Mezzanine Financing refers to any kind of subordinated debt or preferred equity used to finance a company. In general, any form of Mezzanine Captial will represent a claim on a company’s assets but will only be senior to that of the common shares.
Mezzanine Capital sits between the common equity and senior debt in the Capital Structure of a company. This form of financing is often used in acquisitions
Debt instruments, such as bonds have a claim on the lender’s assets in the event of a bankruptcy or liquidation. The formation of the capital structure determines which claims have priority on the assets. Subordinated debt ranks behind the more senior debt in terms of priority of their claims.
Mezzanine Debt, in general, has more variability in terms of structure than higher grade debt. Being farther back in line, in terms of priority, it also carries more risk.
The interest on the debt can be both fixed or a floating rate. The effective interest rate will also be affected by the interval of interest payments (monthly, quarterly, biannually, early). In some cases, credit is issued on Payable-in-Kind (PIK) terms. In this case, the interest on the debt is not paid out, but it accumulated on the principal of the loan.
In order to sweeten and incentivize Mezzanine Financing, lenders are often offered additional participation in the upside of the deal, through warrants or conversion features in the loan terms.
In the case of warrants, the lender will be able to exercise the warrants if the equity becomes more valuable than the exercise price of the warrants (in-the-money). In the case of convertible debt, the lender will be able to convert the debt into equity at a predefined exercise price into common equity.
Preferred equity, refers to any form of stock that have particular characteristics that set them aside from the common equity. There are various types of features that Preferred Equity can be equipped with, ranging from fixed dividend payouts, seniority over common shareholder.
As Preferred Equity often has characteristics more akin to credit than common equity, they are often referred to as hybrid securities. They generally do not carry voting rights and do in some instances have callability features. Convertible Preferreds is Preferred Equity that can be converted into common equity at predetermined conversion price.
Leveraged Buyouts (LBO)
Private Equity Firms have historically been frequent users of Mezzanine Financing in conjunction with other forms of debt, for Leveraged Buyouts. The Mezzanine Debt is behind the other debt in priority, it does not affect other lenders. Furthermore, it has a lower cost of capital than equity, meaning that the PE Firms can increase the expected return of their investment with a higher leverage ratio.
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