The world of personal and business finance can sometimes be seemingly endless. There are so many financial terms and products that are new to even those who consider themselves well-informed. But if you are in the business of always learning, you will be ready to take in further information as it presents itself to you so you can utilize your newfound knowledge to make all your goals a reality.
If you have not heard of mezzanine loans yet, they can be beneficial tools in financing and investing if you are in a position to use them as they are intended. In this article, we will be walking you through the purpose of a mezzanine loan and how one works so you can better understand the usefulness of mezzanine financing for both funding and investment.
The Definition of Mezzanine Financing
Mezzanine financing is a way for companies to obtain funding through a hybrid of debt and equity financing. The combination of debt and equity gives rights to the mezzanine lenders to convert the debt into an equity interest in the borrowing company in case of default. Typically, this will only occur after the senior lenders have been paid. Therefore, the risk is narrowed down to the senior debt and equity.
Mezzanine debts have equity instruments attached to the Subordinated debt to increase its value. You will often see mezzanine financing occur in situations of leveraged buyouts and acquisitions to give the new owners more flexibility and priority instead of the existing owners.
Mezzanine financing is also a common occurrence when a company wishes to embark on a significant purchase or development project. Mezzanine debt can enable well-established corporations to complete their goals through the use of debt and equity.
How Mezzanine Debt Works
Mezzanine financing is a more creative financing approach that can fill the gaps when more traditional lenders are unwilling to provide the money needed for new purchases or development projects. Mezzanine debt is considered a higher-risk debt that will come at higher costs to the borrowing company. However, mezzanine loans tend to have more flexible repayment terms.
The senior lenders provide subordinated loans, and equity interest from the company is paired with it to create these unique mezzanine bridge loans. The hybrid of equity financing and subordinated debt may unfold differently depending on the terms of the agreement, but occasionally, the equity investment could benefit the mezzanine lenders greatly.
Common Uses for Mezzanine Financing
What mezzanine financing is used for depends on whether you are on the borrowing side or the investing side. Unlike ordinary debt, a senior lender for a mezzanine loan can receive some kind of equity ownership in the capital structure of the company they are lending to, which can become a lucrative investment if everything goes well.
You will find that mezzanine financing is used by more extensive and well-established corporations rather than start-ups, as the way it is typically structured does not fit well with early-phase funding. Mezzanine funds are often used for the expansion of the existing business or as a way to handle acquisitions.
Real Estate Mezzanine Loan
A real estate mezzanine loan will help a company achieve expansion by acquiring new commercial real estate property or starting a new development project. Specific projects may be too big and ambitious to rely solely on traditional funding options. Real estate mezzanine loans allow companies to get further financing through their equity. Real estate mezzanine loans are subordinate to senior debt, but they do take priority over common equity as well as preferred equity.
Buyouts and Acquisitions
Mezzanine financing is often relied upon in situations of buyouts and acquisitions because mezzanine debt has a lower priority than senior debt when borrowers go bankrupt. The mezzanine funding can be used to make the changes necessary for the acquisition while maintaining flexibility uncommon with traditional loans.
As a mezzanine lender, one can receive a generous amount of interest payments through a mezzanine loan. Mezzanine financing has relatively high-interest rates which, although costly for the borrower, can provide a handsome investment. Mezzanine capital can also be gained as an investor through potential equity. Some lenders may receive equity interest right away through interest payments or in the case that the borrower defaults.
Pros and Cons of Mezzanine Financing
Just like with every single other funding option, mezzanine debt comes with benefits and drawbacks. Whether a company or investor should engage in mezzanine financing depends significantly on their particular situation, needs, and overall financial priorities.
Benefits of Mezzanine Loans
Getting mezzanine financing can be the perfect solution a company has been looking for to increase its cash flow to make its expansion dreams a reality. When traditional methods don’t cut it, mezzanine financing can be an attractive alternative for additional capital if the company is sure it can afford the increased risk interest rate.
Mezzanine debt can decrease equity dilution by minimizing the amount of equity you would need to offer for the amount of capital required. Additionally, in some instances, current interest payments can be tax deductible on a mezzanine fund for the company. Since the loan is not pure debt, it will show up on the Balance sheet as equity which will allow borrowers to show lower debt levels in the financial ratios.
Another significant benefit to mezzanine financing is that repayment can be incredibly flexible to the company’s needs depending on the terms set up at the beginning.
Drawbacks of Mezzanine Loans
It is always risky to take on debt with the possibility that your project or venture may not bring in return that is more than you borrowed. Just like with any other corporate financing, there will be drawbacks if you cannot bring in enough cash flow to match and exceed the debt you accumulated.
If things do not go as planned and the senior debt holders default, there may be substantial equity loss which could harm the company on the whole. Another possible drawback of mezzanine financing is that control is shared with the senior debt lenders, which means that they could make specific demands that the company needs to meet.
Other Funding Options for Individuals
If you are looking for some kind of funding that works for individuals, there are plenty of options for you that are nowhere near as confusing as mezzanine financing can sound. Corporate financing looks a lot different than personal financing because the amount of debt a corporation can take on is wildly different from that of an individual.
Here are a couple of standard options for funding regularly relied upon for individuals:
Even if your funding needs are business related, there are options for individuals to finance their small business dreams. Business loans can be approved for individuals or start-ups on a smaller scale. They typically function similarly to other types of installment loans, except that in the qualification process, you will be required to show how you plan to use the money to make a profit.
Credit cards are a form of revolving credit that can be paid down and re-borrowed without a specified end date. It is not advisable to rely heavily on credit cards for daily expenses, but they can be used strategically with a good credit score to get affordable funding.
Credit card companies often offer a promotional period of a 0% interest rate for the first year to 18 months. This means you can borrow money up to the credit limit interest-free as long as you pay off the balance by the end of the promotion.
Personal loans come in all different shapes and sizes and can be used for a wide variety of purposes. You can find a personal loan with a competitively low-interest rate if you have excellent credit. And there are personal loans for bad credit online that might be a slightly more expensive debt. Whatever your needs are, you will likely find a lender who offers the kind of financing you are looking for.