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 debt) for an agreed interest rate.
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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- What is Mezzanine Finance?
- Pros and Cons of Mezzanine Finance
- How Does a Mezzanine Loan Work?
- Mezzanine Finance Example
- How Does Mezzanine Funding Work in Commercial Real Estate?
- Typical Interest Rates for Mezzanine Finance Deals
- What is the Difference Between Senior and Mezzanine Debt?
- Are Mezzanine Loans Safe?
- What are the Lending Criteria for Mezzanine Financing?
- Is Mezzanine Financing Risky?
- Mezzanine Finance Lenders
- Key Takeaways About Mezzanine Finance
What is Mezzanine Finance?
Mezzanine finance is a type of capital that falls between debt and equity financing. It is often used by businesses that are seeking to raise capital but do not want to issue more equity or take on additional debt.
Typically, mezzanine finance takes the form of subordinated debt, which means that it is repaid after other debt obligations in the event of a default. It often includes an equity component in the form of warrants or options, which can provide the lender with an ownership stake in the company.
The terms can be structured in various ways, but it is generally more expensive than debt and less expensive than equity. It’s useful because it offers companies additional flexibility and the ability to raise capital without diluting existing ownership.
Pros and Cons of Mezzanine Finance
- It helps diversify a company’s funding relationships, reducing dependence on any one investor or lender.
- Lower cost than equity financing: You don’t have to relinquish ownership
- It can generate much higher amounts of funding than a bank loan or asset-based loan
- Mezzanine lenders are passive: Generally, business owners encounter very little interference from the lender.
- Tax Deductible – In some cases, interest payments on this type of finance may be tax deductible.
- Immediate access to necessary capital
- Capital Structure – Mezzanine finance is commonly listed as equity on the company balance sheet, meaning lower debt levels are maintained
- Higher cost than debt financing: Although less expensive than equity financing, it is still more costly than traditional debt financing.
- Can dilute equity: Although less dilutive than equity financing, it still involves issuing securities that can dilute a business’ equity.
- Risk of fluctuating interest rates: The interest rates can be adjustable, which makes it harder for businesses to budget.
- Default risk: Mezzanine financing is unsecured debt, increasing the risk of default and negatively impacting a business’s credit rating.
- 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
How Does a Mezzanine Loan Work?
A mezzanine loan is a type of financing that blends elements of both debt and equity financing. It plays a crucial role in filling the financing gap between senior debt and equity, particularly in high-cost transactions such as leveraged buyouts, mergers, and real estate developments. Here’s how it typically works:
1. Loan Agreement:
A company or individual seeking additional funding (borrower) enters into a loan agreement with a mezzanine lender. This lender is usually a private equity firm or a specialist finance company. The terms of the loan including the interest rate, repayment schedule, and any equity conversion rights are negotiated and agreed upon.
Once the agreement is signed, the lender provides the mezzanine loan to the borrower. The loan augments the borrower’s capital, allowing them to fund business growth, acquisitions, or other projects that would otherwise be beyond their financial reach.
3. Interest Payments:
The borrower must make regular interest payments to the mezzanine lender according to the terms of the loan agreement. This interest rate is generally higher than that of a traditional bank loan due to the increased risk taken on by the mezzanine lender.
4. Equity Conversion:
In addition to the interest payments, mezzanine loans often include an equity component. This typically takes the form of warrants, or a conversion feature that gives the lender the option to convert their loan into an ownership or equity interest in the company under certain conditions, usually if the borrower defaults on their loan repayments.
At the end of the loan term, the borrower must repay the principal amount of the loan to the mezzanine lender. If the borrower cannot make the payments, the lender may choose to convert the debt into equity, thereby obtaining a stake in the borrower’s company.
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.
Mezzanine Finance Example
Let’s say you’re a property developer in London who specialises in converting old commercial properties into luxury residential apartments. You’ve found an old office building in Shoreditch with excellent conversion potential. The cost to purchase the property and complete the conversion is estimated to be £10 million.
However, you only have £2 million available to invest in the project, and due to the project’s risk profile, a traditional bank is only willing to lend you £5 million as a senior secured loan, which is not enough to finance the whole project.
This is where mezzanine finance comes in.
To secure the remaining funds needed, you approach a mezzanine lender – a specialist finance company. They agree to lend you the remaining £3 million you need to complete the project. The £3 million loan is mezzanine finance.
Here’s how the structure looks:
- Equity: As the property developer, you contribute £2 million of your own money. This represents your equity stake in the project.
- Senior Debt: The bank provides a senior loan of £5 million. This loan is secured against the property and must be repaid first in case of default. It’s the least risky part of the capital stack, so it has the lowest interest rate.
- Mezzanine Finance: The mezzanine lender provides £3 million. This loan sits between the senior debt and equity in terms of risk and return. If you default, the mezzanine lender has the right to convert their loan into equity ownership or to take control of the project. This is riskier than the senior loan, so it has a higher interest rate.
This way, you’re able to raise the £10 million you need to complete the project.
While this example is a simplification, it illustrates the general idea of how mezzanine financing can be used in the UK, particularly within property development scenarios.
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.
It’s useful for property developers because it facilitates 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 fast-track loans of this type.
Typical Interest Rates for Mezzanine Finance Deals
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 equity being 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.
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.
To balance this risk, 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 tricky 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 in this type of finance, meaning you only pay monthly interest rather than paying the interest and principal in different amounts each month.
What are the Lending Criteria for Mezzanine Financing?
- Finance is secured by a second charge
- Requires full planning consent
- It’s available for both residential and commercial real estate development in England, Scotland or Wales
- Will require a personal guarantee document
- This will only be an option for experienced property developers with a proven track record
Is Mezzanine Financing Risky?
Yes, mezzanine financing is generally considered risky, both for the borrower and the lender. Here’s why:
Risks for the Borrower:
- High Interest Rates: Mezzanine financing typically carries higher interest rates compared to traditional loans due to its subordinated status. If the business does not perform as expected, the cost of servicing the debt could place a significant strain on its finances.
- Potential Loss of Control: Mezzanine financing often comes with the option for the lender to convert their debt into equity if the borrower defaults. This could potentially lead to a loss of control or ownership in the business.
- Increased Leverage: Using mezzanine finance increases the company’s financial leverage. While this can enhance returns in good times, it can magnify losses when business conditions deteriorate.
Risks for the Lender:
- Subordinated Debt: Mezzanine loans are subordinate to senior debt. If a borrower defaults, the mezzanine lender is repaid only after the senior lenders have been paid in full, which increases the risk of loss.
- Limited Collateral: Mezzanine finance is often unsecured or only partially secured, meaning there is limited collateral that the lender can claim in the event of default.
- Dependence on Business Performance: Since the ability of the borrower to repay the loan is typically dependent on the performance of the business or project, the mezzanine lender faces the risk that the borrower’s business may not perform as expected.
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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