Mezzanine Financing

Mezzanine financing is a type of funding that sits between senior debt and shareholders' equity in a company's capital structure. It is legally debt, or sometimes preferred equity, but it ranks behind senior lenders for repayment and therefore charges a much higher return. That return usually combines cash interest, interest added to the loan instead of paid (payment-in-kind, or PIK), and an "equity kicker" such as warrants or a share of sale proceeds.

Mezzanine is a specialised form of subordinated debt. It is used most often in leveraged buyouts, growth financings, recapitalisations and real estate development, where senior lenders will not lend enough on their own and owners want to avoid issuing more shares. Providers include dedicated mezzanine funds, private credit managers, insurers and some banks.

Picture a building with a ground floor, a top floor and a small floor squeezed in between. The ground floor is the main bank loan: it is the safest and gets paid first. The top floor belongs to the owners, who take the most risk and keep whatever is left. The mezzanine floor is in the middle: it gets paid after the bank but before the owners.

Because the mezzanine lender waits behind the bank, it wants a better deal. It charges higher interest and often asks for a small slice of the profits if the company is sold for a good price. For the owners this is still often cheaper than bringing in a new partner who would take a large share of the business for good.

A typical mezzanine instrument has a longer maturity than the senior secured debt it sits behind, often by six months to a year, so that senior lenders are repaid first. It is normally repaid in one go at maturity, a bullet repayment, or when the company is sold or refinanced. Its return has several parts:

• Cash interest. A fixed or floating rate paid regularly, usually higher than on senior loans.
• PIK interest. Interest that is added to the principal rather than paid, so it compounds and is collected at the end. This preserves the borrower's cash for servicing senior debt.
• Equity participation. Warrants to buy shares at a set price, a conversion right similar to a convertible bond, or a fee linked to the sale value.
• Fees and prepayment protection. Arrangement fees and penalties for early repayment, which protect the lender's expected return.

Some mezzanine is issued as preferred stock rather than debt, which strengthens the balance sheet in the eyes of senior lenders but gives the investor fewer creditor rights.

The relationship between senior and mezzanine lenders is set out in an intercreditor agreement. It typically fixes the order in which cash is applied, the cash flow waterfall, allows senior lenders to block mezzanine payments after a default, and imposes a standstill period during which mezzanine lenders cannot enforce. In return, mezzanine lenders often get the right to buy out the senior debt at par, so they can take control of a restructuring.

Subordination may be contractual, through these agreements, or structural. In structural subordination the mezzanine loan is made to a holding company that owns the operating business, so its claim reaches the operating assets only after the creditors of the operating company are paid. This order of claims is the subject of debt seniority. In US commercial real estate, a "mezzanine loan" is usually secured by a pledge of the shares in the entity that owns the property, rather than by the property itself, and is enforced through a sale of those shares under the Uniform Commercial Code.

Mezzanine allows a buyer to raise total leverage without contributing more equity, which can lift private equity returns. Family companies use it to fund growth or buy out a shareholder without giving up control. Developers use it to cover the gap between a construction loan and the cost of a project.

Since the 2010s the market has changed. Much traditional mezzanine has been replaced by second-lien loans, holding-company PIK notes and "unitranche" loans from direct lenders, which combine senior and junior risk in a single facility at a blended price. Mezzanine remains common in mid-market deals and in regions where direct lending is less developed.

Mezzanine lenders recover less than senior lenders when a borrower fails, because they are paid only after senior claims. Their loss given default is therefore high, and in a deep downturn the instrument can be wiped out entirely, behaving more like equity than debt. Accumulating PIK interest also increases the debt load each year, which can make a later debt restructuring harder. For borrowers, the high all-in cost, prepayment penalties and dilution from warrants are the main drawbacks, and a breach of any financial covenant in the mezzanine agreement can trigger cross-defaults across the capital structure.

• Loan Market Association (LMA)
• Uniform Law Commission