A Guide to Mezzanine Financing from Lending Expert
What does an architectural feature have to do with financing? From its name to how it's structured, it’s easy to see why so many business owners are confused about mezzanine financing and how it works.
In this article, we’ll guide you through everything you need to know about mezzanine financing — and when it might be a good option for your financing needs.
What is mezzanine financing?
Mezzanine financing is a type of unsecured financing that sits, priority-wise, between equity and debt. It has priority over equity financing but is subordinate to debt financing. In other words, if the business goes under, mezzanine debt will be paid before equity holders (e.g., common and preferred shareholders). Still, its claim is secondary to more senior, secured debt (e.g., bank loans and lines of credit).
“Mezzanine financing is considered a filler in the capital stack,” says Will Howard, Foro’s Vice President of Relationship Management. “A capital stack is the combination of debt and equity used to finance a business. So mezzanine financing bridges the gap between senior (i.e., secured) debt and equity in the capital stack.”
How mezzanine financing works
Mezzanine financing is usually used with senior debt to round out the capital stack. For example, suppose you need to put together $5 million to acquire another business. In that case, you’ll typically use some mixture of debt and equity — perhaps 50:50 or 60:40 debt to equity — to get that $5 million.
“You might be looking at $2.5 million in senior debt and $2.5 million in equity,” Howard explains. “But let’s say your senior lender will only provide $1 million of senior debt, which means you’ve got a $1.5 million shortfall on the debt side. Now, you could put in equity to make up the difference, but that would mean $4 million in equity and $1 million in senior debt.” With a mezzanine deal in this scenario, you could still have $2.5 million of debt, but, for example, only $1 million would be senior debt, and $1.5 million would be mezzanine.
The deal is attractive to the mezzanine investor, too, because despite being subordinate to senior debt, it has priority over equity. And if the company defaults on its mezzanine debt, or if certain events happen, the investor will typically have the right to convert their debt to preferred equity. “So even though it’s an airball situation, meaning there’s no collateral, that right to convert to an ownership stake in the company is the investor’s security,” Howard notes.
Typical structure of a mezzanine deal
Mezzanine financing will always be structured as a junior debt subordinate to senior debt. And it’s often structured as a term loan with interest-only payments, so you only make interest payments during the life of the loan. When the loan ends, you repay the principal.
“Some mezzanines have a principal repayment component, but most often, it’s interest-only payments,” Howard adds. “And sometimes it might be structured as a PIK or paid-in-kind interest deal, which means the interest gets added back to the principal, so you won’t have to pay the interest until the very end when you’re repaying the principal.”
The senior-junior debt relationship
Even though a mezzanine deal involves junior debt through a mezzanine lender, you’ll need to consult with your bank, the senior lender, to make sure it’s happy with the deal. Your bank will usually want to see how the deal is structured. “That’s where it’s a conversation,” Howard notes. “And what usually happens is the bank will require the mezzanine lender to sign an inter-creditor agreement and a subordination agreement. These will pretty much guarantee the bank a priority cash flow and asset position.”
Uses for mezzanine financing
Use cases for mezzanine financing usually involve the acquisition of a long-term asset, with the most common being the purchase of a business. While mezzanine financing can be used for real estate or equipment financing, it’s much less common.
Will Howard offers two examples to illustrate typical use cases: “In the first example, the company is doing great, and it wants to expand by buying a new business. It has the assets to secure a senior loan and can put its own cash into it, too. But this takes away cash flow, and it will have to draw back on its existing operations.”
In this situation, mezzanine financing is a good option. “With a mezzanine deal, the company could have senior and junior debt financing 85% to 90% of the purchase, so only a smaller portion of its cash flow is initially needed,” Howard explains. “That way, the company can maintain more cash and continue to grow its operations by deploying its own cash.”
In Howard’s second example, a company is in an airball situation, with $5 million in senior debt but only $2 million in assets, leaving $3 million of debt with no collateral. “No senior lender is going to refinance that entire $5 million because there aren’t enough assets,” he notes. “And that’s where a mezzanine loan comes in. With a mezzanine deal, the junior lender refinances the $3 million airball. They’re willing to take the risk because they’ll get their interest and have a right to equity if things go wrong.”
With the senior lender willing to refinance the remaining $2 million as a working capital line, since it’s supported by assets, the company can refinance the entire $5 million, despite being in an airball situation.
A temporary fix
The critical thing to remember about a mezzanine loan is that it’s meant to be temporary. “The ultimate goal will always be to repay your mezzanine lender, " Howard explains. “A good analogy is a consumer credit card. Consumer credit card debt is a higher-interest debt, and you’ll want to pay it off before you pay off anything else. For a business, a mezzanine loan is similar in that it’s also a higher interest, temporary debt.”
Mezzanine financing pros & cons
According to Howard, the pros of mezzanine financing include:
- Access to capital despite lack of assets. To Howard, this is the biggest pro. “You’ll have the cash flow necessary to pay the interest,” he notes, “but you’re able to retain your assets and use someone else’s capital at a higher cost.”
- Capital stack filler. With mezzanine financing, you don’t have to work with less funding than you asked for. It’s a good option if, for example, your bank will only agree to finance a portion of the funds you need for your acquisition.
- More flexibility. Like equity financing, mezzanine financing offers more flexibility than senior debt because you’re usually not restricted in how you can use your mezzanine funds.
Nothing is ever all pros and no cons, however, and mezzanine financing is no exception:
- Impact on your leverage. While banks are mainly concerned with the leverage associated with your senior debt, regulatory rules require them to consider total leverage, which takes into account your mezzanine debt.
- Higher cost. While mezzanine debt is typically comparable to equity, it always costs more than senior debt, with an average interest rate of 10% to 13%. Mezzanine deals might also be structured to include prepayment penalties, deterring you from paying down your debt and reducing your interest costs.
- Not a permanent solution. Mezzanine financing should only be a temporary solution, which means you need to find a mezzanine lender who understands this and is willing to be an equity partner when the time comes.
How to get mezzanine financing
So how does a business get mezzanine financing? According to Howard, it’s not as simple as going to talk to a lender. You’ll need an advisor or a banker who’s experienced with mezzanine financing and has a network of junior mezzanine lenders. You may have a banker like this if you’re with a big commercial bank. But if you’re like most middle-market companies, you probably don’t have a banking partner you can turn to for advice on mezzanine financing.
That’s where Foro’s platform comes in. “Obviously, we have an algorithm-driven match, but we also provide the human component,” Howard says. “When you work with us, you get a Foro advisor with banking experience. They will have a network of senior lenders and will know which junior lenders are a good match for them. And we can help you raise both mezzanine capital and senior debt at the same time, which is something no one else can fulfill in the market right now.”
Mezzanine financing alternatives
The only real alternatives to mezzanine financing are equity and debt. Howard notes that mezzanine is a unique type of capital. “The only solution is to get more senior debt or equity. While you can do something like a seller note, where the seller of the business you’re buying rolls some of their equity over, there really is no good alternative to mezzanine financing if you’re in a situation where you need x amount of dollars, and your assets can’t support that amount.”
Mezzanine financing can be an invaluable option when you’re in acquisition mode and need to fill out your capital stack. And working with a partner like Foro gives you access not only to a network of senior lenders but also to the junior lenders these senior lenders are willing to work with.
What are the pros & cons of mezzanine financing?
The main pro of mezzanine financing is that it can give you access to capital even if you don’t have enough assets to finance that capital. On the con side, mezzanine financing will always be more costly than senior debt.
How can I get mezzanine financing?
Getting mezzanine financing can get complicated if you don’t have a banker with experience in mezzanine financing and a network of mezzanine lenders. A partner such as Foro can also help match you with a mezzanine lender your bank will be willing to work with.
Is mezzanine financing secured?
No, mezzanine financing isn’t secured by any physical assets. It’s an unsecured debt that’s subordinate to senior debt. However, it is often convertible into equity in an event of default, so if you don’t replay the loan, you may be at risk of giving up a portion of the company.
About The Author
Belle Wong is a freelance writer specializing in finance, tech/SAAS, small business and marketing. She spends her spare moments testing out the latest productivity apps and plotting her latest novel. Connect with Belle on LinkedIn.