Mezzanine financing is a type of debt-equity financing that allows the lender to convert to an equity stake in the company in the event of default, usually after venture capital firms and other senior lenders have been paid.
Mezzanine debt has embedded equity instruments, sometimes referred to as warrants, that raise the value of the subordinated debt and provide bondholders more flexibility. Mezzanine finance is typically related with acquisitions and buyouts, and it can be utilized to give new owners priority over existing owners in the event of bankruptcy.
How does mezzanine debt work?
Mezzanine loans help businesses generate more capital while also allowing them to raise their returns on equity and display a stronger bottom-line profit. Mezzanine loans are often not repaid throughout the life of the debt, but only at the conclusion. A company’s cash flow can be improved as a result of this. The company can also utilize the extra cash to pay down existing debt, invest in working capital, develop new goods, or expand its market. The corporation may also choose to keep the extra cash on hand and let it accumulate on its balance sheet while looking for future opportunities to put the money to the best possible use.
Why is it called mezzanine debt?
Mezzanine debt gets its name from the fact that it blurs the distinctions between debt and equity. It is the riskiest type of loan, but it also has some of the best yields a typical rate is between 12 and 20 percent each year.
In most buyouts, a mezzanine lender is brought in to replace some of the capital that would normally be spent by an equity investor.
Mezzanine debt replaces some of the funding that would otherwise be provided by an equity investor.
Let’s say a private equity firm wants to purchase a $100 million business. A senior lender may only be willing to lend up to $75 million, or 75 percent of the company’s value. The private equity sponsor does not willing to put up the remaining $25 million on its own, so it seeks for a $10 million mezzanine investor.
The sponsor only needs to pay $15 million of its own money to the buyout now that it has secured $85 million in debt financing. This maximizes the buyer’s potential profit while reducing the amount of money it has to spend on the transaction.
What is mezzanine debt for dummies?
Mezzanine debt is a type of investment banking financing that falls somewhere between standard debt and equity. In fact, mezzanine debt is sometimes referred to as a hybrid form of financing because it combines the benefits of both loan and equity. An equity kicker or equity sweetener is commonly included in mezzanine debt.
What is debt financing?
Although the terms debt and loan are often used interchangeably, there are some distinctions. Anything owing by one person to another is referred to as a debt. Debt might be in the form of real estate, money, services, or any other form of payment. Debt is more narrowly defined in finance as funds raised through the issuance of bonds.
A loan is a type of debt, but it’s also a contract in which one party loans money to another. The lender establishes repayment terms, such as how much and when the loan must be repaid. They may also require the loan to be returned with interest.
Who uses mezzanine debt?
There are many different types of equity that can be coupled with debt. Stock call options, rights, and warrants are instances of embedded options. In actuality, mezzanine debt acts more like a stock than a debt since the imbedded options make debt-to-stock conversion more appealing.
In leveraged buyouts, mezzanine debt structures are the most common. For example, a private equity firm may want to borrow $100 million to buy a company, but the lender only wants to lend $80 million since it only wants to put up 80% of the value. The private equity group does not want to put up $20 million of its own money and instead seeks a $15 million mezzanine investor.
After that, the company only needs to put up $5 million of its own money to cover the $100 million price tag. Due to the usage of mezzanine financing, the investor will be able to convert the debt to equity if certain conditions are met. Using this kind of financing maximizes the buyer’s potential return while lowering the amount of funds required to complete the deal.
A hybrid security classification on the balance sheet is determined by how the loan element influences the embedded option, according to US Generally Accepted Accounting Principles (GAAP). If the debt structure influences the act of exercising the embedded option in any manner, the two parts of the hybridthe debt and the embedded equity optionmust be classified in the liability and shareholders’ equity sections of the balance sheet.
How is mezzanine debt repaid?
Because mezzanine debt lenders don’t need principal payments for the first three years of the loan, the company can keep the money in the business to ensure that its growth goal is met.
Principal repayments normally begin in year 4 or can be totally backdated to the maturity date, which is usually 5 years. The loan must be repaid only after the company has successfully completed its growth period and has a considerably greater cash flow and asset base.
- Through cash flow – the company’s cash flow has greatly increased, and it is now possible to make current principal payments with current earnings.
- The company has doubled in size and boosted its hard asset worth on the balance sheet as a result of a bank refinancing. On the foundation of traditional collateral, a bank can now refinance a mezzanine debt loan.
- Through a company sale – if the firm’s value has increased sufficiently and the timing is good, the owner can sell the company and use the proceeds to repay the mezzanine lender.
How is mezzanine debt secured?
A mezzanine loan is backed by a pledge of the equity of the organization that owns the mortgaged real estate (such as a limited liability corporation). If the mezzanine borrower defaults, the mezzanine lender forecloses on the pledged asset and becomes the new owner.
What is the difference between preferred equity and mezzanine debt?
Mezzanine debt and preferred equity are both types of debt that reside between senior debt and common stock in the capital stack, and they both serve the same purpose of filling funding gaps and/or providing additional leverage.
The main distinction between the two is that mezzanine debt is typically structured as a loan secured by a lien on the property, whereas preferred equity is an equity investment in the entity that owns the property.
What is hybrid debt?
A hybrid security is a financial product that combines two or more separate financial instruments into a single security. Hybrid securities, sometimes known as “hybrids,” are securities that have both debt and equity features. A convertible bond, which has the characteristics of a traditional bond but is highly influenced by the price fluctuations of the stock into which it is convertible, is the most prevalent type of hybrid investment.
What is the difference between mezzanine debt and subordinated debt?
Subordinated debt with some type of equity enhancement is known as mezzanine debt. The borrowing business is only required to pay interest and principal on regular subordinated debt. The lender gets a piece of the action in the company’s business through mezzanine debt. A mezzanine loan’s equity kicker might take the form of attached stock warrants or bonus payments to the lender dependent on the company’s valuation. With publicly traded companies, warrants are used, and other types of equity participation will be connected to the mezzanine loans of privately held enterprises.
