When a business needs funds for a significant project or acquisition, traditional lenders may be unwilling to provide all of the money required. Creative financing approaches like mezzanine loans might be able to fill the gap.
How Mezzanine Loans Work
Mezzanine loans are a hybrid of both debt and equity. Depending on the terms of the agreement and how events unfold, the arrangement can provide an equity interest to lenders. Mezzanine lenders usually work with companies that have successful track records. For example, you might use a mezzanine loan to acquire an existing business or expand operations for a business that’s already profitable.
Interest and Repayment
Mezzanine loans often come with higher costs than traditional borrowing. Interest rates in the double digits are common, or lenders may demand equity exposure to supplement interest income. Depending on the terms of an agreement, borrowers may have several options for repayment. If cash flow isn’t available—or if the business wants to reinvest instead of pay interest—businesses can capitalize interest charges, known as a “payment in kind.”
Subordinated Loans
Mezzanine debt typically has a lower priority than senior debts when borrowers go bankrupt. If a business fails, it may need to sell assets like buildings and equipment to generate cash and pay off debts. If there’s not enough money to pay everybody, those creditors get in line. Banks and senior bondholders are usually near the front of the line, giving them a better chance of receiving payment in a liquidation. (Their interests also may be secured by collateral.) Mezzanine loans are typically farther back in priority, although they are above common equity.
Pros and Cons of Mezzanine Loans for Borrowers
Like every kind of borrowing, mezzanine loans come with benefits and drawbacks for borrowers.
Pros Explained
Access to capital: Borrowers get the money they need for a purchase or expansion. Minimize equity dilution: Instead of trading a substantial amount of equity for capital, borrowers can minimize their equity dilution while borrowing more than traditional banks want to lend. Deductible interest payments: Interest payments may be deductible to the business. Multiple repayment options: Borrowers can potentially pay interest charges with cash, add them to the loan balance, or provide equity-like instruments to the lender. Benefits capital structure: Mezzanine financing often appears as equity on the balance sheet, enabling borrowers to show lower debt levels and more easily qualify for other types of financing.
Cons Explained
Financial consequences: Leverage (borrowing money with the hope of earning back more than you borrowed) is always risky. Borrowers may face significant debts and other consequences if things don’t work out as planned. Risk of equity loss: If borrowers default on loans, they may have to provide equity interests to lenders. Shared control with lenders: Mezzanine lenders may set specific criteria that borrowers must maintain. For example, lenders could specify limits on financial ratios or make other demands.
Pros and Cons of Mezzanine Loans for Lenders
Borrowers aren’t the only ones who face benefits and drawbacks from mezzanine loans. This type of lending structure has pros and cons for lenders as well.
Pros Explained
Interest income: Mezzanine financing has relatively high interest rates to compensate lenders for the high level of risk.Equity and participation: Lenders can potentially receive equity, allowing them to participate in a business’s success. For example, warrants may be part of the lender’s compensation, or lenders may receive equity when borrowers default.
Cons Explained
Risk of default: Lenders always risk losing money to default, especially with mezzanine debt. Low seniority: These loans might not be secured by any physical collateral. For example, there might not be liens on property, equipment, or other company assets. When the business pays senior debtors, it may deplete any available funds before the mezzanine lenders receive payment.
