What is Mezzanine Capital?

Last Updated: 5 Jul 2022

Funding is important if a company is considering scaling, expansion, and growth in the market. A company can raise from multiple sources and have different ways to obtain finances. Debt and equity are two majorly used forms of raising money. The hybrid format of investment avenues not only exists for investors but for companies, too. Mezzanine capital funding is one such concept of raising funds from the public.

Mezzanine capital?

Mezzanine capital is a total hybrid form of raising funds that lie between equity and debt financing structures. This method is generally chosen by companies in case of emergency requirements of capital. Companies chose mezzanine capital for specific projects like acquisition, business expansion, recapitalization, leveraged buyouts, and growth needs. Therefore, mezzanine capital is mostly preferred by matured companies rather than startups or youth companies.

Mezzanine finance is an expensive affair as a company needs to pay higher interest rates as compared to interest on bank loans. Companies usually choose mezzanine financing for two major reasons. The company might have exceeded its borrowing capacity, or they are preserving it for some future needs. Mezzanine finance is mostly treated as equity in the company’s balance sheet. This mostly takes the form of preferred stocks or unsecured debts. It is also addressed as cheap equity by experts.

Mezzanine funding is generally a buy-and-hold for long-term products and is not liquid unlike other debt instruments as they are not traded. Investors usually receive higher returns on mezzanine investing as they are mostly unsecured, thus making it a costly road to choose for companies.

How does mezzanine funding work?

The mezzanine funds are often in a long-term tenure of 7 to 8 years and offer a typically higher rate of returns, around 15-20%. Mezzanine financing is an insecure form of investment that welcomes higher interest rates, thereby getting more attention from general investors. Investors generally receive returns from five different sources. Cash interest, payable kind of interest, ownership, participation layout, and agreement fees.

Companies should have a proven track record of consistent profitability, and a proper expansion plan to raise funds from mezzanine capital. Therefore, only companies with positive cash flows opt for it.

In mezzanine financing, the investors are given the right to convert their investment amount into equity if the company defaults on the repayments. However, this can only be done if a warrant is available which increases the value of mezzanine debt in the eyes of investors.

What are the advantages and disadvantages of mezzanine financing?

For companies

Mezzanine funding has many advantages that make it lucrative for companies:

• Mezzanine financing doesn’t require dilution of equity, thus reducing the use of available equity.
• The interest paid is deductible from the tax, therefore making it more attractive.
• Only institutional lenders can invest in mezzanine capital, which makes it easy to get loans from banks as having a presence of institutional lenders reduces the risk of default.

In this manner mezzanine funding is the best way to raise funds with maximum return on equity and minimum cost of capital.

For investors/lenders

For investors or lenders, there is no uncertainty of income like dividend payouts, as companies will compulsorily have to pay interest regularly. Additionally, if the company performs well, there are high chances of this debt getting converted into equity and thus increasing average returns.

On the flip side, lenders have a higher risk as there is no guarantee in lending for mezzanine funding. Mezzanine debt is a subordinate debt, so if a company defaults and is not left with any assets, the lender will lose all its money. For the company raising funds through the mezzanine funding method, the cost of borrowing is higher as compared to debt like bank loans, and also increases the interest the longer it holds these funds.

Final Words

In short, mezzanine funding is a good avenue to raise funds through a hybrid format that reduces the cost of capital for the company and also keeps the door open for borrowing funds from banks. For investors, it is a good opportunity to cash risks mezzanine funding is often opted forby companies with positive cash flows and having a matured time frame in the market.

Frequently Asked Questions

Why is mezzanine finance needed?

Mezzanine capital works as a gap filler between equity and senior debt which may arise due to reasons like, a higher proportion of intangible assets on the balance sheet, fear of not realizing the values of not realizing the value of inventories or debt receivables.

Mezzanine finance is majorly needed for short term capital needs that are used for growth opportunities like acquisition or leveraged buyout. Alternatively, mezzanine financing builds a layer of trust for banks to lend the money to companies with mezzanine finance due to the existence of institutional lenders. Also, it keeps a road open for companies to raise funds for the long term when companies raise funds for short term needs via this method.

What is a mezzanine loan structure?

Mezzanine funding is also a form of debt funding. It is an unsecured form of lending with a maturity period ranging from 5 to 8 years. The only guarantee that mezzanine funding provides is an equity warrant, which allows investors to convert to equity holders in case of defaults.

Who provides mezzanine debt?

Mezzanine debt is usually provided by institutional lenders who have a high risk-bearing capacity.