By
Alehar Team
November 22, 2023
•
7
min read
Introduction
Mezzanine financing is a hybrid form of financing that combines debt and equity features, providing companies with a flexible capital option. It's typically employed by companies that have stable positive cash flows and are entering an expansion phase of their business. The term "mezzanine" is derived from the Italian word 'mezzano', meaning 'middle' - a fitting name for a financing option that sits in the middle of a company's capital structure, subordinate to senior debt but ranking above equity. Mezzanine debt comes with two main components: a mandatory interest payment obligation, similar to traditional debt, and an additional payment tied to the company's performance, akin to equity.
Our goal is to simplify and clarify the concept of mezzanine financing, giving an overview of its purpose, structure, costs, benefits, and potential risks for businesses considering this type of funding.
Putting Mezzanine Financing to Work
Mezzanine financing, thanks to its unique blend of debt and equity attributes, is incredibly versatile. It can come into play in various scenarios such as business expansion, acquisition, buyout, and recapitalization.
Firms with steady cash flows and aspirations to significantly scale up their operations may opt for mezzanine financing. It serves as the fuel to power various expansion strategies, from launching a new product to entering a new market, or setting up new production facilities. Usually, companies turn to mezzanine financing when they face a three-fold scenario: their senior debt capacity is maxed out (so they cannot raise additional senior debt), they have adequate cash flows to service more debt, and they prefer not to raise equity, perhaps to avoid diluting ownership or due to the cost or limited availability of equity.
Another area where mezzanine financing shines is in facilitating acquisitions and buyouts. Whether it's a management buyout, a leveraged buyout, or a strategic acquisition of another company, mezzanine financing may bridge the funding gap. Corporate recapitalization and balance sheet restructuring are other scenarios where mezzanine financing can be beneficial. Besides corporate financing, mezzanine financing is also commonly used for project financing such as real estate development or infrastructure projects.
In essence, mezzanine financing can be structured in many ways to suit a wide range of business needs. It is a form of growth capital for companies that may otherwise have limited alternatives to finance their companies’ growth expansion plans.
Understanding the Structure of Mezzanine Financing
The structure of mezzanine financing truly sets it apart. Like a financial chameleon, it bears the traits of both debt and equity, sliding into a company's capital structure in a way few other finance options can. In the capital structure pecking order, mezzanine financing is sandwiched between senior debt and equity. This spot makes it subordinate to senior debt, meaning if a company is liquidated, senior creditors get paid first. But mezzanine financing has priority over equity, providing a safety net to mezzanine investors.
On one side, mezzanine financing mirrors debt through its loan-like structure. There's usually a principal amount to repay along with an interest component. However, unlike conventional loans, the interest on mezzanine financing can often be deferred via a payment-in-kind (PIK) structure. With PIK, the interest is added to the principal balance and paid off at the end of the loan term. On the other hand, the equity-like features of mezzanine financing can come into play through the inclusion of a variety of mechanisms that offer the potential for upside participation (e.g. profit participation, participation based on predefined financial variables, warrants or conversion features). This feature provides the potential for equity upside, making mezzanine financing attractive to investors in terms of the risk/return profile.
Since mezzanine refers to any hybrid between debt and equity, there are countless types of possible mezzanine financing structures that can be tailored to specific needs and circumstances. The choice of structure depends on the company's financial situation, the lender's risk tolerance and the specific objectives of the financing. A unifying theme across all mezzanine structures is the balance it offers to investors—it provides protection through regular interest payments, resembling debt, while also offering the chance to partake in the company's success, akin to equity.
Understanding the Key Advantages and Risks of Mezzanine Financing
Mezzanine financing offers a host of benefits. For borrowers, one of the key benefits of mezzanine financing is its flexibility. Unlike traditional loans, mezzanine financing can be structured in a way that aligns with the company's cash flow and growth projections. This can include features such as payment-in-kind interest, where interest payments are deferred and added to the principal balance, reducing the burden on the company's cash flow. In various situations, mezzanine financing may be one of the few options to bridge the funding gap for a significant expansion project.
Moreover, mezzanine financing enables companies to access growth capital without diluting their ownership. This proves especially advantageous for business owners who aspire to maintain control over their enterprise, while simultaneously accessing the capital required for growth. Another significant benefit for borrowers may be the potential tax advantage since in many jurisdictions the interest may be tax-deductible.
While mezzanine financing provides numerous advantages, it's crucial to acknowledge and understand the associated risks. For borrowers, one of the main risks is the cost. Mezzanine financing costs generally land somewhere between the cost of debt and the cost of equity, which largely depends on the precise structure of the financing. Importantly, if a company's cash flow is not sufficient to cover the interest payments, it could lead to financial distress and even default.
Borrowers need to fully understand and negotiate the exact mechanism of the equity kicker. While mezzanine financing can include a variety of types of equity kickers, it may include equity warrants, which could dilute the ownership of current shareholders. It's also important for the borrower to thoroughly negotiate the conditions and covenants associated with the mezzanine loan as they can limit the company’s operational flexibility.
Conclusion
As we wrap up our deep dive into mezzanine financing, let's recap the main takeaways. Mezzanine financing, with its unique fusion of debt and equity features, holds a position in a company's capital structure that falls between senior debt and equity.
This financing solution is flexible and versatile, finding use in various scenarios such as business expansion, acquisitions, recapitalizations, and balance sheet restructurings. Its adaptability makes it a highly appealing option for companies aiming to secure growth capital without diluting their ownership stakes. Therefore, mezzanine financing stands out as a viable financial strategy, particularly when conventional debt or equity routes might not be sufficient for a company's growth expansion plans.
At Alehar, we're deeply passionate about M&A and fundraising, equipping us with the expertise and extensive network needed to carry out transactions efficiently and represent the interests of our clients effectively. Our expertise is particularly valuable for transactions ranging from USD 3m to 200m, as we guide companies through every step of their M&A and fundraising journey (including both equity and debt transactions)
