Mezzanine capital is a unique financing solution that can enable ambitious growth plans without immediate dilution of loans or collateral requirements. However, mezzanine capital investments come at a higher cost of capital and a potential loss of control.
If your rapidly expanding company needs capital with more flexible terms, should you go for mezzanine financing? Today’s article will explore the basics of mezzanine capital, how it works, and its pros and cons. Let’s begin!
What is the mezzanine capital?
Mezzanine capital is a new kind of finance that combines elements of both equity and debt.
In mezzanine financing, the company/borrower takes the loan at a higher interest rate without any collateral. However, if the company fails to repay the loan, the lender has the option to convert the loan into a stake in the company.
Whether for acquisition, company development, recapitalisation, leveraged buyout, or general growth requirements, mezzanine financing is popular among large corporations.
Mezzanine capital fund (Mez funds)
A fund dedicated to investing in mezzanine financing for various purposes, such as acquisitions, expansion, recapitalisation, administration, or leveraged buyouts, is known as a mezzanine fund. Common types of mezzanine financing include preferred shares and subordinated and unsecured debt.
How does mezzanine funding work?
The combination of debt and equity makes this kind of financing ideal for acquisitions. Mezzanine debt may be structured in many ways; the most common one is to include a legal right to convert to equity in the case of late or full repayment.
Mezzanine financing makes it easier for a business to take out loans from the market since it does not require collateral or equity dilution. It’s a kind of junior debt with more flexibility. These investments are characterised as “subordinated debt” or “preferred equity.”
They come with the assurance of regular dividend or coupon payments as well as a stake in the company’s common equity. However, unlike stocks, it does not dilute because mezzanine financing does not require the company to issue new shares. The lender only gets equity interest if the company fails to repay the loan.
Example of mezzanine financing
If a company needs ₹100 crore to fund an acquisition, it can either issue new equity shares or use mezzanine financing. If it issues new shares, the company is, in turn, diluting the ownership and earnings per share for the existing shareholders.
However, if the company goes for mezzanine financing, in this scenario, suppose the company takes the ₹100 crore loan at a 20% interest rate; it needs to pay ₹20 crore annually, keeping the stake of the existing shareholders intact.
In the event that the company fails to repay the principal amount, the lender will convert the debt into equity, diluting the existing shareholders’ stake.
Pros and cons of mezzanine funding
Advantages to the borrower (the issuer)
Mezzanine financing is an affordable alternative to stock that does not dilute current shareholders. In addition, you may claim the interest you pay on your mezzanine debt as a tax.
An organisation may lower its actual cost of capital and boost asset returns by using the right balance between equity, senior debt, and mezzanine finance.
Advantages to the lender
Mezzanine investors, in contrast to stockholders, are contractually able to receive interest payments. This reduces the potential for loss and makes returns more stable. In addition, if the business takes off, the investor may see an increase in their return thanks to the possibility of converting it into equity.
An investor in mezzanine finance may also have the opportunity to buy a share in the company via the exercise of warrants or convertible stock options.
Disadvantages to the borrower (the issuer)
Although mezzanine finance is easily accessible, the interest rates are pretty high. The creditor will be responsible for repaying a costly debt if it turns out that the project is a failure.
Taking up mezzanine debt means giving up some authority and freedom, as the debt may be converted to equity at any time. Exercising the equity option also dilutes earnings per share, likely disappointing existing shareholders.
Disadvantages to the lender
Mezzanine finance is given out without collateral and is often invested in projects with high returns that are extremely risky. As a result, there is a chance that investors can lose their money if the business declares bankruptcy.
It takes time for these kinds of initiatives to pay off. Individuals seeking quick profits shouldn’t go after mezzanine finance.
Conclusion
In closing, mezzanine capital provides an intermediate option between debt and equity financing, but one that comes with tradeoffs. Carefully weighing the pros and cons and negotiating key terms allows high-growth companies to strategically tap this flexible capital source.
FAQs
Mezzanine financing is a high-risk form of debt that combines elements of both equity and debt. Large companies typically use it to finance expansion and acquisition plans. It carries a higher interest rate than traditional loans.
It is called mezzanine because it is a middle layer of capital that lies between senior debt and equity. It is subordinate to senior debt but senior to equity in terms of repayment priority and risk.
Private equity firms, venture capital firms, mezzanine funds, or other institutional investors who seek higher returns than traditional lenders frequently provide mezzanine debt.
Mezzanine debt (mezz debt) is a type of subordinated debt that gives the lender the right to convert the debt into equity in case of default. Subordinated debt (sub debt) is a debt that ranks below senior debt in terms of repayment risk and priority.
Mezzanine debt is a form of convertible debt that is usually unsecured and subordinated. Convertible debt is a debt that can be converted into equity at the option of the lender or borrower. Convertible debt can be secured or unsecured, senior or subordinated debt.