While the words ‘debt’ and ‘equity’ are often heard when discussing loans or business funding, you may find the term ‘mezzanine finance’ used less frequently. However, it does offer an alternative halfway point between debt and equity.
Mezzanine finance is one of the more complicated forms of funding, given that it is essentially a mixture of two different finance types. However, it does offer a third option to businesses seeking working capital for their needs, which proves handy in particular situations.
In this blog, we explain what mezzanine finance is and how it could help your enterprise.
What is mezzanine finance?
As previously stated, mezzanine finance presents a middle ground to debt and equity finance, combining features from both.
Debt finance applies to any money you borrow, such as bank loans, mortgages or leasing of equipment. Equity finance refers to investment opportunities, where you exchange shares in your company for funding. Mezzanine finance provides the additional loan while ensuring the funder obtains their required rate of return via a loan and secured by the option to convert to equity in the event of default.
The technicalities behind mezzanine finance will vary depending on the lender. A typical example is where a loan is taken out, which converts into an equity share after a set period or a specific event. This means the borrower has the chance to pay back the loan (either as a lump sum or through instalments) before the agreed timeframe if they are financially able. If they aren’t, the lender can recover the balance by converting it to shares in the business, which will hopefully increase in value over time.
Alternatively, shares may be used as a form of collateral (similarly to the way assets would in an asset-based loan. At the same time, the lender is secure in the knowledge that they in the event of default they can convert into shares that hopefully will grow in value. In these contexts, the lender would get interest payments as in a standard loan, plus, in the event of default or another event, a share of profits.
Mezzanine finance can also be used alongside other equity loans or investment, so may offer additional support for those enterprises that need it.
When would you use mezzanine finance?
There are some select scenarios where mezzanine finance would be most prudent. It’s often used when, for some reason (such as being too high-risk), a borrower cannot get the full funding they need from a traditional avenue and needs to ‘top-up’ their money.
It is most commonly known in relation to property, with developers often using it to secure additional capital for their projects. In this instance, these mezzanine loans take the position as a second-charge mortgage (meaning that the lender of the original loan or mortgage is paid first as a priority, and the mezzanine paid after). Mezzanine finance works particularly well in property as the property in question acts as equity, in which lenders can get a return on shares once the project is complete and the market value increases.
Another popular use of mezzanine funding is in leveraged or management buy-outs. In this situation, the buyer is likely to need substantial funding to cover the entire value of the business, so mezzanine offers an additional layer on top of any other equity or debt funding they are using. The shares of the firm being bought act as security.
It is worth noting that mezzanine loan arrangements vary from scenario to scenario, as well as dependent on the lender and borrower’s requirements, so what one company may experience could differ from another.
Mezzanine funding isn’t for everyone. As the nature of it is that lenders are able to obtain shares with the intention of these maturing over time and offering favourable returns, lenders will likely seek businesses who can provide long-term growth. If your enterprise is facing a downturn, for example, you may be unable to utilise a mezzanine loan unless you are able to convince a lender you will turn a profit in the future.
Pros and cons
The most significant advantage of mezzanine finance is that it gives enterprises a way to secure additional ‘top up’ funding when they have been unable to get a loan that covers all their requirements. Some businesses do not wish to utilise equity finance, so mezzanine offers an alternative.
Unfortunately, this only works if the company pays back the loan in the designated timeframe. Otherwise, they risk losing shares in their business to the lender. So, if you are against offering equity in your company, you should carefully consider whether you will be able to pay back the loan in full to eliminate the risk of it turning to shares.
The equity set-up of mezzanine loans means that if your company grows, you will be able to provide lenders with the payments and interest they want while retaining control of your company. However, if you cannot meet repayments, you will have to hand some control over to the lenders, which gives them an increased say in your operations and fate.
Another pro of mezzanine funding is that it is incredibly flexible. The arrangements in place are variable, depending on the needs of all the parties involved, so you can find a structure and repayment schedule that suits you. This will be welcome to those using it as a ‘top-up’ option, who will already be dealing with repayment on their traditional debt loans.
Despite its flexibility, mezzanine lenders will have set requirements you need to meet to be accepted. This could include the need for security, in the form of assets or even personal guarantees, which could restrict who is eligible.
It is also a more expensive option compared to alternative debt finance types. Interest rates tend to vary between 10% and 30%, with these higher rates offering additional protection to the lender as a response to equity being used instead of other assets. Due to this, mezzanine funding tends to be used on high-value projects and deals (such as property development and buy-outs), where the capital offered remains worthwhile despite the level of interest.
Find out what is right for you
Mezzanine finance is a complex and high-interest solution, but there are situations where it could prove useful for firms.
However, it is vital to be sure that you are willing to offer shares as security (or are confident of repaying the loan before it gets to that stage). Due to the variable structure of mezzanine loans, it’s also fundamental that you understand the technicalities associated with any offers given to you and are comfortable before committing.
If you have struggled to get the capital you need via a traditional loan and are wondering whether mezzanine funding or another solution could enable you to top-up your finances, we can advise you.
Our team of experts have experience working with a variety of businesses to solve their unique financial challenges with the ideal route for them. As such, we will discuss your requirements and take you through the best options available for your situation.