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.