that they offer a risk/return ratio that is lower than that of equity, but greater than that of debt. Borrowers usually consider mezzanine financing after a senior lender is no longer willing to make additional loans. However, the company’s financial structure must still have the capacity for additional long-term loans. Mezzanine financing is often combined with senior debt to reduce the amount of equity that the borrowing company must give to the lender.
Mezzanine Finance Uses
A company may use mezzanine finance for a variety of specific purposes. This includes growth opportunities such as the expansion of a plant, a new distribution channel, a new product or the acquisition of a property. The managers of a company may also use this type of financing to buy out the owners of the company as part of a succession or exit strategy. The capital provided by mezzanine financing in these scenarios is typically a small portion of the total capital available to the company. However, mezzanine financing is essential for corporate expansion and succession planning.
Mezzanine Funding Gap
The funding gap between equity and senior debt is the primary reason for using mezzanine funding. This gap often occurs when accountants reduce the estimated value of a company’s fixed assets, anticipating that the value of these assets will not be realized. Senior lenders may also be reluctant to use intangible assets as collateral, or they may wish to limit the company’s risk from a particular source of income. The finance structure of some companies may also make the cost of equity prohibitively expensive.
Senior lenders typically view mezzanine financing as borrowing equity, although mezzanine financing has several advantages over equity. Mezzanine financing has greater security since it takes precedence over equity in the finance structure. Borrowing additional equity also reduces the value of the existing shares of stock. The dilution of stock from mezzanine financing is limited, since most of the loan is made through interest payments.