What is Mezzanine Financing?
If you run a business and want to acquire a new smaller company, you may need to look for additional sources of funds. Ever wonder about what you should opt for – equity or debt? Then maybe you can choose mezzanine financing which lies between the equity and debt and at the same time provides you more benefits than these two.
Mezzanine financing definition is nothing but a kind of financing that has both features of debt and equity financing that provides lenders the right to convert its loan into equity in case of a default (only after the private equity companies and other senior debts are paid off)
For example, let us take the example above. The China-backed buyer of a Hong Kong skyscraper from billionaire Li Ka-shing for a record $5.2 billion is seeking to borrow as much as 90 percent to fund the deal and around 40% of this $5.2 billion in one-year mezzanine financing at 8% interest rate.
Let’s understand it in detail about Mezzanine Financing. And also the disadvantages and advantages of Mezzanine Financing.
Have you ever bought a house?
If yes, you would know that most of the owners of the house would go for a down payment. This down payment is the money he has saved for himself. And the rest of the amount is mortgaged through a bank, meaning that the remaining amount is taken as a loan.
In the case of Mezzanine Funds, it works just like that.
Since Mezzanine Funds is not about buying houses, but buying companies; it happens like the following –
The firm who has been purchasing the company uses its own cash. Then the remaining portion is taken as a debt from different banks.
Generally, private equity acts as a mediator here. Either they buy the company themselves or they help the management of the company to buy the target company.
Now Mezzanine Financing Definition can be of different types –
- Usually, a portion is given from own savings by the private equity. And they take loans from multiple investors for funding the purchase.
- Another type is the private equity company uses its own savings and then take a debt from the company itself and thus arrange for the funding.
As a result, Mezzanine Fund aren’t something everyone would go for. The risk is much higher and the expectation of benefits is also quite high.
Let’s see few of the important characteristics of Mezzanine Financing and then we will take a practical example to illustrate how it works –
Here are the top-most important characteristics of Mezzanine Financing –
- Mezzanine Financing is for companies who have moved beyond start-ups: Mezzanine Financing aren’t for start-ups. Since in the beginning, start-ups don’t have enough cash flow, it’s difficult to take up this highly risky investment. It is for those who are yet to put their foot forward for IPO but still needs a boost in their growth capital so that they can expand.
- A pretty flexible form of financing: Mezzanine are called subordinate debts. And it is particularly useful for small business owners who aren’t yet ready to pay a huge cost of capital on the equity financing. Since mezzanine funds are offered with a tailor-made approach in mind, it suits the small business owners quite well. And as small amounts are borrowed from multiple sources like private investors, mutual funds, insurance companies, banks etc., no one runs after the borrower immediately. Another reason, it’s quite flexible is because it is considered as an unsecured loan; that means the borrower doesn’t need to provide an asset to take the loan.
- Highly risky: Mezzanine Funds are pretty risky. On one side, it helps the small business owners to boost their growth capital; but at another side it turns out to be so risky. If the small business owners aren’t able to generate enough revenue (or cash flow), it would be impossible for them to pay off the debt on time because the interest rate of mezzanine financing is quite high. That’s why it is always recommended that mezzanine debt should not be more than double of the cash flow of the company. For example, if a company has been generating around $100,000 in cash flow; it should take $200,000 as mezzanine financing and not more than $500,000 as a total debt (including the mezzanine debt).
- As Mezzanine Funds are unsecured, lenders restrict the borrowers in certain cases: This is not good news for borrowers, but since mezzanine debts are unsecured, the lenders should have some hold on the loans. That’s why they often incorporate restrictive conditions that the borrowers need to adhere to. For example, the lender may ask for the warrants or for the option of ownership if the borrower defaults to pay off the amount, or the borrower may be asked not to borrow an additional loan, or else few financial ratios the borrowers must need to meet.
Let’s go through a practical mezzanine financing examples.
Mezzanine Financing Example #1 – Mr. Richard Ice Cream Parlour
Mezzanine funds can be used for buying a company or for expanding one’s own business without going for an IPO.
Let’s say that Mr Richard has an ice-cream parlour. He wants to expand his business. But he doesn’t want to go for the conventional equity financing. Rather he decides to go for mezzanine financing.
He goes to mezzanine financiers and asks for mezzanine loans. The lenders mention that they need warrants or options for the mezzanine loans. Since the loans are unsecured, Mr Richard has to agree to the terms set by the mezzanine lenders.
So Mr Richard takes $100,000 by showing that he has a cash flow of $60,000 every year. He takes the loans and unfortunately defaults at the time of payment since his ice-cream parlour couldn’t generate enough cash flow. The lenders take a portion of his ice-cream parlour and sell off to get back their money.
Mezzanine Financing Example #2 – Federal Capital
As we see from above, Federal Capital Partners (a Private Equity firm) has provided $6.5 million in mezzanine fund to The Altman Companies for the development of Altis Grand Central.
As you can already see that there are many advantages of Mezzanine Funds. Here are the most significant advantages of Mezzanine Financing –
- Can get loan easily: Small business owners need funds to expand. Mezzanine funds is easy to get and one doesn’t need to provide any asset as a mortgage.
- The structure of the loan is quite flexible: The structure of mezzanine debt is quite flexible. The borrowers take loans from multiple sources and as a result, the amount from each is smaller.
- Interest on the mezzanine debt is tax-deductible: This the main advantages of Mezzanine fund and one of the reasons for which small business owners go for mezzanine debt is that the interest they pay on the debt reduces the tax they need to pay to the government.
Along with the pros, Mezzanine Financing has couple of demerits as well –
- Restrictive covenants: Since the loans are unsecured, the lenders incorporate restrictive conditions on the borrowers like warrants, options of partial ownership, not to borrow additional loans from a lender etc.
- High-interest rates: Since mezzanine loans are unsecured, the borrowers need to pay quite a high interest rate and if you have not been earning half of what you intend to borrow, stay away from taking mezzanine loans.
This has been a guide to what is Mezzanine Financing, its definition, structure, advantages and disadvantages. Below are another set of useful articles that you may like –
- Financing Acquisitions
- What is Venture Capital?
- Term Sheet in Private Equity
- Debt vs Equity Financing