Mezzanine Fund – Usages, Characteristics, Example, and Advantages

Mezzanine Fund (Mezzanine loan) does not belong to the class of pure debt or pure equity. In other words, it is at the same time a very high risk as well as a high reward instrument that fills the gap between senior debt and equity. An organization needs such type of funding to raise money for specific purposes rather than using traditional ways of financing.

Mezzanine financing is often associated with acquisitions and takeovers, for which it may be used to rank new owners before existing owners in case of bankruptcy.

Usually, it is treated as equity in the statement of financial position of the companies. The mezzanine fund is a popular source of financing which is used by most of the companies who are interested in rapid growth and for this, they do not mind paying a little higher rate of interest for getting quick money.

Usages:

The mezzanine fund is utilized for the following purposes.

  • For acquisition: Companies commonly go for mezzanine funds if they plan to acquire another company. They generally take interest in acquiring another company if they know that acquiring another company would increase their revenue stream and ultimately profits. However, the major problem that usually occurs here is that the firm would not have liquid cash available, and would therefore need quick funds.
  • Expansion: Apart from the above three activities, companies also go for mezzanine financing for expanding their boundaries into new territories. They do not just want to expand their business but at the same time, they also want to make it flourish. They demand rapid growth for which these funds can assist them to achieve the same in a short period of time.
  • Refinancing: Companies mostly also go for such funding to make their debt capital structure more elastic. Such readily available funds ensure that companies have sufficient funds for opportunities like shareholder buyouts and acquisitions.
  • Shareholder Buyouts: Normally this happens that the family businesses are concerned more about keeping majority shares with themselves and at the same time such investors would also want to acquire other companies’ shares to strengthen more their ownership in the company. The mezzanine fund comes very conveniently to assist in handling such a situation.
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Characteristics:

The following are a few characteristics of the mezzanine fund.

  • Higher Yield: Mezzanine fund yields higher than ordinary debts.
  • Unsecured debts: Mezzanine funds are often debts that are not secured against any assets.
  • No amortization: There is no amortization of the principal loan amount.
  • Interest: Interest in mezzanine funds can be split into half fixed and half variable interest.

Example:

Let’s understand this concept of mezzanine funding and how this whole process works with the help of the example.

Mezzanine funds can be utilized for purchasing a company or for amplifying one’s own business without going for the option of IPO.

Let’s assume that Mr. Tom has a pizza shop. He desires to enlarge his pizza business but he is reluctant to go for ordinary equity financing. Rather he intends to for mezzanine financing.

He approaches mezzanine financiers and asks for mezzanine loans. The loaners informed him that they need warrants or options for the mezzanine loans and since the loans are unsecured so Mr. Tom has to agree to the terms as set out by the mezzanine lenders.

Hence Mr. Tom takes $500,000 by taking them in confidence that he has a cash flow of $100,000 every year. He took the loan and regrettably defaults at the time of payment. Since his pizza shop couldn’t generate enough cash flow so the loaners took a portion of his pizza shop and sold it off in order to get their money back.

Importance:

The mezzanine fund is of significant importance owing to the following reasons.

  • A mezzanine loan providing facility is designed in a way to ensure that the owner keeps outright control of the company and over its strategic direction. Mezzanine loaners are passive and not active. Generally, business owners see very little intervention from the lender.
  • Mezzanine funding works absolutely fine for companies that have passed beyond the start-up stage but still do not have the capital to finance big growth moves by themselves. For growing companies with strong cash flow, desiring business expansion, mezzanine funding is also a good option.
  • Its importance is also due to the fact that it provides a highly flexible arrangement, allows customized solutions to structure coupon, amortization, and covenants to reconcile the specific cash flow requirements of the business which means that the loan is back-ended with repayment of the principal amount occurring near the expiry of the loan term.
  • A company can borrow three to four times a bigger amount of loan as compared to its cash flow in a mezzanine deal hence, it provides higher amounts of funding comparatively than a loan provided by a bank.
  • This funding method is always popular and considered as a lower-cost alternative to raising equity or selling shares to an investor.
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Advantages to the Borrower (the recipient of the loan)

  • Once availed, it dilutes the need for equity financing.
  • Interest on mezzanine debt is a tax-allowable expense for the company.
  • Banks also do not hesitate to lend to a company with mezzanine funding, as the mezzanine loaner is usually an institutional investor whose presence declines the risk of lending to the company.
  • Mezzanine debt is cheaper as compared to other sources of financing like equity and also does not result in the dilution of current stakeholders.
  • A company can get a cost-effective capital structure with maximum funding, maximum return on equity, and minimum cost of capital by using mezzanine funding, as a borrower.

Advantages to the Lender (loan provider)

  • Returns on mezzanine financing are more consistent and also the downside risk is much minimized since a mezzanine investor is contractually entitled to interest payments monthly, quarterly, or annually.
  • Additionally, if the company starts doing well after getting mezzanine funding, the option of converting to equity may also increase the investor’s returns.

Apart from understanding its significance and benefits, a company must also be aware of the fact that these loans are unsecured and the borrowers have to pay quite a high-interest rate on this.

Hence, a company should critically analyze and make sure that either they would be able to pay the interest or not and if they believe that they will not be able to earn half of what they are borrowing then they are required to stay away from this mode of financing.

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