There are three basic categories of business funding. The most common, debt funding, is the name given to finance where you borrow money (take on a debt) for an agreed rate of interest.
With equity fundraising, you offer a portion of your business in exchange for finance.
The third category, known as ‘mezzanine finance’ offers something of a balance between the other two.
In this article we’ll explore what it means, and how best to use mezzanine financing to grow your business
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How Does a Mezzanine Loan work?
Mezzanine financing is a complex type of property finance that covers a range of funding scenarios. For certain situations it makes more sense than either debt or equity funding, particular where the borrower can’t raise enough money via traditional means.
This type of finance is commonly used for larger finance amounts whereby the money borrowed is intended to be repaid through profit gained. The loan is originally offered as cash with a portion transforming into equity after an agreed timeframe has passed.
Effectively, the company is therefore using it’s own equity as loan security.
The lender would also benefit from interest payments on the amount loaned.
Debt or Equity?
Mezzanine finance is a hybrid of both debt and equity. With this type of funding the lender provides a second charge (subordinated) loan, plus the potential for equity should the loan extend beyond a certain point.
This type of finance means that this loan will rank after some other debts should the company fall into liquidation.
Anyone with a first charge (or first ‘lien’ in US terminology) would be paid before the lender of a subrogated debt. In the UK, a subordinated loan is more commonly referred to as a ‘second charge’ loan.
Typically, mezzanine finance lenders would be paid after ‘senior debt’ holders, but before common equity.
Key Takeaways About Mezzanine Finance
- Subordinate to senior debt, i.e. first charge loans
- Mezzanine finance is often unsecured
- Often structured to include part fixed and part variable interest
- Can be offered in addition or as a ‘top up’ to funds offered by a main lender
- Helps achieve a maximum return for companies with valuable equity seeking significant finance
How Does Mezzanine Funding Work in Commercial Real Estate?
In commercial property deals, mezzanine funding has a particular place because the property itself can be used as equity.
Its useful for property developers because it faciliates significant finance deals, while placing the investment property itself as collateral.
Deals like this usually come with terms of between 1 and 5 years, though in certain cases they may go up to 10.
They’re popular because the centrality of a property with a verifiable market value gives lenders immediate security and can hence fastrack loans of this type.
What are the typical interest rates you’re likely to find in mezzanine finance deals?
10 to 30% would be a common range: the higher rates correspond to the fact that equity is offered in lieu of cash. While this denotes a certain level of security it still takes time for a lender to translate into cash should the worse occur. They therefore cover themselves via a higher interest rate.
As with bridging finance, mezzanine funding is preferable for large, profitable deals where this kind of percentage interest remains worthwhile.
Pros of Mezzanine Finance
- Immediate access to necessary capital
- Leverage – Borrowing less means a higher return on equity
- Equity – Borrowing against equity means, assuming the deal goes as planned, the overall equity is less diluted compared with equity finance
- Capital Structure – Mezzanine finance is commonly listed as equity on the company balance sheet, meaning lower debt levels are maintained and therefore access to additional finance, where necessary
- Tax Deductible – In some cases, interest payments on this type of finance may be tax deductible.
Cons of Mezzanine Finance
- Debts – If the deal doesn’t work out as planned, the company could find itself in debt
- Equity – Not paying on time could mean giving up equity as interest to your lenders
- Loss of Control – Terms and conditions tend to be very detailed in cases like this, with many lenders stipulating paticular criteria which borrowers must maintain, such as financial ratios
What is the Difference Between Senior and Mezzanine Debt?
Senior debt is the terminology for a debt which carries a ‘first charge’ over a particular security. This means, should you default, this lender will have the primary right to be paid, over other lenders.
Mezzanine debt, by contrast, is a kind of hybrid debt, made up of part loan and part investment. The money lent via mezzanine funding carries a second or ‘subordinate’ charge, meaning these lenders carry more risk.
It is to balance this risk that mezzanine lenders are assigned equity in the company should their debt not be repaid within certain terms.
Are Mezzanine Loans Safe?
While we are frequently asked this question, it’s a tricky one to answer in a concrete fashion. No finance is completely safe since it exists within a marketplace that is constantly shifting within broader economic forces.
The key points with mezzanine finance is that it is often unsecured, and with a higher interest than senior debt. Part of the return is always fixed, which makes it less dilutive than a standard equity finance deal.
No principal amortization exists on this type of finance, meaning you only pay monthly interest, rather than paying the interest and principal in different amounts each month.
What’s the Lending Criteria for Mezzanine Financing?
- Finance is secured by a second charge
- Requires full planning consent
- It’s available for both residential andcommercial real estate development in England, Scotland or Wales
- Will require a personal guarantee document
- Will only be an option for experienced property developers with a proven track record
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