Mezzanine Debt
Candlefocus EditorAs an example of the way mezzanine debt is used, assume Company XYZ needs to finance an expansion and the lender has offered $20,000,000 in pure debt, in the form of a loan. In addition to the loan, the company might opt to issue $5,000,000 in mezzanine debt. The mezzanine debt will be contributing in equity-like acts as they are riskier than pure debt and provide higher potential returns in return. This incorporates the potential upside of equity, primarily capturing the growth of the company to increase returns, combined with the downside limitation of debt.
The specifics of each mezzanine debt transaction are highly customized between the issuer and lender, but generally, mezzanine debt has a much lower interest rate than other forms of pure debt. This is because of the higher risk associated with investing in the mezzanine debt versus pure debt. Normally, investors in these situations are looking for returns in the range of 12%-20% per year—much higher than traditional bonds or loans.
Mezzanine debt can be incredibly valuable to the issuer as the structure allows them to access additional capital without giving up any more control or equity than they may have intended. This can be especially important for fast-growing companies that are looking to scale quickly, but have a hard time obtaining traditional financing. Mezzanine debt can therefore serve as a bridge that enables operations to be resourced until sufficient profitability or capital is secured.
Given the higher risk associated with mezzanine debt products, mezzanine financing should be entered into cautiously and any investor should thoroughly analyze the risks and potential rewards before diving into a mezzanine debt transaction. Mezzanine financing is a great way to access additional capital but can also be quite costly, particularly when the markets or economy do not support the debt-issuer’s ability to meet their obligations.