Restaurant dinner conversation turns to business.” What is a mezzanine lender?” asks a guest. Your brief explanation is followed by, “are they involved in a recapitalization and are they profitable?” Motioning for the check, you state, “Event Driven Daily has an article on the subject, you should give it a read”.
What is a Mezzanine Lender?
A mezzanine lender is a funder that provides financing that is sandwiched between the equity financing and senior debt of a firm’s capital structure. The lender offers a type of loan called mezzanine financing. Mezzanine loan characteristics, why would a company need such financing and how do these lenders make money are to follow:
Mezzanine Loan Characteristics
Subordination – Mezzanine loans are repaid after senior loans. Loan repayment priority is based on the loan’s position on the title of the collateralized asset. Loans with title claims prior to the mezzanine loan are called senior debt (loans). Mezzanine loans are called subordinate financing because they are paid after senior debt. However, they have a higher claim on assets than equity.
Increased Risk and Return – Mezzanine loans are higher risk than senior loans, thus they demand a higher rate of interest. The loan structure usually includes not only fully amortized repayment but also an equity kicker as well. The mezzanine lender may receive equity participation in the form of warrants or stock options, which can magnify the lender’s return providing the borrowing firm performs well.
Financing Flexibility – Mezzanine financing offers flexibility that senior debt lacks. Mezzanine terms and covenants can be tailored to meet the borrowing firm’s needs. This form of stop-gap financing can be invaluable for acquisitions, recapitalizations and useful for short-term liquidity.
Hands-Off Interaction – Mezzanine lenders do not seek nor have control over their borrowing companies, unlike equity investors. Business owners like mezzanine liquidity, minimal lender interference and not having to give up a portion of their ownership.
Bridging the Gap – Mezzanine funding can be used as a bridge loan, which is a short-term loan used to meet an immediate fiscal need until permanent funding with more attractive terms and conditions can be obtained. It bridges the gap between equity financing and senior debt and can be allocated for growth initiatives, maintaining senior debt covenant requirements, or market expansion.
Understanding what is a mezzanine lender and their financing structure is a benefit to firms in need of the short-term liquidity this stop-gap option provides.
Why Would a Company Use Mezzanine Financing?
Mezzanine financing is a versatile and effective tool firms can use to achieve their strategic objectives. This form of financing can ignite growth through organic expansion or external acquisitions. Mezzanine financing is useful for balance sheet recapitalization, oftentimes replacing existing high-interest debt with more favorable loan terms or buying out existing shareholders.
The leverage and mezzanine’s ability to increase loan-to-value (LTV) ratios are beneficial as well. The use of mezzanine financing allows a company to leverage its capital structure more effectively. When the company’s return on investment (ROI) is greater than the cost (interest rate) of the mezzanine loan, the additional debt will amplify the return on equity (ROE). Mezzanine financing also allows a company to increase its LTV compared to senior debt. The benefit is a firm can obtain a larger loan against its current assets.
What is a mezzanine lender and why a company would use this form of financing can increase capital structure expansion and facilitate managed debt growth? Let’s not discount the retained owner control and flexible terms mezzanine loans offer.
How Do Mezzanine Lenders Make Money?
The primary revenue avenues of mezzanine lending are:
Interest Payment – Borrower-paid interest payments are the primary mezzanine lender income source. The high returns are based on higher interest rates thus higher payments, which reflect the riskier nature of this financing compared to senior debt.
Fees - Mezzanine lenders charge multiple fees, such as origination, commitment, and exit fees. This represents income in addition to the interest payments and any returns from equity participation.
Equity Participation – Mezzanine funders usually request the right to purchase equity in the borrower’s firm at a later date. This equity participation takes the form of warrants or stock options. The lender profits from the capital gains of these equity instruments when the borrowing firm’s profitability increases.
Payment-In-Kind (PIK) – Borrowers may offer lenders additional debt or equity in lieu of cash interest payments. The interest on the loan is still owed and accrues, but it can be either paid off or later converted to equity. Again, depending on the borrower’s future performance, the equity may be of more value than the interest owed.
Profit Sharing – A mezzanine lender’s financing agreement may contain a provision in which the lender has profit-sharing participation. The lender may receive a percentage of the profits in addition to the scheduled fully amortized payments.
What is a mezzanine lender and how they make money illustrates the combined benefits of higher interest rates, potential equity upside, and additional fees, making it a lucrative but riskier investment compared to senior debt.
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