Mezzanine debt is a hybrid form of capital that is part loan and part investment. Senior debt is a loan from a bank. There are many differences between the two. Banks lend off of asset values so most senior loans are collateralized with assets. The bank loan is always secured and in the first position. Mezzanine debt is not collateralized by assets and is usually in the second position with assets. Mezzanine loans are made against the cash flow, not the assets of the business. Because of this feature, mezzanine debt providers use different criteria than banks in qualifying borrowers. They look closely at their EBITDA, their EBITDA margins, and the strength of their historical cash flow.
They also focus on growth opportunities and the strength of the management team. Once the mezzanine loan is given to the borrower, the mezzanine debt provider is completely dependent on the future cash flow for repayment of their loan principal. This forces them to be patient with the borrower and to have a long term horizon. They have higher risk than a senior lender and consequently charge higher rates for their loans. They also have higher upside because they usually receive some warrants in the company. Warrants are an extra return feature. The value of the warrant is a floating number based on the future value of the company. The senior debt provider has very little upside as an asset based lender to the company.
They receive their interest rate but have no upside in the growth of the company. They are controlling with their covenants and borrower requirements, because they are regulated by the OCC and the Fed. Because they are continuously audited by government agencies, they tend to be very conservative in their approach. Typically, companies use both mezzanine debt and senior debt in a harmonious manner. The mezzanine lender puts his capital beneath the senior loan, and has an inter-creditor agreement with the bank. The mezzanine debt can fund the growth or an acquisition of the borrower. This helps increase the company’s asset base, leading to greater senior debt capacity.
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