3/8/24, 9:25 PM Mezzanine Financing - Overview, Rate of Return, Benefits

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Mezzanine Financing
A layer of financing that fills the gap between senior debt and equity in a company

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Written by CFI Team

What is Mezzanine Financing?

Mezzanine financing is a layer of financing that fills the gap between senior debt and equity
in a company. It can be structured either as preferred stock or as unsecured debt, and it
provides investors with an option to convert to equity interest. Mezzanine financing is
usually used to fund growth prospects, such as acquisitions and expansion of the business.

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A gap between senior debt and equity financing exists due to the following common
reasons:

Inventory, accounts receivable, and fixed assets are discounted at higher rates for fear of
non-recognition of their value.

There is a substantial volume of intangible assets recorded on the balance sheets.

To address the rise in defaults and regulatory pressure, banks impose limits on the total
debt that a business can acquire.

Mezzanine Financing Rate of Return

The basic form of mezzanine financing is unsecured debt and preferred stocks. As
mezzanine financing is unsecured, it carries higher risks, and investors require a higher rate
of return than secured lenders. Typically, it pays an investor 12-20%, which is higher than the
rate of return on ordinary debt.

Mezzanine investors can earn returns from the following available sources:

1. Cash interest

Based on the portion of the outstanding mezzanine funding balance, investors receive cash
periodically. The interest rate may either be set or may fluctuate over the loan period.

2. Payment in Kind (PIK) interest

It is also a periodic method of payment. However, the interest amount is not paid in cash.
Instead, it is added to the principal sum of the security, and the total amount is paid at the
end of the loan period. For example, a $50 million bond with a 10% PIK interest rate will
amount to $55 million at the end of the period, and there will be no cash interest payment.

3. Ownership

Similar to a convertible bond, mezzanine financing often includes an equity interest in the
form of a conversion feature or warrant. Usually, the PIK interest or the cash interest follows
the ownership portion of the securities.

4. Participation payout

In place of equity, investors may take a return on equity in the form of a percentage of the
company’s performance as measured by net sales or EBITDA, or profit.

5. Arrangement fee

Mezzanine investors are also required to be paid an arrangement fee upon closing the
transaction.

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Benefits of Mezzanine Financing

To the Issuer

1. Increase in total capital

Mezzanine financing can help a company secure more capital and circumvent the under-
capitalization of the business. The interest payment on mezzanine funding is also tax-
deductible.

Let us assume you want to start your own business and you need $15 million. You plan to
raise $5 million through equity and approached a bank seeking a loan of $10 million.
However, a bank will usually deem it as unreasonable and will lend only 75% of the required
loan. It leaves you with an option to raise $7.5 million through equity.

Suppose a mezzanine investor proposes to lend you $5 million. Since the bank considers
mezzanine as equity and sees a trusted partner with the mezzanine component, the bank
will ultimately lend you the originally requested amount of $10 million. Therefore, the total
capital raised with and without mezzanine will be:

Hence, the mezzanine layer reduces the equity requirement and helps to secure more total
capital.

2. Reduction of capital cost and an increase in equity returns

Equity is the costliest source of capital, and it dilutes the current shareholders. Therefore,
mezzanine debt may be an attractive alternative for accessing much-needed capital.
Companies use an appropriate combination of senior debt, mezzanine debt, and equity to
reduce the true cost of capital and increase asset returns.

To the Investor

1. Attractive and safe investment

The mezzanine investor enjoys the advantages of equity investment in the form of high
returns and a diverse portfolio. In the case where the borrowing company becomes
successful, the mezzanine investor can exercise the equity option and receive the benefits.

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In addition, even in the worst case, the mezzanine investor gets at least the interest
payment. The interest received for mezzanine financing outperforms the one received
against traditional financing.

2. Warrant option

Mezzanine financing often includes warrants or convertible equity options that a mezzanine
investor can exercise to earn a stake in the company. The rights can be exercised at a given
date or the occurrence of any specific event, as outlined in the agreement.

Mezzanine Financing Limitations

For the Issuer

1. Probability of failure

Mezzanine financing, though readily available, demands high interest rates. In case the
project fails to take off, the creditor will need to pay back the extremely costly loan.

2. Potential loss of control and freedom

When creditors take mezzanine debt, they sacrifice freedom and control, as conversion to
equity is always a possibility. Moreover, the equity option, when exercised, results in the
dilution of EPS, triggering a negative reaction from existing shareholders.

For the Investor

1. High risk

Mezzanine financing is provided without collateral, and the investment is mostly made in
high-yield but risky, projects. Thus, investors are exposed to the risk of losing the investment
in case the company goes bankrupt.

2. Long time-period for return on investments

Companies usually seek mezzanine financing for the growth or expansion process. Such
ventures require some time before they can produce returns. Mezzanine financing is not
intended for investors who are looking to make quick money. It is why mezzanine financing
agreements specify the interest commencements after a period, not immediately.

Key Takeaways

Mezzanine financing produces higher returns than traditional debt, and investors can
earn returns through cash interest, PIK interest, ownership, and payout as a percentage
of the company’s performance.

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It helps a business secure more capital, lower the cost of capital, increase the rate of
return, and save tax on interest payments.

Mezzanine financing includes a convertible option or warrant that provides investors

with a right to earn a stake in the business. It, however, results in the existing owners
being diluted by the issuance of additional shares.

Additional Resources

CFI offers the Commercial Banking & Credit Analyst (CBCA)® certification program for those
looking to take their careers to the next level. To keep learning and advancing your career,
the following resources will be helpful:

Cost of Capital

Pro-Rata Participation Rights

Rate of Return

Series A Financing

See all commercial lending resources

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