Mezzanine Fund: How Does Mezzanine Financing Work?

Mezzanine funds are a form of financing that comes with hybrid features of equity and debt. These are unsecured forms of financing and are considered risky. Hence, lenders often demand higher returns on these funds than normal debt instruments.

Mezzanine funds can come as convertible financing instruments that are initially issued as a debt and can be converted later to equity. These are flexible financing options for the borrowers. However, these funds are riskier for lenders as they are unsecured without collateral.

What is Mezzanine Financing?

A mezzanine fund is a source of financing that has characteristics of equity and debt at the same time. It is issued as a debt but can be converted to equity if the borrower defaults on the payment. It falls in the middle or “mezzanine” category when it comes to seniority, it ranks higher than common equity and lower than debt instruments.

Convertible bonds and preference shares are common forms of mezzanine financing. These funds are subordinated funds to senior debt instruments. However, issuers attach warrants to these instruments that can be converted to equity to raise the credibility of these funds. Mezzanine funds are commonly used in acquisitions, management buy-outs, growth projects, and recapitalization requirements.

How Does Mezzanine Financing Work?

Mezzanine funds can be used for several reasons by borrowers. Foremost, if a company has limited access to normal debt instruments and cannot afford to offer further dilution of ownership stakes.

Mezzanine funds are unsecured loans that do not require collateral. Hence, companies with a larger portion of intangible assets can utilize these funds easily. However, the lenders would demand a higher rate of return on these funds due to the unsecured nature of the financing.

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Asset-backed debt financing is the most secured form of financing. Equity being the riskiest is unsecured. Mezzanine financing falls between the two categories in terms of risk as well. For that reason, the cost of mezzanine financing also falls between the two categories. It may range from 10% to 20% on average.

Here are some key features of mezzanine funds.

  • Mezzanine financing is subordinated to debt financing but is senior to equity (preferred and common shares).
  • Startups and newly established companies cannot obtain this type of financing as it requires positive cash flows in the absence of collateral.
  • It is a flexible form of financing in terms of maturity, options of fixed and variable interest payments, and conversion.
  • The rate of return on these funds is higher than debt instruments and lower than equity.
  • These instruments are convertible to equity but cannot be used as marketable securities on the secondary market easily.
  • Due to the lack of marketability, these instruments face liquidity challenges.
  • Due to unsecured loans and other risks attached, the lenders can attach covenants to these instruments such as warrants, conversion clauses, etc.

Special Considerations with Mezzanine Financing

The eligibility and availability of mezzanine financing are discrete. Technically, any company can obtain the facility but is often available to stable companies with positive cash flows only.

Since the lenders do not require collateral, they often attach covenants in the form of warrants or other restrictions. For instance, a lender may impose a condition to meet a certain leverage ratio or a profitability ratio during the tenure of a mezzanine loan.

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Mezzanine funds are typically used for expansion or acquisition projects. A company’s existing creditors can fund these projects. The maturity period of these instruments falls between short and medium-term in most cases. Typically, these loans are issued for 5- or 10-years maturity.

Mezzanine funds may pay interest in different forms:

  • Cash payments as with any other debt instrument
  • Payment in kind for example in the form of shares
  • Conversion of debt into equity
  • Participation rights in the company’s rights such as in profits

Advantages of Mezzanine Financing

Mezzanine financing isn’t available for every borrower. However, it offers several advantages to the borrowers and lenders alike.

  • It is cheaper than equity financing and does not dilute existing ownership stakes.
  • Borrowers do not require collateral.
  • Borrowers can make interest payments flexibly with different options.
  • Lenders enjoy a higher rate of returns on these instruments as compared to debt financing.
  • Borrowers can enjoy the benefits of equity financing and debt financing benefits such as tax-deductibility of the interest costs.
  • Both parties can customize these instruments with flexible options such as maturity, payment structure, and conversion features.

Disadvantages of Mezzanine Financing

Mezzanine funds can come with some disadvantages as well.

  • Borrower’s cost of borrowing is higher as compared to debt financing.
  • Borrowers may have to ultimately sacrifice ownership stakes.
  • Lenders also face risks of default and illiquidity.
  • Due to its unsecured nature, lenders may impose covenants with these instruments such as warrants or conditions for maintaining certain profitability ratios.

Conclusion

Mezzanine funds are hybrid instruments that fall between the debt and equity categories. These are unsecured loans with higher interest rates and can be converted into equity if the borrower defaults.

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