What is Mezzanine Finance?
Mezzanine financing is a form of debt that sits behind senior debt normally on a development loan and reduces the amount of common equity required by the borrower. This enables the borrowing company to leverage at a higher loan to value or gross development value and therefore maximises the return of the equity investment made by the existing shareholders. There are a number of mezzanine lenders in the market but it is a specialist area of debt financing.
Why is it called mezzanine financing?
Mezzanine loans get there name because they sit between the senior loan and equity requirement so its terminology is the similar to a mezzanine level and in this case fills a funding gap. This forms part of the structure for both debt and equity. As mezzanine funding sits behind senior debt holders it helps provide a better return for the equity stake portion and should be a consideration for the company's capital structure.
Tell me the difference between senior and mezzanine debt?
Senior lenders provide senior debt and it sits a first ranking debt and is normally secured by way of a first ranking legal charge and/or a debenture against the SPV. Mezzanine debt lender provide a mezzanine loan that ranks second to senior debt and is normally secured by a second legal charge and/or debenture. After this comes equity finance but this is usually provided by the borrower in the form of common equity.
Mezzanine financing structure
Mezzanine financing will usually be structured in a ring fence SPV. Gone are the days of traditional bank debt with many ways of providing a hybrid financing solution in todays market. Senior debt from a long list of alternative other senior lenders will take a legal charge on the asset and a debenture on the SPV. Sometimes they will also take a share charge. The mezzanine financing will then sit behind the senior loan provider and also take a legal charge on the asset together a debenture on the SPV and again sometimes take a share charge. After the mezzanine financing sits the developers common equity. The priority of the debt and equity will also be repaid in this order.
Example of Mezzanine Financing
An example of mezzanine development finance would be where senior debt would be put in place for around 65% loan to GDV including interest and approximately 80% loan to cost and would attract lower interest rates as it is a lower risk of debt finance. Then you would obtain from a mezzanine lender up to 75% loan to GDV and up to 90% loan to cost, both to include interest received. As mezzanine loans are a higher risk they attract higher interest rates. Normally, due to the risk, the mezzanine fund will require personal guarantees. The interest payment is normally rolled up and would attract an arrangement fee payable at the outset and sometimes at the exit. The main lender that sits in front of the mezzanine loan, otherwise known as the senior lender, will require a deed of priority that protects the senior lender position. All finance costs are tax deductible as it is treated as a business loan.
How Mezzanine Financing Works
Mezzanine finance aims to reduce the gap between debt and equity and represents high risk debt. It's superior to merely equity but subordinate to purely debt. Compared to other types of debt, the debt is often given a rate of between 15% and a maximum rate of 30%. Mezzanine financings are sometimes considered very expensive debt - or cheaper equity - as they carry higher interest rates compared with senior debt holders which companies could get through the banks and are therefore significantly less expensive than equity.
Mezzanine finance for property development
Developers may use mezzanine financing to close a gap between the amount they can obtain of ordinary debt and the equity deposit to acquire a property. Mezzanine financing allows developers to repay a lower deposit to spread equity over several development and purchase types and therefore providing a better IRR.
Types of finance
There are several types which make up the capital stack and are senior debt and equity together with mezzanine capital. They would be subordinated debt to each other with the senior lender taking priority over the mezzanine capital. You can also get lenders that provide preferred equity which allows for slightly higher leverage than traditional mezzanine lenders. In some cases you may raise the equity from an investor which would either attract equity interest or profit share or a combination of both. The lending criteria of these different types of lenders will vary depending on their risk appetite.
Why do you need mezzanine financing?
It assists in relieving pressure around business cash flow which allows for improved financial ratios across the business activities and is always a consideration when any corporate finance company is advising a borrower. In order for mezzanine finance work at its best for your company you need to ensure all the detail is on point ensuring your costs and program are in line and that the exit strategy is robust.
Is mezzanine debt risky?
Mezzanine lenders providing mezzanine finance require a higher skill in terms of loan origination and management as the risks are considerably higher which is why the interest rate is higher than that of a traditional business loan where a first charge position is taken. A senior lender is considerably less exposed than with mezzanine loans but ultimately it comes down to prudent underwriting and detailed loan management through every stage of the loan lifespan. However it is also important to note that the perceived risk of equity finance and preferred equity is even higher so those lenders need to have a more hands on approach to asset management but also have the right level of experience to make appropriate decisions.
Is Junior debt the same as mezzanine?
Junior debt term can be called mezzanine debt as it sits behind first charge debt which is also known as "senior" taking priority over the ranking of mezzanine loans within the capital stack. When you borrow money it is important to consider the bigger picture and ultimately the better return you can obtain on the equity financing the better the position will be for your business projects.
Why is mezzanine funding important?
The mezzanine capital element of the capital stack is a great tool to have in your armoury as it ultimately enables you to leverage higher, reducing the equity contribution and maximising returns which would only normally be seen by a private equity firm. Although it is a secured debt mezzanine loans give you the opportunity to spread your equity over multiple projects which leads to a higher IRR whilst preserving critically important working capital.
How to mezzanine funds make money?
Mezzanine finance attracts a higher interest rate, due to its inherent risks but if originated and managed prudently can provide good returns to those mezzanine debt lenders. They normally charge arrangement fees at drawdown together with exit fees aswell as the annual rate of circa 15-30%. The mezzanine finance will have cost of funds which is paid to investors and the difference between what the mezzanine finance receives and pays out will be the gross profit before operating costs. The interest only payments are rolled and normally compounded which further enhances the returns of the mezzanine finance providers. Although on paper the returns can look very good the effort required to protect that mezzanine capital is considerable and hence why the cost of a very experienced team is a significant part of the margin.