What is Mezzanine Debt Financing (Mezzanine Loans)?
Mezzanine debt financing is a subordinated and unsecured loan which typically features a warrant. This type of debt has higher interest rates because of its subordinated and unsecured status. It is not backed by collateral. In the event of debtor default, the claims of mezzanine lenders are senior only to the claims of common shareholders. Therefore, use mezzanine debt to finance startup companies with growth potential or to complement other forms of debt in a leveraged buyout.
Like other debt instruments, mezzanine debt includes a contract that stipulates the details of the loan. The contract describes the amount of the loan, the rate of interest and the interest payment schedule, the due date for principal repayment, and whether or not there is a conversion feature. The loan may also allow a portion of the interest payments to be accrued over the life of the loan and paid along with the principal at maturity. This feature is payment-in-kind.
Interest rates on mezzanine loans are substantially higher than other types of loans. This is to compensate the lender for the riskiness of making a subordinated and unsecured loan.
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Mezzanine lenders are often private equity funds or venture capitalists. Therefore, consider these mezzanine loans speculative investments. The debt instrument provides a stream of income and some downside protection, while the warrant feature offers the potential for upside gains.
Advantages and Disadvantages of Mezzanine Debt Financing
For borrowers, mezzanine debt financing allows companies with less collateral to secure funding for growth. On the other hand, the interest rates on this type of loan are comparatively high. So it is expensive source of capital.
For lenders, mezzanine debt instruments offer higher yields than secured or more senior forms of debt. Also, the warrant feature offers the promise of gains if the borrowing company’s equity increases in value in the future. On the other hand, there is a greater risk of default because the claims are subordinate and unsecured.
Mezzanine capital refers to subordinated and unsecured debt or preferred equity. It often includes a warrant, or a conversion feature, that allows the lender or investor to convert the debt or preferred stock into a specified quantity of the company’s common stock at a set price within a stated period of time.
The equity warrant feature of mezzanine capital allows the lender or investor to convert the loan or preferred stock into a specified quantity of the company’s common stock at a set price within a stated period of time. Design it to give the lender or investor an equity stake in the possible future success of the company.
The word “mezzanine” derives from the Italian diminutive form of the word “middle.” Use it to describe the lowest balcony in a theater.
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