Last Updated on September 20, 2023 by BFSLTeam BFSLTeam
Companies typically resort to any one of two major types of financing to fund their business operations. The first is equity, which involves issuing equity shares that represent units of ownership in the company. The second is debt, which can be obtained from banks, other financial institutions and even investors who purchase bonds and other debt instruments. But what if we told you there’s a third type of financing — one that acts as a bridge between equity and debt? In financial parlance, this is known as mezzanine financing or mezzanine capital. Let’s discover the meaning and how it works and delve into the finer details of this type of funding.
Table of Content
What is Mezzanine Capital?
Mezzanine capital is a kind of funding that is a hybrid of debt and equity financing. It combines some features of regular loans as well as equity capital. More specifically, it is offered as a loan, but the lender has the right to convert the debt into equity if the company defaults on its repayments.
In terms of debt, it is classified as subordinate debt. This is different from senior debt, which consists of pure loans that carry no element or characteristics of equity. Since it bridges the gap or acts as a stepping stone between pure equity and senior debt, this type of financing is termed mezzanine capital.
Understanding Mezzanine Capital
If a company is in need of funds, mezzanine capital funding is typically not the first channel that’s chosen. Other types of financing — like issuing equity shares or bonds and availing business loans — may be more common. Mezzanine financing is used for more specific and exclusive purposes like business expansion or acquisitions and mergers. This essentially means that mature companies that are well-established are more likely to seek mezzanine capital funding than younger companies or startups.
Such blue-chip companies may also be more successful in securing mezzanine financing. This is because the likelihood of default may be lower. Even if default does occur, converting the debt to blue chip equity may be a more lucrative option for lenders than, say, converting it to equity in a startup.
How Mezzanine Financing Fits Into a Company’s Capital Structure
As you’ve already gathered from the meaning of mezzanine capital, this type of funding lies in the space between equity and debt. But what does that mean in terms of financing costs, repayment priority and risks to the lender? Let’s find out.
- Repayment Priority
The company’s senior debts carry first priority in terms of repayment order. Since mezzanine capital is subordinate debt, it is repaid only after senior debts are settled. Equity shareholders come last in the lineup.
- Risk to the Lender/Financier
Mezzanine capital is often structured as an unsecured sub-debt. This, combined with its repayment priority, means it carries more risk for the lender than senior debt.
- Financing Costs
Mezzanine capital usually carries higher interest rates than secured or senior debt. In other words, it is more affordable than equity, but more expensive than pure debt.
Additional Read: What is a Stock Symbol?
The Key Features of Mezzanine Capital Funding
Now that you have a good idea of the meaning of mezzanine capital and its place in the capital structure of a company, let’s list out the key characteristics of this type of financing.
- It is an unsecured debt that is not backed by any collateral.
- It is subordinate to senior debt, but senior to equity in terms of repayment priority.
- The yields or interest rates on mezzanine funding are higher than that of ordinary or senior debt.
- Different companies structure the repayment of their mezzanine capital funding in different ways.
- The loan principal in mezzanine financing is not amortised.
Top Reasons to Choose Mezzanine Financing
Mezzanine capital offers many advantages for companies. Lenders can also benefit from this channel in different ways. Let’s take a closer look at the top reasons companies choose mezzanine financing, and why lenders/investors prefer to extend this type of debt/capital.
- Flexible Loan Structure
The loan structure in mezzanine capital funding is quite flexible. Depending on the terms of the loan, companies may have the option to repay only the interest initially for the specific period till maturity. Additionally, if the company is unable to make some of the scheduled interest payments, it may be possible to defer them to a later date — provided the fine print allows it.
- Liquid Capital Availability
Mezzanine financing may be obtained from long-term investors or existing financiers of the company. If the capital involves preferred equity along with sub-debt, it may not be necessary to make full repayments — as is typically the case with senior debt like loans. This effectively leaves more liquid capital in the hands of the company.
- Immediate Access or Rights to Future Equity
For lenders (or investors), choosing the mezzanine financing route results in immediate access to equity rights in the company. The equity warrants embedded in the mezzanine capital can become valuable if the company does well in the future. Additionally, the investor’s money also has higher priority than pure equity, making it a win-win
- Opportunity for Debt Restructuring
It can also be restructured into senior loans at a later date. This typically happens if the company expands quickly. By restructuring mezzanine capital into senior debt, the cost of borrowing is reduced for the company, making it a lucrative proposition. This may also be beneficial to the lender because senior debt takes priority over sub-debts like mezzanine financing.
- Tax-Deductible Interest
Depending on the prevailing tax laws, the interest paid on mezzanine capital borrowings may be tax-deductible. This is because they can be classified as business expenses. For the company, this means reduced tax burdens while simultaneously enjoying access to capital at lower rates than the cost of equity.
Additional Read: What is Delisting of Shares?
The Downsides of Mezzanine Capital
On the flip side, mezzanine capital comes with the following limitations or downsides:
- It could mean a potential dilution of ownership for the company if mezzanine lenders convert their debt to equity.
- Mezzanine financing may come with restrictions on future debt financing or refinancing.
- The cost of borrowing is higher than the cost of senior debts.
- Mezzanine investors/lenders may not receive payouts in case of bankruptcy.
- Finalising the terms and conditions of mezzanine financing can be tedious and time-consuming.
Conclusion
As a retail investor, mezzanine capital may not directly feature in your investment portfolio because companies tend to rely on established investors for funding. However, it’s important to track news about which companies have opted for this kind of financing and check whether or not they have defaulted on the loans. This could impact share prices and trigger buying or selling opportunities for you.
