What is Mezzanine Financing?

For example, a China-backed buyer of a Hong Kong skyscraper from billionaire Li Ka-Shing for a record $5.2 billion is seeking to borrow as much as 90 percent to fund the deal and around 40% of this $5.2 billion in one-year mezzanine financing at 8% interest rate.

Source: reuters.com

Structure

Have you ever bought a house?

If yes, you would know that most of the house owners would go for a down payment. This down payment is the money he has saved for himself. And the rest of the amount is mortgaged through a bank, meaning that the remaining amount is taken as a loan.

In the case of Mezzanine Funds, it works just like that.

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Since Mezzanine Funds is not about buying houses, but buying companies; it happens like the following –

The firm that has been purchasing the company uses its cash. Then the remaining portion is taken as a debt from different banks.

Generally, private equityPrivate EquityPrivate equity (PE) refers to a financing approach where companies acquire funds from firms or accredited investors instead of stock marketsread more acts as a mediator here. Either they buy the company themselves, or they help the company’s management buy the target company.

Now Mezzanine Financing Definition can be of different types –

  • Usually, a portion is given from own savings by private equity. And they take loans from multiple investors for funding the purchase.Another type is the private equity company using its savings to take debt from the company itself and thus arrange for the funding.

As a result, the Mezzanine Fund isn’t something everyone would go to. The risk is much higher, and the expectation of benefits is also quite high.

Characteristics

Here are the top-most important characteristics of Mezzanine Funding –

  • Mezzanine Financing is for companies who have moved beyond start-ups: Mezzanine Funding isn’t for start-ups. It is for those who are yet to put their foot forward for an IPO but still need a boost in theirGrowth Capital, also called Expansion capital, is the amount of money offered to the fast-growing businesses requiring finances to expand their operations or new market ventures. All in all, it helps facilitate target firms for accelerating their growth rate. read more growth capitalGrowth CapitalGrowth Capital, also called Expansion capital, is the amount of money offered to the fast-growing businesses requiring finances to expand their operations or new market ventures. All in all, it helps facilitate target firms for accelerating their growth rate. read more to expand. Since, in the beginning, start-ups don’t have enough cash flow, it’s difficult to take up this highly risky investment..A pretty flexible form of financing: Mezzanine is called subordinated debts. And it is particularly useful for small business owners who aren’t yet ready to pay a huge cost of capital onEquity financing is the process of the sale of an ownership interest to various investors to raise funds for business objectives. The money raised from the market does not have to be repaid, unlike debt financing which has a definite repayment schedule.read more equity financingEquity FinancingEquity financing is the process of the sale of an ownership interest to various investors to raise funds for business objectives. The money raised from the market does not have to be repaid, unlike debt financing which has a definite repayment schedule.read more. Since mezzanine funds are offered with a tailor-made approach, it suits the small business owners quite well. Another reason it’s quite flexible is that it is considered an unsecured loanUnsecured Loan;An unsecured loan is a loan extended without the need for any collateral. It is supported by a borrower’s strong creditworthiness and economic stabilityread more; that means the borrower doesn’t need to provide an asset to take the loan. And as small amounts are borrowed from multiple sources like private investors, mutual funds, insurance companies, banks, etc., no one runs after the borrower immediately.Highly risky: Mezzanine Funds are pretty risky. On one side, it helps the small business owners to boost their growth capital; but on another side, it turns out to be so risky. If the small business owners cannot generate enough revenue (or cash flow), it would be impossible for them to pay off the debt on time because the interest rate of mezzanine financing is quite high. That’s why it is always recommended that mezzanine debt should not be more than double the company’s cash flow. For example, if a company generates around $100,000 in cash flow, it should take $200,000 as mezzanine financing and not more than $500,000 as total debt (including the mezzanine debt)As Mezzanine Funds are unsecured, lenders restrict the borrowers in certain cases: This is not good news for borrowers, but since mezzanine debts are unsecured, the lenders should have some hold on the loans. That’s why they often incorporate restrictive conditions that the borrowers need to adhere to. For example, the lender may ask for the warrants or the option of ownership if the borrower defaults to pay off the amount, or the borrower may be asked not to borrow an additional loan, or else a few financial ratiosFinancial RatiosFinancial ratios are indications of a company’s financial performance. There are several forms of financial ratios that indicate the company’s results, financial risks, and operational efficiency, such as the liquidity ratio, asset turnover ratio, operating profitability ratios, business risk ratios, financial risk ratio, stability ratios, and so on.read more the borrowers must meet.

Examples

Example #1 – Mr. Richard Ice Cream Parlour

Mezzanine funds can be used to buy a company or expand one’s own business without going for an IPO.

Let’s say that Mr. Richard has an ice-cream parlor. He wants to expand his business. But he doesn’t want to go for conventional equity financing. Rather he decides to go for mezzanine financing.

He goes to mezzanine financiers and asks for mezzanine loans. The lenders mention that they need warrants or options for mezzanine loans. Since the loans are unsecured, Mr. Richard has to agree to the terms set by the mezzanine lenders.

So Mr. Richard takes $100,000 by showing that he has a cash flow of $60,000 every year. He takes the loans and unfortunately defaults at the time of payment since his ice-cream parlor couldn’t generate enough cash flow. The lenders take a portion of his ice-cream parlor and sell off to get back their money.

Example #2 – Federal Capital

source: prnewswire.com

As we see from above, Federal Capital Partners (a Private Equity firm) has provided $6.5 million in the mezzanine fund to The Altman Companies to develop Altis Grand Central.

Advantages

  • Can get loans easily: Small business owners need funds to expand. Mezzanine funds are easy to get, and one doesn’t need to provide any asset as a mortgage.The loan structure is quite flexible: The structure of mezzanine debt is quite flexible. The borrowers take loans from multiple sources, and as a result, the amount from each is smaller.Interest on the mezzanine debt is tax-deductible: This is the main advantage of the Mezzanine fund. One of the reasons small business owners go for mezzanine debt is that the interest they pay on the debt reduces the tax they need to pay to the government.

Disadvantages

  • Restrictive covenants: Since the loans are unsecured, the lenders incorporate restrictive conditions on the borrowers like warrants, options of partial ownership, not to borrow additional loans from a lender, etc.High-interest rates: Since mezzanine loans are unsecured, the borrowers need to pay quite a high-interest rate and if you have not been earning half of what you intend to borrow, stay away from taking mezzanine loans.

Mezzanine Financing Video

This has been a guide to what Mezzanine Financing is and its meaning. Here we discuss the Mezzanine Funding structure, advantages, disadvantages, and examples. Below is another set of useful articles that you may like –

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