Mezzanine loans can be a valuable financing option for business owners who want to fund quick growth initiatives and projects. Here are the main characteristics of a mezzanine loan:
- Subordinate to pure debt but senior to pure equity
- No amortization, no immediate repayment
- Potentially lower equity dilution
- 20 to 30 percent interest rates
- Flexible structure
- Riskier for lenders but with higher potential returns
It is essential to conduct due diligence before signing the loan agreement of a mezzanine loan. Consider all aspects of the loan terms, conditions, and potential equity impact. Make sure you obtain the necessary approval from stakeholders and evaluate the company’s cash flow generation and exit strategies before choosing mezzanine financing. With responsible due diligence, mezzanine loans can offer great advantages to both the lender and the borrower.
Mezzanine loans are a hybrid of debt and equity for businesses. Unlike traditional financing strategies, mezzanine financing does not come with amortization and does not require collateral. Companies often use mezzanine loans to finance expansions, growth projects, and buyouts.
The high risk nature of mezzanine financing may be worth it for investors due to the potentially high returns. In this guide, we go over what is a mezzanine loan, its unique structuring and advantages, as well as risks that both business owners and lenders need to know.
Characteristics of mezzanine loans
Only interest payments and no amortization
Mezzanine loans only require the borrower to make interest payments before the loan’s maturity date. There is no amortization of the loan principal that spreads the loan amount out over time for repayment.
The lack of amortization and mandatory payments make mezzanine loans advantageous to companies. Companies can free up more liquid capital to fund expansions, acquisitions, and other expensive projects. If your company needs financing in a short or medium time frame, a mezzanine loan could be the accessible and flexible gap financing you need.
Mezzanine loans have both debt and equity components, giving them a hybrid nature. It can be considered as expensive debt or cheaper equity due to its high interest rates.
Subordinated position in capital structure
It is important to know that mezzanine financing is subordinate to pure debt (though it is senior to pure equity). Subordinated debt is riskier than unsubordinated debt because if the borrower defaults, faces insolvency, or files for bankruptcy, the other corporate debts and loans have priority in repayment.
Higher risk and potential return for investors
Mezzanine loans come with one of the highest risks of any loan type. There are no mandatory payments before the loan’s maturity date. However, mezzanine loans also offer potentially high returns to the investors up to 30 percent, which incentivizes investors to provide the loan despite the risk.
Key players in mezzanine financing
Different lenders will offer varying amounts of mezzanine loans with different loan terms. How much of a loan amount you can receive and whether your company qualifies for a mezz loan will depend on numerous factors such as your company revenue and size.
Financial institutions like banks may provide mezzanine loans.
Private equity firms are another lender option for mezz loans.
Existing funders and long-term investors of the company might also be willing to provide mezzanine loans.
Borrowers of mezzanine loans
Real estate developers might be interested in the unique mezzanine loan option as a solution for filling in financing gaps.
Growing businesses can benefit from mezzanine financing. Because there is no loan principal amortization schedule for mezzanine loans, smaller to middle market businesses don’t need to worry about the stress of immediate repayment installments.
Buyouts and acquisitions are a common reason for borrowers to obtain mezzanine financing. The structure and subordination of mezzanine loans can facilitate growth and buyouts.
Structuring mezzanine loans
Interest rates and terms
Mezzanine loans may have either fixed or variable interest rates. Depending on negotiations, it is also possible to have partial fixed and partial variable interest rates as a sort of hybrid interest rate option. This mitigates the potentially harmful effects of shifting market conditions on the mezzanine loan.
Because mezzanine loans are subordinated to senior debt and are lower in the hierarchy of claims in case of bankruptcy, mezzanine loans typically have higher interest rates.
In general, mezzanine loans have an interest rate between 20 and 30 percent. If you’re looking to obtain funding for your business, it’s a good idea to consider other financing options and evaluate which aligns best with your company’s interests.
Security and collateral
Mezzanine loans are typically unsecured, which means that no collateral is required. In some cases, you might be asked to secure the loan with minimal collateral, such as your ownership interest in the company for which you’re obtaining the corporate mezzanine financing. For real estate expansions, you might use your real estate interests to secure a mezz loan.
Bankruptcy order of claims
Mezzanine loans are subordinated to senior debt, so lenders undertake higher risk when giving out a mezzanine loan. However, mezzanine loans are positioned above equity in the capital structure, making them often preferable to other financing methods for growth initiatives and acquisitions.
In the event of a default or liquidation, senior lenders will be entitled to be repaid before mezzanine lenders. This means that the lender providing mezzanine loans will not receive repayment until the senior debt obligations have been met.
Advantages of mezzanine financing
Flexibility in capital structure
Mezzanine financing offers flexibility that can be valuable for borrowers. It allows you to customize the structure based on your company’s specific needs.
Unlike other financing strategies, mezzanine loans either require no collateral or minimal collateral. This makes them easier to obtain if your company doesn’t have significant assets that qualify as collateral.
By taking out a mezzanine loan, businesses won’t need to take on additional senior debt. This can decrease the potential risk compared to other types of financing.
Interest rate flexibility
Mezzanine loans offer the flexibility of flexibly structuring interest rates. Your company could benefit from partial fixed rate and partial variable rate interest for the mezzanine loan terms, reducing the volatility of long-term financing.
Compared to other ways of financing like raising equity capital, mezzanine financing can help companies avoid significant equity dilution. This is a particular advantage to business owners who want or need to retain greater ownership stakes.
Consider the tax implications of taking out a mezzanine loan. The interest payments on mezzanine debt may be tax deductible, which could provide a meaningful tax advantage. Check with the latest IRS guidelines to determine the expected tax impact.
Companies may be able to use mezzanine loans as a catalyst for growth. Mezz loans can be good for event-driven situations and needs, such as:
- Expansions into new regions
- Ownership transitions
- New vertical integrations
Risks and challenges
Like with any loan, there is a risk for the borrower to be incapable of paying back the loan according to the repayment terms. This loan default can come with serious negative consequences for both the lender and the borrower.
In case of default, the lender will not be able to recover the principal loan amount plus interest. A significant amount of the money invested may be lost because mezzanine financing does not have amortization like traditional loans.
Subordination is a risk taken on by lenders when multiple creditors lend money to different entities within a corporate group. There are various forms of subordination, which determines the seniority of debt. The senior lender will be given priority and rank higher than the other creditors.
Mezzanine loans come with a subordination risk because they are subordinate to senior debt. Certain strategies may be used to effectively mitigate the risk of subordination, but recouping losses for the lender is never guaranteed.
If the parent company is a non-trading company without many direct assets, lenders find it highly risky to extend loans because of this subordination risk. In these cases, business lenders often require subsidiary companies to guarantee a parent company’s loan because they don’t want to be structurally subordinated.
Contractual subordination may also take place if the different creditors sign a contract that ensures one lender gets payments before another. The four common contractual subordination types are contingent debt, simple contractual, turnover, and trust.
Economic downturns can impact mezzanine loans. Similar to preferred equity, mezzanine financing could be called in and replaced by lower-interest financing if the current market interest rate drops significantly.
To avoid being excessively affected by fluctuating market conditions, the lender and borrower of a mezzanine loan may negotiate a partial variable and partial fixed interest rate for the loan.
Expert advice and best practices
Whether you are a business owner or investor, it is always important to perform due diligence and appraise all facets of the mezzanine loan agreement. A comprehensive financial analysis can help decide whether the mezzanine financing should be beneficial to you.
Legal and financial experts can help you with determining the structure of the mezzanine loan and negotiating the financing terms. Proper and good faith negotiations help ensure a win-win experience for both the lender and borrower.
Exit strategy and debt repayment
It is advisable for businesses that take out a mezzanine loan to consider their repayment plan for the mezzanine loan. While this kind of debt is less pressing due to the lack of amortization, it is still a good idea to plan for paying off the debt by generating adequate cash flow over time.
Common pitfalls to avoid
When lending or borrowing money, especially a large loan amount in the case of a mezzanine loan, it is recommended to watch out for common pitfalls and red flags. Here are some pitfalls to avoid when obtaining mezzanine loans.
Insufficient cash flow: Even though mezzanine loans don’t require you to repay fixed amounts of the principal balance each month, interest payments still need to be covered. If your business is lacking cash, it might not be a good idea to obtain a large mezzanine loan.
No exit strategy: It’s critical to have a clear exit strategy for paying off the mezzanine debt. Otherwise, when the loan matures, your business might face financial difficulties.
Inadequate due diligence: Always conduct due diligence before agreeing to a financing strategy. This includes assessing your business’ financial standing, market conditions, interest rates, repayment capacity, cash flow generation potential, and the reputation of the other party.
Not communicating with shareholders: It’s typically expected to negotiate terms with existing stakeholders when a business obtains mezzanine financing. Keep in mind the conditions and attitudes of equity holders and senior lenders. If you fail to obtain all the necessary approval from essential parties, it can cause legal and financial issues down the line and impede the completion of your mezzanine financing deal.
Equity dilution: As a borrower, make sure you consider the potential dilution of equity and see whether the equity upside is worth it. Even if the mezzanine loan dilutes equity less than traditional equity financing, it still might pose issues for your ownership stakes.
Additional information on mezzanine loans
Unique industries and mezz financing
Certain industries are more attracted to mezzanine financing than others. For example, real estate commonly leverages mezzanine loans for expansions and growth initiatives.
Technology startups and renewable energy projects are also attracted to the structuring flexibility of mezzanine financing. Tech startup founders often make retaining ownership majority a priority, seeking mezzanine financing over other options. The lack of immediate repayment expectations also makes it easier for smaller startups and companies to fund their growth and push through barriers of entry in their industries.
Cross-border exchange rates and regulatory differences should be considered when obtaining a mezzanine loan. Different jurisdictions may regulate mezzanine financing differently, and shifting market conditions and geopolitics can also impact mezzanine lending globally. In some places and times, a mezzanine loan may not be a feasible option for business owners.
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