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What is Mezzanine Debt?

Mezzanine debt or mezzanine capital is a form of hybrid capital that has been around for 30 years and which can be structured as either preferred equity or unsecured debt. It is generally referred to the layer of debt that sits between senior debt and equity. Mezzanine debt lays claim to a corporation’s assets, yet also incorporates equity-based security options in its structure. It is senior only to common shares and is often a more expensive form of financing because of its positioning and inherently higher level of risk to the lender. And unlike Venture Capital, Mezzanine debt is used for adolescent and mature companies who are cash flow positive that need capital for a number of growth-related uses.

Mezzanine debt provides the following benefits:

  • The company being funded gains capital while increasing their leverage
  • The senior secured lender sees an injection of new opportunity equity and reduced leverage
  • The mezzanine debt provider can put its capital to use at an attractive rate
  • Shareholders avoid unnecessary dilution from new equity (which is also the most expensive form of capital)
  • The company sees a lower cost of capital when compared to equity
  • The company receives less rigid terms when compared to senior debt
  • The company’s weighted average cost of capital (WACC) can be reduced
  • The company’s return on equity (ROE) can be increased

Mezzanine debt is often seen as a positive move for mature companies because all parties involved in the capital structure can end up benefiting. And because it is not senior debt, it comes with less stringent payment terms and is more “patient”. Mezzanine debt is also advantageous because the desired return is 13% – 25% which is lower than equity which helps reduce the overall cost of capital for a mature company. In fact, a company that properly incorporates mezzanine debt into its capital structure can take it’s WACC from as high as 35% and reduce it down to 11% while moving it’s return on equity from only 12% up to as high as 40%.

Although mezzanine debt is a form of debt financing, it is considered hybrid capital, since it may also incorporate equity instruments such as warrants. Other options may also play a role such as call options and rights. When these equity instruments and options are embedded in the debt, mezzanine debt behaves more like stock, allowing for easy conversion of the debt into stock. This characteristic makes mezzanine debt very attractive as it allows for greater flexibility when dealing with bondholders thereby increasing the value of this subordinated junior debt.

Mezzanine debt is quite often used when restructuring ownership of a corporation or in the case of an anticipated bankruptcy. When an acquisition or buyout is being transacted mezzanine debt can be used to prioritize new owners over existing owners during the transition period.

For more information, please read our full white paper on mezzanine debt.

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What is Senior Debt?

Senior debt is the first level of a corporation’s liabilities which means it is paid out first, ahead of all other creditors. Senior debt, as opposed to junior debt, is first in seniority and is often secured by collateral in the form of a lien.

Senior debt is among the safest form of financing for the party providing the funds. Due to its inherent low risk, it also provides the least amount of return. However, in exchange for this low return, significant protection is provided even in the event of bankruptcy. Should a corporation go bankrupt, any remaining funds, dissolved assets or other available sources of value must first repay senior debt before other creditors are able to collect.

Senior debt is financing that has been lent to a corporation for a pre-negotiated period of time with interest paid on the principal. The lender profits from this arrangement due to the scheduled period of borrowing on which the interest applies. The risk is low, since the borrower is contractually obligated to make payments on a pre-determined schedule. The lender does not gain the benefit of a higher potential return since the financing and its recoupment is not based on the borrowers financial performance. For this reason, senior debt is prioritized over other investments and creditors.

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What is Equity?

Equity describes the value of an ownership stake or interest in a property. When a corporation is initially established, owners contribute funds to help finance assets. In exchange for those funds, a liability is created on the corporation to its owners in the form of share capital. The capital that is formed is equity and it represents the sum of the investments made in a corporation – typically in exchange for shares. Equity is also known as risk capital or liable capital.

Shareholders’ equity is the amount of funds that have been contributed by the owners of the corporation, plus any retained earnings that have accumulated. Losses incurred by the corporation will negatively affect shareholders equity since the losses are ultimately the responsibility of the owners. Equity is found on the corporations balance sheet and is an integral element of how a business’s finances are managed and accounted for.

Because equity is inherently risky, equity investors are generally looking for at least a 25% return if not more which is fundamentally the reason why equity capital is considered the most expensive form of capital compared to mezzanine debt.

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What is Working Capital (WC)?

Working Capital (WC) is calculated by subtracting a corporation’s current liabilities from its current assets. This financial metric determines a corporation’s operating liquidity and is necessary in understanding how readily available funds are for necessary financial transactions related to daily operations. A corporation whose current liabilities are more than its current assets is considered to have a working capital deficiency.

Working Capital (WC) is calculated as follows:

Working Capital = Current Assets – Current Liabilities

The danger of having negative working capital is that a corporation may be unable to meet its short-term liabilities. Examples of current assets are cash, accounts receivables and inventory. These assets are easily liquidated for the purpose of raising funds. If a corporation is unable to meet its short-term obligations, then in a worst case scenario, bankruptcy may be a threat. In addition, negative working capital may also be a sign of trouble ahead. If negative working capital remains over a long period of time, this may be an indication that sales volumes are on the decline.

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What are the Different Types of Capital?

Capital is used by a corporation to finance its assets, daily operations, expansion and other activities that require financing beyond what can be provided by its on-going returns. The types of financing available to corporations are extensive and each form of capital has a different set of conditions and rules associated with it. Understanding the variety of capital types available is pertinent when weighing the pros and cons of each. Keeping these pros and cons in mind becomes imperative to making responsible choices when seeking financing options for a corporation’s continued growth.

Examples of Capital types:

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