Mezzanine Financing: A Practical Guide

What is mezzanine financing?

Mezzanine financing is a hybrid of debt and equity that fills the capital gap between senior debt and common equity. It typically sits subordinated to senior loans but ahead of equity in the capital stack. Mezzanine instruments often include features such as high-yield interest, equity kickers (warrants or conversion rights), and flexibility on repayment.

Key takeaways

• Hybrid instrument: combines characteristics of debt (interest payments) and equity (conversion or warrants).
• Positioning: subordinated to senior debt but senior to preferred and common equity.
• Returns and cost: lenders typically expect high returns (commonly 12–30% annually), making it more expensive than senior debt but generally cheaper than issuing new equity.
• Typical uses: acquisitions, leveraged buyouts, growth capital, recapitalizations, refinancing, and management buyouts.
• Borrower benefits: less dilution than equity and interest is usually tax-deductible.
• Risks: subordinated repayment priority, restrictive covenants, higher interest costs, and potential loss of control.

How mezzanine financing works

Mezzanine capital can be structured as subordinated debt, preferred equity, or a combination:

• Subordinated (sub-debt): unsecured loans or bonds ranking below senior lenders; repayment only after senior claims are satisfied. Often no principal amortization until maturity.
• Preferred equity: an equity investment senior to common stock that pays fixed dividends (or coupons) and may include redemption rights; typically more control and distribution priority than common equity.
• Equity participation: lenders commonly receive warrants or conversion rights to participate in upside if the company performs well.

Typical terms and mechanics

• Maturity: often five years or more, but can be tied to the company’s overall debt schedule.
• Payments: interest is usually periodic; principal is frequently due at maturity. Interest can be fixed, variable, or partially PIK (payment-in-kind) where interest accrues.
• Transferability: mezzanine loans are generally transferable by the lender; preferred equity transfers may be restricted.
• Covenants and control: agreements often include covenants, financial ratio tests, restrictions on additional borrowing, and sometimes board or information rights for mezzanine providers.

Advantages

• Provides growth or acquisition capital without significant dilution of common equity.
• Interest is typically tax-deductible for the borrower.
• More flexible than senior bank debt (deferral options, tailored amortization).
• Lenders gain downside protection from interest payments and upside potential via warrants or conversion.
• Can help bridge to a future refinancing into lower-cost senior debt if the company improves.

Disadvantages

• Higher interest costs than senior debt.
• Subordinated status increases lender risk; recovery in bankruptcy is limited.
• Negotiation and documentation can be complex and time-consuming.
• May include restrictive covenants that limit strategic flexibility.
• Potential loss of control or influence if lenders obtain board seats or conversion rights.

Examples of use

• Company A replaces a higher-cost credit line with a $15M mezzanine loan paying 10% interest and granting warrants; borrower gains working capital and avoids large equity dilution.
• Issuing preferred series stock (e.g., 10% preferred) to provide dividends and liquidation priority without issuing common shares.

Mezzanine financing in real estate

• Commonly used to finance acquisitions or developments when senior mortgage proceeds are insufficient.
• Often structured as an unsecured loan secured indirectly by the borrower’s ownership interest; in default, lenders may convert to equity.
• Appears on the borrower’s balance sheet in a way that can preserve senior lender relationships while increasing overall funding.
• Attractive to lenders for high yields and potential upside participation.

Who provides mezzanine capital?

• Specialized mezzanine funds, private debt funds, and some institutional investors.
• Providers typically look for companies with predictable cash flow, a clear plan to de-lever, and a path to refinance or exit.
• Lenders often customize deal terms and expect strong documentation and collateral/structural protections.

How mezzanine funds make money

• Interest and PIK yields on loans.
• Equity upside through warrants or conversion into equity when company value increases.
• Capital gains from selling mezzanine positions or exiting investments.

Are mezzanine loans secured?

• They can be unsecured or secured. In corporate deals they’re often unsecured subordinated debt backed mainly by the borrower’s promise to pay (and sometimes by pledges of equity interests).
• In real estate, mezzanine loans may be indirectly secured by ownership interests in the property-owning entity; practical protection is limited relative to senior mortgage liens.

When to consider mezzanine financing

• You need capital for growth, an acquisition, or a buyout but want to minimize immediate equity dilution.
• The company has a credible plan to improve cash flow or refinance into cheaper senior debt.
• Management and owners are willing to accept restrictive covenants and possible board or investor oversight in exchange for capital.

Conclusion

Mezzanine financing is a flexible but costly tool that bridges debt and equity. It suits companies seeking expansion or M&A funding without excessive dilution, while offering investors high yields plus equity upside. Before pursuing mezzanine capital, weigh the higher cost and potential governance implications against the benefits of preserving ownership and enabling growth.