A business can obtain finance from different sources. The two main types of finance are equity finance and debt finance. Both of these types of finance come with their costs to the business and their advantages and disadvantages.
There’s also a third type of finance, not as common as these two. It is called hybrid finance, which has characteristics of both debt and equity finance. A well-known type of hybrid finance is Mezzanine finance.
Mezzanine finance is a type of hybrid finance that allows lenders to convert to an equity interest in the company if the company defaults. Mezzanine finance usually comes in the form of preferred stock or subordinated and unsecured debt.
Companies use mezzanine finance to raise funds for specific types of projects or to finance an acquisition through a combination of debt and equity.
Mezzanine finance is highly-regarded by companies as it is a way for them to achieve the benefits of both equity and debt finance. Mezzanine finance is a middle ground for companies that want to lower their finance costs but cannot receive any debt.
Mezzanine capital is also one of the riskiest types of debt for lenders. However, for lenders, it does come with warrants attached, which increases the value of the debt. Mezzanine finance is usually costlier than debt finance but less costly as compared to equity.
Unlike other types of debt, though, lenders cannot sell or transfer it to others. It means the mezzanine debt is not as liquid as regular bonds and other securities.
Therefore, when managing these funds, managers need to consider their transferability. Especially considering mezzanine debt usually comes with a maturity period of 5 years or more.
Why do companies need Mezzanine Finance?
As mentioned above, companies can use mezzanine finance for several purposes. Companies use it during leverage buyouts to fund the acquisition of another company.
Usually, companies use it to fill the gap between equity and other less expensive types of financing, such as senior debt, second lien debt, etc. Companies use mezzanine finance as a last source of finance after they have used every other type of finance up to a maximum.
Mezzanine finance can prove to be cheaper in leverage buyouts as compared to using equity to finance them. By using mezzanine finance, companies can also ensure that returns are maximized for the equity holders while also making an investment in them more attractive to investors.
Similarly, some companies may not have access to other types of finance, and mezzanine finance may be the only option for them.
Advantages of Mezzanine Financing
Mezzanine financing is a great way for companies to finance different short- or medium-term activities. It is because it is usually cheaper than equity and does not result in the dilution of control in a company.
Similarly, mezzanine finance can reduce the need for a company to rely on equity financing. Interest paid on this type of finance is also tax-deductible, making it an attractive option for companies. Mezzanine finance can also help in budgeting as companies can easily calculate the interest due based on its balance at any time.
While mezzanine finance can be beneficial to borrowers, it also has some advantages for the lender. First of all, mezzanine finance guarantees an interest payment to the lender. It is a characteristic similar to debt where the lender gets paid regardless of the profits of the business.
Through regular interest payments, the risks associated with the debt for lenders minimize. Since lenders can also convert mezzanine debts into equity, it is more attractive to them as compared to other forms of debt as well.
Disadvantages of Mezzanine Financing
Mezzanine financing does come with some disadvantages as well. First of all, while it does not come with an immediate dilution of control of a company, there is always a chance the lender coverts to equity stocks.
It means, with mezzanine financing, there is always a potential that the company loses control over its equity in the long run. Similarly, for longer mezzanine finance periods, the interest payments may get expensive.
With mezzanine loans, the lenders are also at a potential disadvantage, especially when the borrower company goes through liquidation.
Although during liquidation of a company, mezzanine finance repayment takes priority over equity, mezzanine lenders still get paid after the senior debt gets compensated.
Similarly, if no assets are remaining after the senior debt holders get repaid, mezzanine lenders won’t receive their repayment. That puts lenders at more risk as compared to other types of debt holders.
Mezzanine finance is hybrid equipment between equity and debt, which allows lenders to convert to an equity interest in the company in case of a default.
Companies use mezzanine finance for several reasons. However, most prominently, they use it for acquisitions. There are many advantages of mezzanine finance for both lenders and borrowers, although it may come with its disadvantages.