'Mezzanine Financing' is explained in detail and with examples in the Corporate Finance edition of the Herold Financial Dictionary, which you can get from Amazon in Ebook or Paperback edition.
Mezzanine Financing refers to an unusual form of hybrid financing. This is a combination of equity and debt financing which provides lenders with the opportunity to convert their ownership and equity interest in the firm. They would want to do this to protect themselves from default possibilities. They would be third in line after both venture capitalists and other types of seniors lenders were paid back.
Mezzanine Financing should always be completed after performing appropriate due diligence by the lender. The borrower does not put up much or any collateral which is why it becomes treated as if it were equity on the balance sheet of the company.
In order to bring in interested parties on to Mezzanine Financing, the firm will have to showcase a solid track record within their industry. They will have to boast an established product and developed reputation, as well as a practical business expansion plan, and a corporate history of profitability. The business plan will need to show opportunities via an IPO initial public offering, acquisitions, or expansions.
Mezzanine Financing commonly attracts an interest rate of from 12 percent to 20 percent. This is because it represents a high return but also high risk form of debt. It usually takes the place of some of the capital which the equity investors would otherwise need to put up for a company to continue to operate effectively or to expand aggressively.
It always helps to consider a real world example in order to better understand a challenging concept like this one. If a private equity firm wants to buy a $200 million business, the senior lenders might consent to delivering $150 million in financing. While the private equity firm pours in $25 million of its own money, they might look for another $25 million in Mezzanine Financing as part of the effective buyout of the company which is the target. Through utilizing the concept of Mezzanine Financing, the buying firm is able to leverage its capital and increase its total return on the deal.
Such Mezzanine Financing can lead to lenders obtaining some equity share and stake in a company or at least warrants for buying in equity at a later point and time. This can dramatically boost the investor ROR rate of return. The Mezzanine Financiers also obtain interest payments which the borrower must make either annually, quarterly, or monthly according to their contract which they originally executed. As an example, if Britannia Capital Corporation is able to earn as much as 20 percent per year on all of its Mezzanine Finance investments, then this ROR proves to be far higher than today’s pitiful interest rates which U.S. Treasury instruments pay yearly. These commonly provide around two percent only. The reason of course it that the Treasuries are perceived to be risk free, which of course is not at all true.
One reason that borrowers like Mezzanine Financing debt is because they may deduct the interest from their taxes. Consider the following example. If the standard tax rate for companies is 35 percent, then the pretax interest rate at 20 percent becomes reduced to 13 percent after taxes are factored.
The other reason is that this type of financing proves to be far more management friendly than competing debt structures since borrowers are allowed to figure up their interest into the loan balance. When borrowers are unable to pay their scheduled interest payment, they can defer part or even all of the interest. This type of choice is usually not available for other kinds of debts. Besides this, companies which are rapidly expanding in value are able to restructure the original mezzanine type of financing into another form of senior loan at a significantly lower interest rate. This will save them hugely on their costs for interest over the longer-term.
There is a downside to mezzanine financing though. The owners of the firm in question will sacrifice some control as well as upside potential since they are losing equity in the transaction. The owners will also be forced into paying a higher rate of interest, which becomes progressively more expensive as the financing remains in force for a longer period of time.
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