Evaluating Alternative Investment Opportunities in Mezzanine Loans

mezzanine debt is the riskiest type of debt-based lending but it is still an attractive asset class to investors because of the high yields that can be generated

Mezzanine loans get their name from being a hybrid of debt and equity, or essentially an investment that bridges the difference between the two. It’s the highest risk type of debt but can offer returns of up to 20-30%

In the hierarchy of debt and repayment in case of borrower default, mezzanine loans are pretty much at the bottom. Unlike secured debt that’s in a strong position of being covered by the sale of an underlying asset, mezzanine loans are in a junior position and have no claim to the underlying property. In fact, they’re senior only to shares of preferred or common equity.

For companies financing projects costing millions, such as shopping malls, hotels, and industrial parks, typical mortgage lenders limit their loans to 60% or less of the property’s value. Rather than coming up with cash for the remainder, businesses with a history of profitability and viable expansion plans often get additional financing through mezzanine loans. While mezzanine loans aren’t backed by assets, they are secured by stock of the borrowing company. The lender has a warrant to convert the loan into stock in case of default, and thus have control over the borrower company, and ultimately all of the assets it owns.

Let’s work through an example of how a mezzanine loan alternative investment would work for an investor.

1) An established company seeks additional financing for its multi-million dollar development project. Perhaps other loans on the project prohibit additional liens (loans with the property as collateral), or time is of the essence, or strategic assistance of lenders is required.

2) Investors are interested in offering a mezzanine loan – while they’d be nearly dead last to be paid off in the event of default (ahead of only common shares of stock), the high potential returns and ability to control the company via stock ownership in case of default is appealing. Often, this relationship also entitles the lender to buy future equity in the borrower’s parent company at favorable rates – a nice bonus if the borrower’s company goes on to become a massive success.

3) The terms of the loan are arranged, with the borrower paying high (tax-deductible) interest in order to obtain liquidity and higher leverage. The borrower may take advantage of features like paying in kind (PIK) – rolling interest into the loan balance, rather than making a scheduled payment. The lender receives returns more consistent with equity than with debt, yet has relative certainty for the timing of payments, unlike with dividends.

4) If the borrower defaults, the investor can convert the loan into stock ownership, and take control of the parent company and the projects it owns.

Bottom Line

There is no denying that mezzanine loans carry a high level of risk, something that’s important to consider before adding such an investment to your portfolio. However, the risk inherent in such loans (since there is no asset as collateral that the lender can sell to recoup their investment) dictates the high-interest rates that borrowers pay. The hybrid debt/equity nature of a mezzanine loan can produce equity-like returns with debt-like consistent interest payments. If the financed project collapses into default, the mezzanine lender can convert their loan into the borrower parent company’s equity, and control all of the underlying assets. However, there is no guarantee that after satisfying the more senior debt (debt backed by assets), the full loan can be recouped. A failed project can harm the standing of a parent company, and the value of other assets, leading to a significant loss on the loan. Still, there are no rewards that come without risk when it comes to investments, and mezzanine loans can be a worthwhile strategic addition to your portfolio.

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