What is “Mezzanine Debt”?
Mezzanine is derived from Mezzano, an Italian word meaning ‘in the middle’. Mezzanine Debt is a hybrid combination of senior-level debt and equity and falls in between for the risk factor. In the event of bankruptcy, mezzanine debt would not be paid until the senior debts are paid, and thus the required Rate of Return (RoR) is also high.
Mezzanine financing often has the equity conversation option known as ‘Warrants’ embedded, which increases the level of subordinated debt and provides borrowers with more flexibility to manage the debt holdings. The higher risk in mezzanine debt increases the interest rates, but it often still remains cheaper, in comparison to equity. Mezzanine debt typically has an annual return between 12% to 20%, which is one of the highest returns in debt instruments.
When a company looks to expand, take up special projects, or acquire/buyout another business, but its funding options for issuing senior debts like a bank loan, asset-based borrowings, etc. are exhausted, it can opt for mezzanine financing. Typically the mezzanine lenders are existing investors as they know the company rationale for the expansion. It is a short-term opportunity for them to gain high-interest payments and in the long run, conversation to equity. It also helps the borrowing company in prioritizing new owners while undertaking M&A activity.
Key Learning Points
- Mezzanine Debt is a combination of debt and equity instruments. Due to higher risk, it has higher interest rates but is considered inexpensive compared to issuing equity
- Companies can opt for mezzanine debt when they want to raise senior debts but traditional funding options are exhausted
- Usually, mezzanine debt works as a short to medium-term debt option due to higher costs compared to traditional debt equivalents
- Mezzanine lenders are often given an ‘Equity Kicker’ in terms of warrants ensuring that the debt will be converted into equity in the future. This, in practice, makes mezzanine debt more like a common stock than debt and also an attractive option to invest
- It is issued to fund growth projects such as expansion, M&A activity, or buyouts
- Mezzanine debt plays a vital role in reducing the equity requirement for the company
- Mezzanine lenders typically receive an annual return of 12% to 20% through interest payments, PIK, equity ownership, and share in the company’s performance
Types of Mezzanine Debt
- Subordinated Debt + Equity Kicker as Warrants
- Subordinated Debt + Co-investment Tag in Equity
- Subordinated Debt without a Share in Equity
- Convertible Debt Option
- Preferred Share
Among different types of mezzanine debts mentioned above, the first one – subordinated debt plus a warrant as an equity kicker ensuring the debt to be converted into equity, is the popular option.
If the borrowing company is sponsored by a private equity firm, depending on the EBITDA, the mezzanine lender does not tend to get a warrant. Here, the EBITDA can be categorized into three groups – $1 to 5 million, $5 to 20 million, and more than $20 million. With a higher valuation, the need to issue a warrant reduces. Also, borrowers need to have a positive cash flow for issuing mezzanine debt as otherwise, they might fail to pay the high-interest payments, and the chances to default increase.
The Need to Obtain Mezzanine Debt
There are certain purposes for which a company issues mezzanine debt, including:
- M&A Activity
- Expansion and Growth
- Management and Shareholder Buyouts
- Leveraged Buyouts
- Refinancing or Capital Restructuring
Note that it does not include minor objectives like general company improvements.
One of the major benefits of issuing mezzanine debt is that it reduces the equity requirement for businesses while undertaking crucial projects.
Below are two examples, in the first one, Company A would acquire Company B using mezzanine debt, while in the second example, sans it. This would help understand how mezzanine financing reduces the requirement of equity capital and how it impacts the Return on Equity (ROE) for the borrowing company.
Company A acquires Company B using mezzanine debt:
Company A acquires Company B with equity:
If Company A doesn’t choose the option of mezzanine debt, it would have to manage the rest of the purchase amount which can be challenging. With mezzanine debt, the ROE is 233.6%, while with equity investment, it is 46.51%. Though for the additional return on equity, Company A would also have to employ $450,000 instead of $75,000. The difference in return on invested capital is significant, but so is the investment amount.
How is Mezzanine Debt Paid Back?
Mezzanine lenders typically earn a higher annual return of around 12% to 20% compared to corporate debt which is typically calculated as a fixed interest rate + country interest rate. Mezzanine lenders receive returns through either periodic interest payments (fixed and floating rates), payable in-kind Interest (PIK – instead of interest payment, the principal amount is increased), ownership in equity, and shares in the company’s performance.
Mezzanine debt is a short-term financing instrument to cater to funding a specific project. Usually, a company would pay back this debt in priority given its higher interest rates during the course of borrowing.