Mezzanine capital is a type of equity on the assets of a company that take precedence over all other claims other than the company’s common shares of stock. This capital can be used to finance a business venture by structuring the capital as an unsecured debt or preferred stock in the company. Mezzanine funding is generally more expensive to obtain than a secured debt since mezzanine capital is subordinate to the common stock for the company. This means that the senior debts must be repaid in full before repaying the mezzanine capital. Small companies typically use this form of financing to achieve greater levels of leverage than those used in the high-yield market. Mezzanine financing therefore carries greater risk and requires a higher rate of return than those provided by secured debts.
The best structure for mezzanine funding depends on the purpose of the transaction and the company’s capital structure. The most basic structure is preferred stock and subordinated notes. Lenders of mezzanine capital typically expect a specific rate of return, which can come from several different sources. This can include cash interest, which is a cash payment based on the outstanding balance of the mezzanine capital. The return can also take the form of payable in kind interest, in which the principal is increased by the amount of the PIK interest. The Mezzanine lender can also receive ownership of the company in the form of equity, which is similar to a convertible bond. Lenders of mezzanine capital typically charge an arrangement fee when the transaction is closed. This fee is primarily intended to cover administration costs and provides the lowest rate of return for the lender.
Financers typically combine mezzanine funding with other types of securities when purchasing a company in a leveraged buyout. In this case, the mezzanine funding fills a gap in financing between less expensive senior loans and the more expensive equity loans. The primary advantage of mezzanine funding is to reduce the capital that a private equity firm must invest. A mezzanine lender requires less capital than a private equity firm, so mezzanine capital can increase the rate of return for the private equity firm. Mezzanine capital can also provide flexible financing to middle-market companies that may not be able to access high-yield financing due to their high size requirements.
Real estate developers often use mezzanine loans to obtain additional financing for large development projects. This is most common with loans that require more than 10 percent equity. The collateral for this type of mezzanine loan is frequently stock in the development company, rather than the real estate.