What is mezzanine financing?

Mezzanine financing is a flexible, hybrid form of capital that blends features of both debt and equity. Think of it like the “mezzanine level” in a building – it sits between senior debt (like traditional bank loans) and common equity (ownership shares) in a company’s capital structure.

Here’s a breakdown of its key characteristics:

  1. Position in Capital Stack: It’s subordinated to senior debt. This means if the business faces financial distress or liquidation, senior lenders get repaid first before mezzanine lenders receive anything. However, it’s senior to common equity, meaning mezzanine lenders get paid before the company’s owners/shareholders.

  2. Hybrid Nature:

    • Debt Component: It usually involves a loan that requires regular interest payments (though sometimes these can be deferred or paid-in-kind). The interest rates are typically higher than senior debt to compensate for the increased risk.

    • Equity Component: Mezzanine financing often includes an “equity kicker,” usually in the form of warrants (options to buy the borrower’s stock at a predetermined price later) or a conversion feature. This gives the lender potential upside if the company performs well.

  3. Common Uses: Businesses typically use mezzanine financing to bridge funding gaps for significant growth initiatives when they might have reached their limit for senior debt or want to avoid diluting existing owners’ equity too much. Common uses include:

    • Funding acquisitions or buyouts (LBOs, MBOs).

    • Financing major expansion projects or capital expenditures.

    • Real estate development projects.

    • Recapitalizations or restructuring the balance sheet.

  4. Risk and Return: Because it’s riskier for the lender than senior debt (due to subordination), mezzanine financing carries higher interest rates (often in the double digits). The potential equity upside helps compensate the lender for this risk.

  5. Collateral: Unlike senior debt, which is often secured by specific assets, mezzanine financing is often unsecured or secured by a junior lien, relying more heavily on the company’s projected cash flow to service the debt.

In essence, mezzanine financing provides crucial “gap” funding, allowing businesses to secure the capital they need for growth without giving up as much ownership as pure equity financing might require, while offering lenders higher returns (and potential equity participation) than traditional loans.