You might think of a mezzanine loan like a second mortgage except the loan is secured by stock in the business or a membership interest rather than real estate. A mezzanine loan is a hybrid of debt and equity. It is subordinate to senior debt, but above common stock in a capital structure.
What Is Mezzanine Financing?
Mezzanine financing is used when a business has maxed out its asset-based loans or bank loans. It lets business owners generate capital quickly by getting a loan without having to put up collateral. It can be high risk with interest rates that can more than double average business loans rates.
Mezzanine lending is most commonly used in the expansion of established companies.
Business owners can put less equity into a deal up front by engaging a mezzanine lender. They might use this financing as a way to bridge the gap between the cash they have and the senior debt they can qualify for.
Banks might require, for example, a 70 percent loan-to-value ratio for a buyer, but the buyer doesn’t have the remaining 30 percent to invest. A mezzanine finance loan could be used to fund some of the 30 percent.
Let’s say a buyer wants to acquire a $100 million-dollar company. The buyer is able to get a senior lender to put up 75 percent of the deal or $75 million. The buyer needs to fund the remaining 25 percent or $25 million. However, the buyer either does not have the funds to come up with the full $25 million or doesn’t want to put that much into the business. Instead, the buyer goes to a mezzanine lender for another 10 percent or $10 million. In turn, the buyer only needs to contribute $15 million of their own money rather the entire $25 million.
Owners might also use the money they would have had to put into equity and instead turn it into working capital for the business.
Why Businesses Do Mezzanine Debt Deals
If the interest rate on a mezzanine loan is so high, you might wonder why business owners would entertain the idea. Besides forgoing collateral, mezzanine loans can make debt service more manageable.
- Mezzanine lenders may include features that allow the borrower to roll interest into the loan balance, thereby delaying the payments. Senior debt does not allow such an arrangement.
- Another reason many business owners prefer mezzanine debt is that it is treated like equity on the balance sheet. The interest is tax deductible. The standard corporate tax rate reduces the after-tax burden of the interest rate.
- Companies may choose to do mezzanine loans because they want to grow quickly without giving up additional equity. When the company grows, so does the value. If the value goes up, the business may be able to refinance its senior debt and mezzanine debt into a consolidated senior loan at a much lower interest rate in the future.
- Businesses may also use mezzanine loans in a similar fashion to that second mortgage on your home. Without having to refinance the senior, you can use the mezzanine loans to pull equity out of your company.
Let’s assume the buyer is acquiring a small business for a reasonable multiple at $1 million. The business in this example earns an annual operating income of $200,000. A senior lender will give you 60 percent ($600,000) at an annual rate of 7 percent a year. Without mezzanine financing, you would need to come up with the remaining $400,000. From the $200,000 annual operating income, subtract the senior debt service of $42,000. Assuming a corporate tax rate of 21 percent, this leaves an after-tax profit of $124,820. All things being constant, your annual ROI for your $400,000 investment would be 31.2 percent.
Reducing your equity investment will reduce your operating income since you’ll have to pay more in loan service, but your ROI will rise and you will have to invest less up front.
In the same example, consider substituting mezzanine finance for half of the $400,000. That means you put up $200,000 and use a mezzanine loan of $200,000 at 15 percent. From the $200,000 annual operating income, you would still subtract the senior debt service of $42,000 as well as the mezzanine debt service of $30,000. Your after-tax profit would decrease to $101,120 but your ROI for your $200,000 investment would skyrocket to 50.6 percent.
Mezzanine finance allows you to decrease your initial investment while improving your return on investment. The downside is that you will pay higher interest rates. The longer these mezzanine lending loans are used, the more interest that is paid. If a business defaults, the lender takes an ownership stake, which it could sell or transfer, ceding some degree of control of the business to someone else.
Businesses sometimes use mezz financing rather than turning to venture capital to avoid having to give voting rights to shareholders that may acquire an ownership interest in the company.
Why Investors Do Mezzanine Debt Deals
For investors, mezzanine debt can be a good deal. Higher interest rates provide a better return on investment than normal loans. Consider that treasury notes average around 2.3 to 2.4 percent mark and mezzanine debt returns can range from 12 to 20 percent annually.
Mezzanine financing lenders get a higher interest rate and contractually mandated interest payments on a monthly, quarterly or yearly basis. Equity investors may have a bigger upside if the company grows dramatically, but there is no guarantee of dividends or regular payments.
Senior debt will have lower returns than a mezzanine loan or common stock but also have lower risks.
These types of investments often include a kicker, which might include an ownership piece or an option to buy equity at a future date. These kickers can pay out significantly if a business hits it big. In addition, if business owners fail to meet the conditions of the loan, the lender can often convert the outstanding balance into equity shares.
Real estate investment trusts (REITs) and closed-end funds (CEF) may own mezzanine debt, which they make available for investors in the form of publicly traded shares.
Do I Qualify for Mezzanine Financing?
Not every business will qualify for a mezzanine loan and it’s not right for every business.
A Mezzanine lender will typically do less due diligence than in a senior debt deal, but they will want a company that has an established business and a history of being profitable. Mezzanine financing lenders will also want to know the business plan. Is the plan to expand the business, acquire other companies, or grow the bottom line?
Established businesses that have big growth plans may want to consider the mezzanine financing route. An example might be a restaurant that wants to open up another location but doesn’t have the capital to fund the expansion or the collateral for a traditional investor loan. A Mezzanine lender might look at your expansion plan as a good investment with a high rate of return. If you were to default on your interest payments or repayment terms, the lender would have an ownership position in your business.
Keep in mind that mezzanine loans typically have shorter terms than standard commercial loans. Most common are 5-year terms where the borrower makes interest-only payments during the term. At the end of the term, the business will need to pay back the loan amount.
Key Points to Remember
- Mezzanine loans are a hybrid of debt and equity financing
- The lender will have the right to convert to an equity interest in case of default
- Mezzanine financing will have significantly higher interest rates than traditional loans
- Mezzanine financing is not right for every business. It is most commonly used in the expansion of established companies.