Mezzanine Financing Overview

Mezzanine financing is a form of a loan that sits beneath senior debt in a company’s capital structure but on top of preferred equity or common stock. Mezzanine financing gets its name for two reasons. A mezzanine level is the middle level in a stadium or theater. True to this description, within a capital structure, mezzanine financing sits in the middle between senior debt and investor share capital. Additionally, a mezzanine is often a structure that leads to a higher floor. True to this description, the use of mezzanine financing leads a company to grow to a higher level. Whether describing its location in the capital structure or its ability to lead to something greater, it is a transformative form of subordinated debt capital. Subordinated debt means that it is a loan that is junior to another loan in a company’s capital structure. Most frequently, mezzanine financing is debt that is subordinated or junior to any senior debt provided by a bank. Due to its position as subordinated debt capital, it has less in common with secured bank loans and more in common with preferred equity otherwise known as preferred stock.

Mezzanine Financing as a Preferred Equity Substitute

For decades, mezzanine financing has been misunderstood as a form of capital. Though it has the elements of a loan including an interest rate and repayment terms, its position in the capital structure makes it more like equity. Unlike senior debt, mezzanine financing is not in a first lien position against the assets and is rarely fully collateralized. This means that the mezzanine loan is often unrecoverable in the event of a liquidation. Like preferred stock or common stock, mezzanine financing is true risk capital and relies upon the long term cash flow viability of the business for principal repayment. If the business is unable to generate sufficient cash flow, the mezzanine principal payments must be deferred or restructured. Due to this reality, mezzanine lenders qualify companies based upon their historical record of producing EBITDA and their future growth potential. The mezzanine financing is most commonly used to fund the future growth of the company. If the growth plan is achieved, then the mezzanine financing is repaid on time. This puts mezzanine financing in the same position as preferred stock. The preferred stock shareholder is senior to the common shareholder but junior to all of the loans in the capital structure. The holder of preferred equity needs the company to grow at a rapid rate in order to achieve its targeted return. Mezzanine financing can provide many of the same benefits of preferred stock but a much lower cost in terms of share dilution.

Mezzanine Financing and High Yield Markets

The High Yield Market refers to the junk bond market. This is a multi-trillion publicly traded bond market. The High yield market is available to large cap companies usually with revenue of $1.0 billion and higher. The yields in the high yield market are the highest in the public bond market and reflect the non-investment grade quality of the companies and the riskiness of the bonds. Mezzanine financing is a similar to the high yield market in that the loans are risky and the companies are not investment grade. The mezzanine financing market is a form of high yield market for private companies that are middle market sized. The size of the companies are much smaller in the mezzanine market than the high yield market. Also, high yield companies are mostly public companies whereas the vast majority of the high yield credits are public companies. Mezzanine financing lacks the liquidity of high yield bonds which are very liquid and traded on a daily basis. The high yield market is also vastly greater in size than the mezzanine market.

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