Mezzanine financing is a hybrid form of financing that incorporates aspects of both debt and equity financing. It typically involves loans that are subordinated to other debts but may also involve an equity component, often in the form of warrants or rights to convert the debt into equity shares in the future.
The term “mezzanine” comes from its intermediate position in the company’s capital structure: above pure equity (like common shares) but below senior debt (like loans and bonds).
Mezzanine financing tends to be more expensive for the borrower than traditional loans due to its subordinated position in the event of bankruptcy (meaning, mezzanine lenders get paid back after senior debt holders) and because it often lacks collateral. However, it can be an attractive option for companies that need financing but do not want to give up control, as would often be the case with equity financing.
Companies often use mezzanine financing as a tool for funding growth initiatives such as acquisitions, buyouts, expansions, or capital improvements. It’s commonly used in leveraged buyouts, where it can provide the additional capital needed to complete an acquisition.
Investors who provide mezzanine financing typically seek high returns to compensate for the level of risk they take on, and they may also seek to influence the direction of the company through stipulations in the loan terms or through the potential conversion to equity.
Example of Mezzanine Financing
Let’s consider a hypothetical example. Imagine a growing manufacturing company, “TechGrowth Inc.,” which wants to acquire a competitor to increase its market share.
The acquisition cost is $10 million. TechGrowth has $5 million of its own funds and has been approved for a $3 million loan from its bank. However, it still needs another $2 million to complete the acquisition. The company does not want to issue additional shares to raise the funds, as the owners don’t want to dilute their ownership.
In this situation, TechGrowth might look to mezzanine financing to fill the “gap” in their financing needs. A mezzanine lender agrees to provide the $2 million as a subordinated loan, meaning it will be paid back after the bank if TechGrowth defaults on its obligations.
To compensate for the higher risk, the mezzanine lender charges a high interest rate. Additionally, they negotiate an equity kicker in the form of warrants that would allow them to purchase shares in TechGrowth at a predetermined price in the future. This gives them the potential for an even higher return if the company does well.
TechGrowth agrees to these terms, uses the mezzanine financing to complete the acquisition, and can later pay back the loan from the increased profits generated by the larger, combined company. If the company performs exceptionally well, the mezzanine lender could also profit from the increased value of the equity obtained through the warrants.