Mezzanine capital
Encyclopedia
Mezzanine capital, in finance
, refers to a subordinated debt
or preferred equity instrument that represents a claim on a company's assets which is senior only to that of the common shares
. Mezzanine financings can be structured either as debt
(typically an unsecured
and subordinated
note) or preferred stock
.
Mezzanine capital is often a more expensive financing source for a company than secured debt or senior debt. The higher cost of capital
associated with mezzanine financings is the result of its location as an unsecured, subordinated (or junior) obligation in a company's capital structure
(i.e., in the event of default
, the mezzanine financing is less likely to be repaid in full after all senior obligations have been satisfied). Additionally, mezzanine financings, which are usually private placements, are often used by smaller companies and may involve greater overall leverage levels than issuers in the high-yield market
; as such, they involve additional risk. In compensation for the increased risk, mezzanine debt holders require a higher return for their investment than secured or other more senior lenders.
and preferred stock. Mezzanine lenders, typically specialist mezzanine investment funds, look for a certain rate of return
which can come from (each individual security can be made up of any of the following or a combination thereof):
Mezzanine lenders will also often charge an arrangement fee, payable upfront at the closing of the transaction. Arrangement fees contribute the least return and are aimed primarily to cover administrative costs and as an incentive to complete the transaction.
The following are illustrative examples of mezzanine financings:
In structuring a mezzanine security, the company and lender work together to avoid burdening the borrower with the full interest cost of such a loan. Because mezzanine lenders will seek a return of 14% to 20%, this return must be achieved through means other than simply cash interest payments. As a result, by using equity ownership and PIK interest, the mezzanine lender effectively defers its compensation until the due date of the security or a change of control of the company.
Mezzanine financings can be made at either the operating company level or at the level of a holding company
(also known as structural subordination). In a holding company structure, as there are no operations and hence no cash flows, the structural subordination of the security and the reliance on cash dividends from the operating company introduces additional risk and typically higher cost. This approach is taken most often as a result of the structure of the company's existing capital structure.
s, mezzanine capital is used in conjunction with other securities to fund the purchase price of the company being acquired. Typically, mezzanine capital will be used to fill a financing gap between less expensive forms of financing (e.g., senior loans, second lien loan
, high yield financings
) and equity
. Often, a financial sponsor
will exhaust other sources of capital before turning to mezzanine capital.
Financial sponsor
s will seek to use mezzanine capital in a leveraged buyout
in order to reduce the amount of the capital invested by the private equity firm
. Because mezzanine lenders typically have a lower target cost of capital than the private equity investor, using mezzanine capital can potentially enhance the private equity firm's investment returns. Additionally, middle market companies may be unable to access the high yield market
due to high minimum size requirements, creating a need for flexible, private mezzanine capital.
finance
, mezzanine loans are often used by developers to secure supplementary financing for development projects (typically in cases where the primary mortgage or construction loan equity requirements are larger than 10%). These sorts of mezzanine loans are often collateralized by the stock of the development company rather than the developed property itself (as would be the case with a traditional mortgage
). This allows the lender to engage in a more rapid seizure of underlying collateral in the event of default
and foreclosure
. Standard mortgage foreclosure proceedings can take more than a year, whereas stock is a personal asset of the borrower and can be seized through a legal process taking as little as a few months.
Finance
"Finance" is often defined simply as the management of money or “funds” management Modern finance, however, is a family of business activity that includes the origination, marketing, and management of cash and money surrogates through a variety of capital accounts, instruments, and markets created...
, refers to a subordinated debt
Subordinated debt
In finance, subordinated debt is debt which ranks after other debts should a company fall into receivership or bankruptcy....
or preferred equity instrument that represents a claim on a company's assets which is senior only to that of the common shares
Stock
The capital stock of a business entity represents the original capital paid into or invested in the business by its founders. It serves as a security for the creditors of a business since it cannot be withdrawn to the detriment of the creditors...
. Mezzanine financings can be structured either as debt
Debt
A debt is an obligation owed by one party to a second party, the creditor; usually this refers to assets granted by the creditor to the debtor, but the term can also be used metaphorically to cover moral obligations and other interactions not based on economic value.A debt is created when a...
(typically an unsecured
Unsecured debt
In finance, unsecured debt refers to any type of debt or general obligation that is not collateralised by a lien on specific assets of the borrower in the case of a bankruptcy or liquidation or failure to meet the terms for repayment....
and subordinated
Subordinated debt
In finance, subordinated debt is debt which ranks after other debts should a company fall into receivership or bankruptcy....
note) or preferred stock
Preferred stock
Preferred stock, also called preferred shares, preference shares, or simply preferreds, is a special equity security that has properties of both an equity and a debt instrument and is generally considered a hybrid instrument...
.
Mezzanine capital is often a more expensive financing source for a company than secured debt or senior debt. The higher cost of capital
Cost of capital
The cost of capital is a term used in the field of financial investment to refer to the cost of a company's funds , or, from an investor's point of view "the shareholder's required return on a portfolio of all the company's existing securities"...
associated with mezzanine financings is the result of its location as an unsecured, subordinated (or junior) obligation in a company's capital structure
Capital structure
In finance, capital structure refers to the way a corporation finances its assets through some combination of equity, debt, or hybrid securities. A firm's capital structure is then the composition or 'structure' of its liabilities. For example, a firm that sells $20 billion in equity and $80...
(i.e., in the event of default
Default (finance)
In finance, default occurs when a debtor has not met his or her legal obligations according to the debt contract, e.g. has not made a scheduled payment, or has violated a loan covenant of the debt contract. A default is the failure to pay back a loan. Default may occur if the debtor is either...
, the mezzanine financing is less likely to be repaid in full after all senior obligations have been satisfied). Additionally, mezzanine financings, which are usually private placements, are often used by smaller companies and may involve greater overall leverage levels than issuers in the high-yield market
High-yield debt
In finance, a high-yield bond is a bond that is rated below investment grade...
; as such, they involve additional risk. In compensation for the increased risk, mezzanine debt holders require a higher return for their investment than secured or other more senior lenders.
Structure
Mezzanine financings can be completed through a variety of different structures based on the specific objectives of the transaction and the existing capital structure in place at the company. The basic forms used in most mezzanine financings are subordinated notesSubordinated debt
In finance, subordinated debt is debt which ranks after other debts should a company fall into receivership or bankruptcy....
and preferred stock. Mezzanine lenders, typically specialist mezzanine investment funds, look for a certain rate of return
Internal rate of return
The internal rate of return is a rate of return used in capital budgeting to measure and compare the profitability of investments. It is also called the discounted cash flow rate of return or the rate of return . In the context of savings and loans the IRR is also called the effective interest rate...
which can come from (each individual security can be made up of any of the following or a combination thereof):
- Cash interest — A periodic payment of cash based on a percentage of the outstanding balance of the mezzanine financing. The interest rate can be either fixed throughout the term of the loan or can fluctuate (i.e., float) along with LIBOR or other base rates.
- PIK interest — Payable in kindPIK loanA PIK loan is a type of loan which typically does not provide for any cash flows from borrower to lender between the drawdown date and the maturity or refinancing date, not even interest or parts thereof , thus making it an expensive, high-risk financing instrument...
interest is a periodic form of payment in which the interest payment is not paid in cash but rather by increasing the principal amount by the amount of the interest (e.g., a $100 million bond with an 8% PIK interest rate will have a balance of $108 million at the end of the period but will not pay any cash interest). - Ownership — Along with the typical interestInterestInterest is a fee paid by a borrower of assets to the owner as a form of compensation for the use of the assets. It is most commonly the price paid for the use of borrowed money, or money earned by deposited funds....
payment associated with debtDebtA debt is an obligation owed by one party to a second party, the creditor; usually this refers to assets granted by the creditor to the debtor, but the term can also be used metaphorically to cover moral obligations and other interactions not based on economic value.A debt is created when a...
, mezzanine capital will often include an equityStockThe capital stock of a business entity represents the original capital paid into or invested in the business by its founders. It serves as a security for the creditors of a business since it cannot be withdrawn to the detriment of the creditors...
stake in the form of attached warrantsWarrant (finance)In finance, a warrant is a security that entitles the holder to buy the underlying stock of the issuing company at a fixed exercise price until the expiry date....
or a conversion feature, similar to that of a convertible bondConvertible bondIn finance, a convertible note is a type of bond that the holder can convert into shares of common stock in the issuing company or cash of equal value, at an agreed-upon price. It is a hybrid security with debt- and equity-like features...
. The ownership component in mezzanine securities is almost always accompanied by either cash interest or PIK interest and in many cases by both.
Mezzanine lenders will also often charge an arrangement fee, payable upfront at the closing of the transaction. Arrangement fees contribute the least return and are aimed primarily to cover administrative costs and as an incentive to complete the transaction.
The following are illustrative examples of mezzanine financings:
- $100,000,000 of senior subordinated notes with warrants (10% cash interest, 3% PIK interest and warrants representing 4% of the fully diluted ownership of the company)
- $50,000,000 of redeemable preferred stock with warrants (0% cash interest, 14% PIK interest and warrants representing 6% of the fully diluted ownership of the company)
In structuring a mezzanine security, the company and lender work together to avoid burdening the borrower with the full interest cost of such a loan. Because mezzanine lenders will seek a return of 14% to 20%, this return must be achieved through means other than simply cash interest payments. As a result, by using equity ownership and PIK interest, the mezzanine lender effectively defers its compensation until the due date of the security or a change of control of the company.
Mezzanine financings can be made at either the operating company level or at the level of a holding company
Holding company
A holding company is a company or firm that owns other companies' outstanding stock. It usually refers to a company which does not produce goods or services itself; rather, its purpose is to own shares of other companies. Holding companies allow the reduction of risk for the owners and can allow...
(also known as structural subordination). In a holding company structure, as there are no operations and hence no cash flows, the structural subordination of the security and the reliance on cash dividends from the operating company introduces additional risk and typically higher cost. This approach is taken most often as a result of the structure of the company's existing capital structure.
Leveraged buyouts
In leveraged buyoutLeveraged buyout
A leveraged buyout occurs when an investor, typically financial sponsor, acquires a controlling interest in a company's equity and where a significant percentage of the purchase price is financed through leverage...
s, mezzanine capital is used in conjunction with other securities to fund the purchase price of the company being acquired. Typically, mezzanine capital will be used to fill a financing gap between less expensive forms of financing (e.g., senior loans, second lien loan
Second lien loan
Second lien loan is a form of loan with a security interest in the assets of a company that are second in ranking behind a traditional senior credit facility...
, high yield financings
High-yield debt
In finance, a high-yield bond is a bond that is rated below investment grade...
) and equity
Stock
The capital stock of a business entity represents the original capital paid into or invested in the business by its founders. It serves as a security for the creditors of a business since it cannot be withdrawn to the detriment of the creditors...
. Often, a financial sponsor
Financial sponsor
A financial sponsor is a term commonly used to refer to private equity investment firms, particularly those private equity firms that engage in leveraged buyout or LBO transactions....
will exhaust other sources of capital before turning to mezzanine capital.
Financial sponsor
Financial sponsor
A financial sponsor is a term commonly used to refer to private equity investment firms, particularly those private equity firms that engage in leveraged buyout or LBO transactions....
s will seek to use mezzanine capital in a leveraged buyout
Leveraged buyout
A leveraged buyout occurs when an investor, typically financial sponsor, acquires a controlling interest in a company's equity and where a significant percentage of the purchase price is financed through leverage...
in order to reduce the amount of the capital invested by the private equity firm
Private equity firm
A private equity firm is an investment manager that makes investments in the private equity of operating companies through a variety of loosely affiliated investment strategies including leveraged buyout, venture capital, and growth capital...
. Because mezzanine lenders typically have a lower target cost of capital than the private equity investor, using mezzanine capital can potentially enhance the private equity firm's investment returns. Additionally, middle market companies may be unable to access the high yield market
High-yield debt
In finance, a high-yield bond is a bond that is rated below investment grade...
due to high minimum size requirements, creating a need for flexible, private mezzanine capital.
Real estate finance
In real estateReal estate
In general use, esp. North American, 'real estate' is taken to mean "Property consisting of land and the buildings on it, along with its natural resources such as crops, minerals, or water; immovable property of this nature; an interest vested in this; an item of real property; buildings or...
finance
Finance
"Finance" is often defined simply as the management of money or “funds” management Modern finance, however, is a family of business activity that includes the origination, marketing, and management of cash and money surrogates through a variety of capital accounts, instruments, and markets created...
, mezzanine loans are often used by developers to secure supplementary financing for development projects (typically in cases where the primary mortgage or construction loan equity requirements are larger than 10%). These sorts of mezzanine loans are often collateralized by the stock of the development company rather than the developed property itself (as would be the case with a traditional mortgage
Mortgage loan
A mortgage loan is a loan secured by real property through the use of a mortgage note which evidences the existence of the loan and the encumbrance of that realty through the granting of a mortgage which secures the loan...
). This allows the lender to engage in a more rapid seizure of underlying collateral in the event of default
Event of default
Event of default is a term used in commercial loan documentation. It refers to the occurrence of an event which allows the lender to demand repayment of the loan in advance of its normal due date...
and foreclosure
Foreclosure
Foreclosure is the legal process by which a mortgage lender , or other lien holder, obtains a termination of a mortgage borrower 's equitable right of redemption, either by court order or by operation of law...
. Standard mortgage foreclosure proceedings can take more than a year, whereas stock is a personal asset of the borrower and can be seized through a legal process taking as little as a few months.
See also
- Private equityPrivate equityPrivate equity, in finance, is an asset class consisting of equity securities in operating companies that are not publicly traded on a stock exchange....
- Growth capitalGrowth capitalGrowth capital is a type of private equity investment, most often a minority investment, in relatively mature companies that are looking for capital to expand or restructure operations, enter new markets or finance a significant acquisition without a change of control of the business.Companies...
- Senior debt
- Subordinated debtSubordinated debtIn finance, subordinated debt is debt which ranks after other debts should a company fall into receivership or bankruptcy....
- Hybrid securityHybrid securityHybrid securities are a broad group of securities that combine the elements of the two broader groups of securities, debt and equity.Hybrid securities pay a predictable rate of return or dividend until a certain date, at which point the holder has a number of options including converting the...
- PIK loanPIK loanA PIK loan is a type of loan which typically does not provide for any cash flows from borrower to lender between the drawdown date and the maturity or refinancing date, not even interest or parts thereof , thus making it an expensive, high-risk financing instrument...
- High-yield debtHigh-yield debtIn finance, a high-yield bond is a bond that is rated below investment grade...
- History of private equity and venture capitalHistory of private equity and venture capitalThe history of private equity and venture capital and the development of these asset classes has occurred through a series of boom and bust cycles since the middle of the 20th century. Within the broader private equity industry, two distinct sub-industries, leveraged buyouts and venture capital...
- Private equity secondary marketPrivate equity secondary marketIn finance, the private equity secondary market refers to the buying and selling of pre-existing investor commitments to private equity and other alternative investment funds....
External links
- Mezzanine Financing
- Additional info on Mezzanine Financing & Mezzanine Loans
- Corporate Mezzanine Debt Primer
- Mezzanine capital
- Mezzanine debt
- Commercial real estate mezzanine finance