Mezzanine finance

Quick facts

Mezzanine financing is a hybrid of debt and equity financing that can be useful for large projects, buyouts, or expansion. It is a fairly complex form of business loan that gives the lender the right to a share of equity in your business if you default on the loan. Mezzanine finance comes under the umbrella of private debt.

Mezzanine finance sits in the middle between debt and equity finance (‘mezzano’ is Latin for ‘middle’). You might use it as a third option alongside business loans and equity finance if you’re considering an acquisition, buyout, or expansion. You can also see it as a form of top-up finance if you can’t borrow as much as you need but don’t want to give away equity at the outset.

Mezzanine finance is effectively a business loan with a twist. Arrangements can vary, but in most cases, if you can’t repay the debt within a pre-agreed timeframe, the debt converts into equity. In other words, if you default on your loan, the lender gets a share of equity in your business – you’re using equity as your security.

Mezzanine finance is often subordinated to bank debt. This is the most common form, also known as a subordinated loan. It is lower in priority for repayment compared to senior debt but higher than common stock or equity.

This type of financing is typically suited for existing businesses with at least two years of successful trading history. Startups with low revenue may struggle to obtain this type of financing.

Pros:

  • Accessible to those with poor credit and no assets to secure the loan
  • Retain equity of your business (upon repayment of the loan and as per contract terms)
  • Greater flexibility: choose upfront whether you want your loan to be equity-bearing or not. Can’t decide between debt and equity? Why choose?!
  • Excellent for management buyouts or preparing for exit scenarios

Cons:

  • You will lose equity if stipulated as part of the agreement in the event of non-repayment
  • The cost of finance may be more expensive than a straightforward (non-hybrid) arrangement
  • Lenders will want to see strong growth projections and profitability

Private debt – Private debt is an umbrella term that refers to debt products that are financed by non-bank institutions. Unlike publicly listed corporate bonds, private debt products are usually illiquid and not issued or traded on public markets.

Direct lendingDirect lending is a type of private debt financing, i.e., it refers to debt investments that come from institutions other than banks. Lenders (usually asset management companies) combine their capital into a professionally managed fund, which provides debt products to businesses.

Special situations‘Special situations’ funds are unusual or one-off events (including rumours and news stories) that mean the market is less able to value a business properly. These events include spin-offs, mergers, bankruptcy, litigation, succession, or shareholder action. Special situations funds are equity funds that look to exploit these events by buying equity in these businesses.

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