Small and mid-market enterprises frequently struggle to obtain loan financing. As a result, middle-market companies have sought alternate financing solutions, such as mezzanine finance, to fund expansion possibilities, acquisitions, and other similar activities.
To accommodate the rising demand, business development companies (BDCs), private equity firms, and venture capitalists have risen in importance. Alternative financiers have become particularly appealing financing options for small businesses that cannot acquire bank finance because they are less subject to federal oversight.
So, what exactly is this well-known type of alternative lending? What exactly is mezzanine debt, and how does it function? This article will explain the concept of mezzanine financing.
Defining Mezzanine Financing
Mezzanine finance is a corporate loan with repayment terms tailored to a company’s cash flow. It is a mix of debt and equity financing that requires cash flow to repay the loan but has more flexible payback periods.
This type of loan is usually not backed by the company’s assets and comes after secured debt in terms of repayment priority in case the company doesn’t pay it back. It is also known as subordinated finance. As a result, it entails more risk for lenders and is associated with higher interest rates.
Companies utilize it to improve operating capital, fund acquisitions, or finance the transfer of a business to family members or the management team, among other things.
One significant advantage of mezzanine financing is that the loan is frequently considered equity on the balance sheet. Thus, calculating the company’s debt-to-equity ratio does not count as debt. This increases its leverage position and allows the company to borrow in other ways, such as traditional bank loans.
Companies that acquire mezzanine financing often have an established reputation, a robust product offering, a track record of profitability, and reasonable expansion ambitions.
How Does Mezzanine Financing Work?
When you get a mezzanine finance loan for your business, the debt becomes an ownership share after a certain amount of time. If the company cannot repay the money, the lender will receive a piece of the company’s equity instead. Equity in the business is used as security in this manner.
In other cases, mezzanine finance combines loan and equity by granting a profit share and interest payments. Put another way, the corporation borrows money, and the lender obtains a percentage of the earnings.
Benefits of Mezzanine Finance
Mezzanine financing is frequently utilized as a ‘top-up’ to the amount granted by the primary lender. For example, if the primary lender contributes 65% of the funds required for a project, mezzanine financing may give an additional 20%, leaving only 15% for the business to contribute.
On the other hand, mezzanine finance is a technique of raising more money with the same amount to put in yourself. It’s frequently the enabler for larger initiatives the organization couldn’t afford.
As a result of such a design, the company may maximize its return with its available cash contribution. Working capital is critical for any firm. Therefore, mezzanine financing can be a welcome addition to traditional financing arrangements.
However, there are specific benefits that the issuer and the investor will experience in the process of mezzanine financing.
Issuer Benefits
Increase in Total Capital
Mezzanine financing can assist a corporation in obtaining more capital and avoiding undercapitalization. The interest paid on mezzanine financing is also tax deductible.
Capital Cost Reduction and an Increase in Equity Returns
Equity is the most expensive kind of capital, diluting present shareholders. As a result, mezzanine debt may be an appealing option for obtaining much-needed finance. Companies use a suitable blend of senior loans, mezzanine debt, and equity to minimize the true cost of capital and maximize asset returns.
Investor Benefits
Attractive and Safe Investment
Mezzanine investors benefit from the advantages of equity investment, such as strong returns and a broad portfolio. If the borrowing firm succeeds, the mezzanine investor can exercise the stock option and earn the rewards.
In addition, the mezzanine investor gets at least the interest payment, even if the worst happens. The interest rate received for mezzanine financing outperforms that of regular financing.
Warrant Option
Mezzanine financing frequently includes warrants or convertible equity options that a mezzanine investor might exercise to gain company ownership. The rights can be exercised on a set date or when a specific event occurs, as specified in the agreement.
Why Use Mezzanine Financing?
This type of financing is typically employed when the perceived risk is high enough that the borrower cannot acquire sufficient funds through a standard commercial loan. The alternative is usually equity financing, but many businesses do not want to relinquish company ownership.
Mezzanine financing enables such enterprises to borrow a greater sum that, if everything goes well, will be repaid with profits.
Simply said, it allows for a larger investment with a higher expected return. In certain cases, a mezzanine loan is repaid in one sum, while interest payments might be deferred in others. Interest on mezzanine financing may be tax deductible. All of these features distinguish mezzanine finance from traditional corporate loans.
Cost of Mezzanine Financing
Mezzanine financing is more expensive than senior financing since a second charge secures it (making it riskier to the lender) and has a greater Loan-to-Value ratio. Interest rates will vary depending on the situation but typically begin at 12% annually.
Arrangement fees often start at 1%. Many factors will influence the interest rate, including deposit input, market demand, location, and necessary finance quantity.
The Risk of Taking Out Mezzanine Financing
Risk is involved, as with any business loan, and the borrower is fully liable for the obligation. You will be personally accountable whether the mezzanine loan is taken out in your name or via your company since you must give a personal guarantee.
If you default and the property is repossessed, you may have to pay the difference between the loan amount and the sale price.
Is It Secure to Take Mezzanine Financing?
Unsecured mezzanine debts can be secured. Real estate uses are frequently indirectly secured to some extent by the borrower’s real estate holdings. The debt in corporate mezzanine financing is secured by the borrower’s ownership interest in the company.
However, a mezzanine loan is relatively low on the repayment schedule. This “collateral” could be of limited worth.
Enhance Business Growth and Stability
Mezzanine financing is undoubtedly a complex commodity, but it has its applications. Suppose you’re seeking mezzanine finance or investigating the numerous ways to fund a project. In that case, MFEG’s mezzanine financing can help you locate the best funding from dozens of lenders throughout the market.
