Mezzanine financing has created opportunities for investors to secure cheaper alternatives to fund companies. The purpose of the article is to present an overview of mezzanine financing and discuss the various features of the debt. Included in the article is a discussion of the benefits associated with mezzanine financing as well as the risk and implications of incorporating mezzanine financing in a company’s capital structure.
CHARACTERISTICS
Mezzanine financing, also referred to as quasi-equity, comprises of both unsecured debt or second lien debt and has debt and equity characteristics. Mezzanine financing is a type of loan that is subordinated to the senior debt in a firm’s capital structure but is above the common stock or preferred equity. This form of debt can take the form of senior subordinated debt, convertible preferred debentures or as preferred equity. Such loans are frequently used for financing acquisitions or fuelling the fire with needed non-dilutive growth capital. Within a capital structure, it is junior to all debt. Mezzanine debt has a higher interest rate since the risk exposure is more than that of senior debt.
The yields of mezzanine financing are the highest in the bond market and are riskier compared to senior debt. Mezzanine debt financing is usually based on covenant packages such as bank facility covenants or high-yield style covenants. The bank facility covenant often has maintenance covenants and is mostly based on the credit facility’s covenants. High yield covenants, on the other hand, can shield a bondholder from unfavorable actions by equity owners and safeguard a bond’s priority of claims.
Mezzanine debt that is similar to high yield debt has components such as optional redemption and call protection provisions that are comparable to high-yield notes. Similarly, mezzanine debt that includes some components of senior debt has mandatory prepayments secured to debt and optional prepayments at par, at low or decreasing premiums. For example, some mezzanine notes can be redeemed at 105% of their principal amount in the first year following the note issuance, 104% in the second year, 103% in the third year and 102% in the fourth year.
BENEFITS OF Mezzanine financing
· Mezzanine financing is valuable in the capital structure of a company. For example, the equity capital of a company is strengthened with mezzanine financing since equity holdings are not diluted.
· Mezzanine financing also enhances the structure and creditworthiness of a company and has a positive impact on a company’s rating.
· Like equity financing, mezzanine financing does not need collateral, thereby, companies have the flexibility to use capital to expand and to manage the operations of the company.
· The use of mezzanine debt reduces the amount of equity invested in a company and lowers the after-tax cost of capital. Additionally, the value of stocks held by current shareholders increases when mezzanine financing is integrated in the company’s capital structure.
· In general, companies that use mezzanine financing have the flexibility to structure covenants, amortization and coupons to adjust and cover exclusive cash flow requirements.
· Mezzanine investors benefit from mezzanine financing as it generates higher rates of return. Investors also obtain steady returns from mezzanine funding due to contractual agreements to make interest payments.
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