Mezzanine finance

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Page written by Chris Godfrey. Last reviewed on October 24, 2024. Next review due March 1, 2025.

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Sometimes, South African SMEs need to boost their business borrowing, but, because of the sector they’re in, their current debt levels, other business issues, or even macro market conditions, they are unable to secure a traditional loan. Without selling valuable equity and losing some ownership, what else can they do?

Mezzanine finance has been designed to bridge this problem. Borrow the funds you need without giving up ownership. Pay the loan back on terms tailored to your circumstances. Sounds interesting? Read on to discover more about mezzanine finance and how it minds the gap in business lending.

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What is mezzanine finance?

Frequently associated with acquisitions and buyouts, mezzanine finance is a hybrid business loan that can usually be converted to equity should the borrower default. Effectively, this means the lender is compensated with shares in the business if the company fails to repay the loan according to its terms and conditions.

Mezzanine loans are useful in various situations. Including:

Recapitalisation of an existing business.
Leveraged buyouts to provide financing to the purchasers.
Management buyouts, to allow the company’s current management to buy out the current owners of the company.
Growth capital for significant capital expenditures or construction of facilities.
Financing acquisitions.
Shareholder buyers, especially attractive to family-owned businesses trying to regain control of shares that may have fallen out of the family’s hands to maintain or increase family control of the business.
Refinancing of existing debt – to pay it off or replace it.
Balance sheet restructurings.

How does mezzanine finance work?

Mezzanine financing is often used when the perceived loan risk is high enough that the borrower can’t raise enough money through traditional business financing. Instead of selling shares in the business to raise capital, mezzanine financing allows the organisation to use their equity as collateral for a loan.

In terms of risk, mezzanine debt sits between senior debt (bank loans, secured loans, etc.), and equity (unsecured shareholder value). If the organisation were forced into liquidation, mezzanine debt holders would only get paid back after the senior debt holders have been made whole.

Mezzanine debt also has something called ‘embedded equity instruments’ attached, (also known as warrants). These are special agreements which increase the value of the subordinated debt and allow greater flexibility when dealing with bondholders.

What is the structure of mezzanine finance?

Mezzanine financing sits in a company’s capital structure between its senior debt and its equity, as subordinated debt, preferred equity, or a combination of the two.

Mezzanine finance is most often structured as unsecured subordinated debt, or sub-debt, indicating it is inferior to senior debt and it does it present any ownership to the lender. Sub-debt is only protected by the borrower’s promise to pay, meaning it can be high-risk. However, some mezzanine financing will take an underlying lien on the organisation’s property, which may provide some security.

Preferred equity is an equity investment in a property-owning business, and it is usually subordinate to mortgage loans and any mezzanine loans but is senior to common equity. Preferred equity is generally deemed to be a higher risk than other mezzanine debt due to increased risk and lack of collateral.

Mezzanine loans usually require monthly payments as debt service and can only be converted to equity in the event of the borrower defaulting in the loan. Depending on the size of the loan compared to the value of the equity, mezzanine debt has the potential to deliver majority ownership to the lender if a distressed debt to equity conversion takes place.

Key elements of mezzanine finance:

Important elements of any mezzanine financing are the debt’s maturity, redemption, and transferability:

Maturity

Mezzanine financing typically matures (is repaid), after five years or longer, although the maturity date will usually be set to reflect the scheduled maturity dates of existing senior debt. Preferred equity typically has no fixed maturity date, although the lender/investor may recall the funds at any time after reaching a set date after investment.

Redemption

Redemption, or prepayment, refers to the lender’s or borrower’s rights to recall or pay back the loan/investment. They will usually be triggered if certain pre-agreed events occur. Mandatory redemption/prepayment is typically required in the event of asset sales or a change in control transactions, although it may also be triggered by lower interest rates, in which case, redeemed or prepaid funds are typically re-issued as new debt or preferred equity.

Transferability

Generally, mezzanine lenders have the unrestricted right to transfer their loans. However, preferred equity is often subject to restrictions or conditions on transferring the investor’s interest in the business. Usually, it is only when all the preferred equity has been contributed, that the business may permit transfers.

Pros and cons of mezzanine finance

Like any business loan, mezzanine finance has its advantages and disadvantages:

Pros

The interest on mezzanine debt is a tax-deductible business expense. This can substantially reduce the actual cost of the debt.
Borrowers may have the option to move their interest to the balance of the loan. If they cannot make a scheduled interest payment, some or all of the interest may be deferred. This option is typically unavailable for other types of debt.
Expanding companies that quickly grow in value may choose to restructure mezzanine loans into one senior loan at a lower interest rate, saving on interest costs in the long term. This means the mezzanine loan is only used as temporary capital until the organisation can secure traditional business funding.

Cons

Business owners may sacrifice some control and upside potential due to the loss of equity.
Lenders may insist on a board presence.
Businesses pay more in interest the longer the mezzanine financing is in place.
Mezzanine debt agreements will often include restrictive covenants, limiting the ability to borrow additional funds or refinance senior debt, as well as establishing financial ratios the borrower must meet.
Restrictions on bonuses or pay-outs to key employees and even owners are common.

Pros and cons of mezzanine financing at a glance – borrower’s point of view:

Pros	Cons
Tax deductible interest	High interest rates – 15% to 20%
May defer interest payments	Pay more in interest the longer the loan is in place
May convert to senior debt	Can be slow to arrange
Long-term "patient" debt	Lender may take a board seat
Cheaper than raising equity	May include restrictions on further credit
Structural flexibility	Owner must relinquish some control
No dilutive effect on company's equity	May restrict bonuses and pay-outs
Lenders tend to be long-term

Example mezzanine financing

Subordinated debt example:

Lender provides Company with R5 million in mezzanine loan financing. This replaces a higher interest R3 million credit line. Company gains more working capital and pays off a higher interest debt, saving money on interest payments. Lender will collect 15% a year in interest payments and will be able to convert the debt to an equity stake if the company defaults. Lender is also able to prohibit Company from borrowing additional funds and to impose certain financial ratio standards upon the business.

Preferred equity example:

Company issues Series B 10% Preferred Stock with a par value of R25 and liquidation value of R500. The stock will pay periodic dividends when funds are available until the defined maturity is reached. The relatively high liquidation value is a takeover defence making it unprofitable to acquire the stock for such purposes.

Where to find mezzanine finance

Mezzanine funding is complicated finance, provided by lenders who specialise in such loans. Lenders usually make loans to companies that can safely service higher debt levels, although they may tolerate a higher degree of risk than traditional banks and business lenders. Mezzanine debt lenders may also be willing to customise the transaction to meet a borrower’s needs and plans. This can give the borrower a better rate of interest and provide the best value for the loan amount, total price, and flexibility of the debt raised.

Because of its specialist nature, businesses may have difficulty in securing the mezzanine finance they need, often going from one lender to another seeking terms that meet their requirements. This can make a process that is typically slow even slower.

How to apply for mezzanine finance

As with any business loan, securing the funds you need requires preparation. Although every mezzanine finance lender will have their own criteria, most will ask for the following information:

Bank statements – last three years.
Tax returns – last three years.
Details of company structure and share allotment.
Profit and loss statement, balance sheet, cashflow forecast.
Details of existing debt.
List of major customers and suppliers.
List of any patents, copyrights, innovative technology.
Business plan – as comprehensive as possible.

Get started with Swoop

Searching for mezzanine financing can be very time consuming, leaving businesses struggling to meet their financial needs. But it doesn’t have to be like that. Get started with Swoop today to find mezzanine financing at the best rates and the best terms and conditions in the shortest time possible.

Written by

Chris Godfrey

Chris is a freelance copywriter and content creator. He has been active in the marketing, advertising, and publishing industries for more than twenty-five years. Writing for Barclays Bank, Metro Bank, Wells Fargo, ABN Amro, Quidco, Legal and General, Inshur Zego, AIG, Met Life, State Farm, Direct Line, insurers and pension funds, his words have appeared online and in print to inform, entertain and explain the complex world of consumer and business finance and insurance.

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