What is Mezzanine Financing?

Key Takeaways

• Mezzanine financing is a hybrid of equity and debt financing that permits the lender, in the case of default, to convert the obligation to an equity interest in the organization. 

• While mezzanine financing has a higher interest rate than senior debt companies would normally be able to get through their financial institutions, it is markedly cheaper than equity relative to overall capital costs.

• Mezzanine financing is popular in real estate and is often used to help fund the purchase of new developments or acquisition projects.

Mezzanine financing derives its name from building mezzanines which are a level above ground floors.  As such, mezzanine financing is a junior debt form that sits above common equity but below senior debt and is frequently associated with buyouts and acquisitions.

But what is mezzanine financing and how does it work? This blog post explores that and more.

What is Mezzanine Financing?

This is basically a business loan with repayment terms that are adapted to organizational cash flows. In other words, it is a hybrid of equity and debt financing that permits the lender, in the case of default, to convert the obligation to an equity interest in the organization. This usually occurs following payment to venture capital companies and other senior lenders.    

How Mezzanine Financing Works

This type of blended financing can help with large projects, growing businesses, and management projects. 

A somewhat complex form of business loan, it involves interest payments and equity features and assumes a middle position — “mezzanine” comes from “middle” in Latin — between senior debt and equity.

Companies seeking to raise money generally can either take on debt through a business loan or use equity, which calls for selling a business share in exchange for cash. Mezzanine finance can also be a way to finance property development.

Generally, this type of finance is employed in cases in which the perceived risk is so high that a traditional business loan will not secure sufficient money. Equity finance would ordinarily be an option, but a lot of companies do not wish to relinquish business shares.

Ultimately, mezzanine financing permits a larger investment, with the goal of a bigger return. While it is high risk, returns for investors in debt often reach between 12% and 20% annually.  In terms of repayment, some situations call for a lump sum, while other situations necessitate a deferment of interest payments. The interest in mezzanine finance may also be tax deductible.

In essence, “mezz finance,” as it is often called, can be considered a business loan in which the debt is turned into an equity share following the passage of a pre-established time period. Thus, if the company cannot repay the funding, the lender instead gets an equity share. Here, equity in the business is employed as security.

Then there are other contexts in which such finance marries equity and debt by offering a share of profit in addition to interest payments. So, the business borrows money, and the lender procures a share of the benefits in return.  

In the end, mezzanine financing may be viewed as either a very pricey debt or less-expensive equity. While such financing has a higher interest rate than the senior debt companies would normally be able to get through their financial institutions, it is markedly cheaper than equity relative to overall capital costs.

Types of Mezzanine Financing

There are various types of mezzanine financing, including:

• Subordinated loans. Subordinated refers to a loan that is, in a company’s capital structure, junior to another loan.
• Preferred equity. Compared to ordinary equity, preferred equity offers the investor a higher return rate. The investor also has the option of repaying the debt earlier.
• Convertible debt. This type of debt typically has lower interest payments but an equity dilution that is higher than a structure with warrants. 

Key Players in Mezzanine Financing 

Figuring prominently in most mezzanine financing are:

• Lenders. For assuming risks that senior lenders eschew, mezzanine lenders expect loftier returns in addition to other sweeteners or incentives. Because such financing is unsecured, it is unlikely the lender will be made whole in liquidation or debt restructuring.
• Borrowers. Most borrowers go the mezzanine financing route to raise additional capital and hit the funding target. Frequently, the borrower aims to minimize the amount of equity contribution necessary for the transaction, the costlier form of financing notwithstanding.
• Investors. In a bankruptcy, investors are junior to senior leaders and thus may not claim any company assets as collateral. Therefore, mezzanine investors assume markedly more risk than senior leaders. Because of that, they require higher yields. 

Benefits of Mezzanine Financing

Despite risks and considerations that will be listed below, there are distinct advantages to mezzanine financing. Such benefits include:

• Flexibility. Such funding permits a great deal of flexibility, permitting tailored solutions to amortization, structure coupon, and covenants to suit the business’s specific cash flow requirements. 
• Leveraging returns. Mezzanine financing could end up with investors or lenders receiving immediate equity in a company or gaining warrants for buying equity at a future date. This could significantly improve an investor’s rate of return.
• Capital structure. Mezzanine capital is a tier in a business’s capital structure between equity and debt. Ultimately, the financing structure allows a company to raise more capital and heighten its returns on equity. 

Risks and Considerations of Mezzanine Financing

As with most aspects of financing, there are risks and other considerations involved in mezzanine financing. The chief ones include:

• Loss of equity in the case of default. In the event of bankruptcy of the borrowing company, mezzanine lenders risk loss of their investment. Another way to say it is, when a company fails, senior debt holders are paid first through liquidation of the company’s assets. 
• Importance of due diligence and risk assessment. Mezzanine investors are wise to first conduct due diligence before risking capital. Such risk assessments may include analyzing a company’s historical financial results and likely long-term prospects. It also may include a commercial assessment of the organization as well as its market position. In fact, some investors get third-party help with their efforts in this regard.    

Mezzanine Financing in Real Estate

Mezzanine financing is popular in real estate and is often used to help fund the purchase of a new development or an acquisition project. Such loans provide capital in the form of subordinated debt to investors and borrowers.

In fact, real estate itself remains a popular investment, in part because it is what is called an “alternative” – an asset other than the stocks, bonds, or cash that comprise traditional portfolios. Because of their low correlation to public markets, such assets decrease portfolio volatility. When added to an investment portfolio, they can also potentially generate secondary returns and help protect against inflation.

The leading alternative investment platform Yieldstreet, on which nearly $4 billion has been invested so far, offers the broadest selection of alternative assets classes available. Such curated and highly vetted private-market offerings include structured notes, art, transportation, legal finance, private credit – and real estate.

Yieldstreet’s real estate opportunities include private and commercial offerings and a Growth & Income REIT, which makes debt and equity investments across varying investment and property types in key areas around the nation. Such investments can help enable the fund to produce investor returns.    

An additional key benefit of investing in alternatives is portfolio diversification, which is essential to successful investing. Crafting a portfolio with a mix of varying asset types can not only stabilize results but can improve prospective returns. Importantly, it can also mitigate portfolio risk. 

Alternative Investments and Portfolio Diversification

Alternative investments can be a good way to help accomplish this. Traditional portfolio asset allocation envisages a 60% public stock and 40% fixed income allocation. However, a more balanced 60/20/20 or 50/30/20 split, incorporating alternative assets, may make a portfolio less sensitive to public market short-term swings. 

Real estate, private equity, venture capital, digital assets, precious metals and collectibles are among the asset classes deemed “alternative investments.” Broadly speaking, such investments tend to be less connected to public equity, and thus offer potential for diversification. Of course, like traditional investments, it is important to remember that alternatives also entail a degree of risk. 

In some cases, this risk can be greater than that of traditional investments.

This is why these asset classes were traditionally accessible only to an exclusive base of wealthy individuals and institutional investors buying in at very high minimums — often between $500,000 and $1 million.  These people were considered to be more capable of weathering losses of that magnitude, should the investments underperform.

However, Yieldstreet has opened a number of carefully curated alternative investment strategies to all investors. While the risk is still there, the company offers help in capitalizing on areas such as real estate, legal finance, art finance and structured notes — as well as a wide range of other unique alternative investments. 

Moreover, investors can get started with a relatively small amount of capital. Yieldstreet has opportunities across a broad range of asset classes, offering a variety of yields and durations, with minimum investments as low as $5000.

Learn more about the ways Yieldstreet can help diversify and grow portfolios.

In Summary

Compared to typical corporate debt, mezzanine financing can provide investors in debt with generous returns, frequently paying between 12% and 20% annually, and even more. However, because it is unsecured, such financing can carry higher risks. Remember that there are a number of ways to include real estate in holdings and diversify portfolios.