Introduction
Mezzanine financing is a hybrid system of financing, which incorporates the features of equity and debt, both. It gives the lender a right to convert their debt into equity shares, in case of a default.
Mezzanine debt is subordinated debt, and close to being the last to be paid off. It is senior only to equity shares. Hence, it is high-risk debt and carries a very high rate of interest, as compared to any other debt.
How Does Mezzanine Financing Work?
This form of financing is typically used in acquisitions, as it bridges the gap between debt and equity. Borrowers generally take on mezzanine debt after they have exhausted other sources of financing. Mezzanine financing is used more by well-established companies to fund projects and growth, rather than companies in the start-up phase.
There are various ways in which mezzanine debt can be structured, the most common being a legal right to convert to equity, in case the debt is not repaid on time or repaid in full. The percentage of interest can be structured differently, with some portion being fixed and some portion variable. In mezzanine financing, interest can also be paid by increasing the principal amount, instead of frequent cash payouts.
Advantages and Disadvantages of Mezzanine Financing
Advantages
Lenders are assured of receiving regular interest payments, and these interest rates are much higher than regular debt.
Mezzanine financing is typically unsecured debt, and there is more flexibility involved for the borrower while taking on the debt, as no assets need to be given on lien.
Mezzanine investors target a lower cost of capital, as compared to private equity investors.
Mezzanine debt is tax-deductible for the borrower.
Deferment of interest payments may be possible with mezzanine debt, but usually not with any other form of debt.
It helps borrowers get additional sources of income when they have exhausted all other options.
Disadvantages
It is a very expensive form of financing for a company.
Mezzanine lenders are paid off only after senior debtors; hence, they could also risk losing their investment as there is generally no lien on the assets.
Owners need to sacrifice equity and control in the event of something going wrong.
Mezzanine lenders are ones who wish to have a long-term strategic relationship with the company, rather than only get a quick return on investment.
