Mezzanine financing is a hybrid of debt and equity that provides companies or businesses with an opportunity to secure capital without offering collateral or security. Ensuring the growth or expansion of any company requires a smooth flow of income, and regardless of how profitable the company‘s accounts are, companies opt for securing a loan.
Apart from the traditional method of securing a loan from a bank against collateral, alternative methods of securing loans like mezzanine financing have become increasingly popular. Let’s dive into the details of mezzanine financing: how it works, the pros and cons, the structure, etc.
How Does Mezzanine Financing Work?
To begin with, mezzanine financing, from its very meaning, talks about a hybrid of debt and equity. In a nutshell, mezzanine financing allows companies or businesses to secure a loan against offering the lender a right to convert the debt into equity in case of default.
Since mezzanine financing does not operate on a traditional loan mechanism that provides debt against collateral, this type of financing comes with high interest rates as the risks are also slightly higher.
One of the key reasons why companies opt for mezzanine financing is that it promises capital without an obligation to repay the loan through liquidity as the lender can convert the debt into equity. This helps the company use its liquid capital to expand the business or meet everyday business needs.
Key Features of Mezzanine Financing
Mezzanine financing provides both lenders and borrowers an opportunity to benefit from the capital and equity. In addition to others, here’s a list of key features of mezzanine financing that can help you understand the mechanism better:
Mezzanine financing is a hybrid of debt and equity.
Mezzanine financing offers loans and unsecured debt.
Under this type of financing the interest rates are usually higher as compared to traditional loans.
This type of financing provides a higher yield compared to standard debt.
Interest rates under mezzanine financing can be structured as a blend of both fixed and variable rates.
Advantages and Disadvantages
Just like any other form of economic financing, Mezzanine financing also comes with certain advantages and disadvantages that you must be aware of.
Advantages of Mezzanine Financing
One of the major advantages of mezzanine financing is that it offers the borrower a chance to raise capital without offering any collateral. This allows the borrower a chance to retain its assets and also secure capital.
This type of financing provides the lender an opportunity to gain equity ownership in a company that helps them boost that comes with a higher rate of return or ROR. Additionally, the lender also enjoys interest payments as per the contract terms.
Mezzanine financing is more flexible than the traditional type of debt. Borrowers have the flexibility to roll their unpaid interest into the principal amount and retain their liquid capital by offering equity ownership to the lender.
Disadvantages of Mezzanine Financing
A drawback of mezzanine financing for the borrower is that these types of debts are offered against high interest rates since it is an unsecured debt.
The lender, despite possessing the right to convert debt into equity, is at the risk of losing money in case the lender's company value declines.
Mezzanine Financing Vs Traditional Debt
Mezzanine financing is different from traditional debt primarily in terms of offering secured and unsecured debt.
Let’s take a quick look at the detailed comparison between the two types of financing:
Mezzanine financing is a hybrid of debt and equity that helps in the growth and expansion of businesses. Traditional debt operates in isolation and typically comes with fixed terms and interest rates.
Mezzanine financing includes subordinated loans or convertible bonds that come at a higher interest rate and equity ownership for the lender. Traditional loans include a loan agreement featuring interest rate, repayment schedule, principal amount etc.
Mezzanine financing is known for offering more flexibility as compared to traditional loans as in the latter the tenure and repayment methods are fixed.
Structure of Mezzanine Financing
Mezzanine financing comes with a simple structure on the company’s balance sheet. It stands between senior debt and common stocks in the capital structure. This is to say that, this type of debt ranks lower than senior debt when it comes to offering rights on the company’s assets or securities.
Under mezzanine financing, unsecured subordinated debts are provided that are also known as sub-debts. Know that, in cases where the borrower makes a default, the sub-debt holder gets to raise claims on the company’s assets or securities only after the claims of senior debt holders are settled.
Since, these are unsecured subordinated debts, the debt holder imposes a higher interest rate to create a just and equitable loan agreement.
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Example of Mezzanine Financing
Let’s take a simple example to understand mezzanine financing better.
Say that there is a mid-size company looking to expand its manufacturing base and implement marketing strategies. However, due to a lack of collateral, the company is unable to secure a loan. To address the challenge, the company opts for mezzanine financing from a venture capital company. The company can secure a ₹50 million loan for a term of eight years with an interest amount of 12%.
Now since this is under mezzanine financing the company also offers a 5% equity stake to the lender.
Now the company can implement its expansion and marketing strategies using the ₹50 million loan and the lender gets to earn from the interest in case the company fails to repay the loan the lender has the option to convert the debt into equity.
Conclusion
Mezzanine financing is a crucial financial mechanism that helps both the borrower and the lender to secure a better financial position in the market. Despite coming with higher costs and interest rates, smart strategies for mezzanine capital can help companies boost their growth and increase their company’s value.
As a borrower or a lender, it is important to carefully read the terms of the mezzanine financing agreement before securing or offering debt.