Mezzanine Financing

This finance term, also known as "mezzanine capital," fills the gap between the first mortgage financing and the equity participation of the borrowing principals.

Last updated: June 16, 2004.

A hybrid of debt and equity financing that is is typically used to finance the expansion of existing companies. Mezzanine financing is basically debt capital that gives the lender the rights to convert to an ownership or equity interest in the company if the loan is not paid back in time and in full. It is generally subordinated to debt provided by senior lenders such as banks and venture capital companies.

Since mezzanine financing is usually provided to the borrower very quickly with little due diligence on the part of the lender and little or no collateral on the part of the borrower, this type of financing is aggressively priced with the lender seeking a return in the 20-30% range.

Investopedia Says:
Mezzanine financing is advantageous because it is treated like equity on a company's balance sheet and may make it easier to obtain standard bank financing. To attract mezzanine financing, a company usually must demonstrate a track record in the industry with an established reputation and product, a history of profitability and a viable expansion plan for the business (e.g. expansions, acquisitions, IPO).

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1. In corporate finance, a Leveraged Buyout or restructuring financed through subordinated debt, such as preferred stock or convertible debentures. This type of financing is very popular in merger & acquisitions, as the transaction is financed by expanding equity, as opposed to debt. Holders of the securities are also assured of having a greater role in managing the resulting company.

2. Second or third level financing of companies financed by venture capital. The mezzanine financing is senior to the venture capital financing, but junior to bank financing, and adds creditworthiness to the firm. It generally is used as an intermediate stage financing, preceding the company's initial public offering (IPO), and is considered less risky than start-up financing.

A loan that is below the first mortgage in priority and has other liens subordinate to it. Has the same priority as if it were called a Second Mortgage.Example: Michael Development Company planned to build an office tower for $10 million. They arranged an $8 million first mortgage and $1.5 million of mezzanine financing. A subordinated loan of $0.5 million completed the capital structure.

Mezzanine financing, also sometimes referred to as subordinated debt or financing, is a rarely used but viable financing option for small businesses in search of capital for rapid growth. Under this arrangement, an entrepreneur borrows some of the money that he or she requires to execute the next stage of company growth (whether through acquisition, expansion of existing operations, etc.), then raises additional funds by selling stock in the company to the same lenders. Mezzanine debt is usually unsecured or junior debt that is subordinate to traditional loans or senior debt. "Subordinated debt is an extremely flexible form of financing," wrote Lawrence M. Levine in Business Credit. "Because they are more concerned than senior lenders about their overall yield, mezzanine lenders are very liberal in tailoring their investment to meet the financial, operating, and long-term cash flow needs of the borrower. As long as the subordinated lender's anticipated yield is satisfied, they can be flexible as to the amortization of the loan and the interest rate." Major sources of mezzanine financing include private investors, insurance companies, mutual funds, pension funds, and banks.

Business experts point to mezzanine financing as a particularly provocative financing option for some companies that have moved beyond start-up status but do not yet have the wherewithal to finance big growth moves themselves or via traditional lending arrangements. Indeed, Juan Hovey observed in Nation's Business that mezzanine financing owes its very name to the fact that "it raises growth capital for firms that are well beyond the start-up stage but not yet far enough off the ground to go public." Entrepreneurs launching start-up businesses, though, should be aware that this method is not viable for them; lenders willing to make this kind of deal will require prospective borrowers to show a proven record of substantial cash flow before they will even entertain the idea.

But for growing companies with a strong cash flow, mezzanine financing may be the answer to securing business expansion funding. Certainly, the amounts that can be raised via mezzanine financing are substantial. According to Private Placement Leter, mezzanine financing raised more than $820 million in 1996 for companies of all sizes, and other sources place the amount considerably higher. Larger companies account for some of this activity, but analysts indicate that even modest-sized companies ($10-12 million in revenues) can expect to raise as much as $15-$20 million through this route. As one investment executive told Nation's Business, "a company can leverage two to three times its cash flow in senior secured debt. It can raise total debt to four to five times cash flow with a mezzanine deal. So if the company is doing $2 million in cash flow, it can probably raise $4 million to $6 million in senior debt and $4 million to $5 million more in mezzanine financing, for a total debt of $10 million, or five times cash flow."

Most experts believe that the use of mezzanine financing will continue to grow among both small and large companies. "More and more U.S. companies are committed to financial restructuring in order to create the incentives to maximize business value," stated mezzanine investment executive Robert F. Perille in Corporate Cashflow Magazine. "In addition, as our economy has become increasingly service-oriented and entrepreneurial, thousands of excellent companies no longer meet the asset-based formulas of commercial banks. These companies need financing to grow or facilitate a change in ownership, but they do not want to issue relatively expensive equity. This growing demand, coupled with an increasing supply of mezzanine capital from a diverse base of institutional investors, will assure mezzanine financing a place in future capital structures."

How Mezzanine Financing Works

In a mezzanine financing arrangement, the borrower negotiates an arrangement with a lender wherein the necessary capital is secured by combining a loan with a stock purchase to the lender.

"As a rule, you pay only interest on the money you borrow (at prime plus two to four points) for five years or so," explained Hovey. "At that point, you [the business owner] cash out your investors by going public or by recapitalizing your business in a new round of financing. Your investors, meanwhile, have earned interest on their loans, and if the value of your business has increased, they realize capital gains by selling their stock in your company."

Lenders that review mezzanine financing requests closely examine several facets of the prospective borrower's business when weighing the deal. The most important consideration examined by a mezzanine lender is the company's capacity to generate cash flow. As Levine stated, "because the primary concern of a subordinated lender is a company's ability to generate cash, if it is anticipated that the business' cash flow is sufficient to repay the loan, it is quite likely subordinated debt can be used." In addition to cash flow, lenders also examine ownership flexibility, company history, growth strategy, and acquisition targets (when applicable). Business owners in need of capital, meanwhile, should do some comparison shopping of their own. "In selecting a source for mezzanine financing, companies should pay attention to personnel turnover, commitment to the business, track record, and flexibility in structuring," indicated Perille. "Low turnover and commitment to the business are key because businesses rarely perform exactly according to plan. Therefore, you need an investor who understands the business and will respond consistently and appropriately."

Advantages and Disadvantages

As with most other types of financing, mezzanine financing includes both benefits and drawbacks for the small business owner.

ADVANTAGES.

1. Even though the owner loses some independence, he or she rarely loses outright control of the company or its direction. Provided the company continues to grow and prosper, its owners are unlikely to encounter any interference from their lender.
2. The flexibility of the arrangement is often a big plus; "[mezzanine financing] offers considerably more flexibility to structure coupon, amortization and covenants to accommodate the specific cash flow requirements of the business," wrote Perille.
3. Lenders who are willing to enter into the world of mezzanine financing tend to be long-term investors rather than people looking to make a quick killing.
4. Mezzanine lenders can provide valuable strategic assistance. "Subordinated debt advisors often bring fresh insights to businesses because they are financially sophisticated and have a great deal of experience developing strategies to maximize long-term value," said Levine.
5. Mezzanine financing increases the value of stock held by existing shareholders, even though they will not have as great an ownership stake.
6. Most importantly, mezzanine financing provides business owners with the capital they need to acquire another business or expand into another production or market area.

DISADVANTAGES.

1. Mezzanine financing does require the business owner to relinquish some measure of control over the firm. This can be difficult for entrepreneurs who have built a promising business in no small measure because of decision-making styles that run heavily toward independence and daring. Moreover, Perille pointed out that "mezzanine investors with long-term incentives like co-investment plans or carried-interest plans, which provide their professionals with a meaningful stake in the business, are more likely to be there for the long term and take a partnership perspective." Finally, entrepreneurs should consider that lender of mezzanine funds will have a vote on the company's board of directors and significant abilities to take decisive action if the company does not meet its financial projections.
2. Subordinated debt agreements may include restrictive covenants. Writing in Journal of Business Strategy, Kent Gross and Amin Amiri pointed out that since mezzanine lenders usually do not have any direct security interest in the assets of the borrower, lenders typically incorporate restrictive covenants into the loans that the borrower has to abide by; these include agreements by the lender not to borrow more money, refinance senior debt from traditional loans, or create additional security interests in the assets, as well as the various financial ratios that the borrower must meet.
3. Similarly, business owners who agree to mezzanine financing may be forced to accept restrictions in how they spend their money in certain areas, such as compensation of important personnel (in such instances, a business owner may not be able to offer above-market packages to current or prospective employees). In some cases, business owners have even been asked to take pay cuts themselves and/or limit dividend payouts.
4. Mezzanine financing is more expensive than traditional or senior debt arrangements.
5. Arranging for mezzanine financing can be an arduous, lengthy process. Most mezzanine deals will take at least three months to arrange, and many will take twice that long to complete.

Further Reading:

Brooks, Rory, and Jim Read. "Mezzanine Gains Ground." Investors Chronicle. October 21, 1994.

Campbell, Katharine. "Development Capital is Industrial Strength." Financial Times. December 2, 1997.

Gross, Kent, and Amin Amiri. "Flexible Financing with Mezzanine Debt." Journal of Business Strategy. March-April 1990.

Hoogesterger, John. "Economic Trends Boost the Fortunes of Mezzanine Funds." Minneapolis-St. Paul CityBusiness. August 25, 2000.

Hovey, Juan. "A Little-Known Pathway to Growth." Nation's Business. March 1998.

Levine, Lawrence M. "The Role of Subordinated Debt in Financing." Business Credit. May 1995.

"Mezzanine: Refusing to be Overshadowed." Acquisitions Monthly. June 1998.

Perille, Robert F. "Mezzanine: Efficient Financing for Recapitalization or Rapid Growth." Corporate Cashflow Magazine. May 1996.