Businesses require money for their daily expenses, loan repayment, payroll, purchasing assets, and other reasons. Most businesses get some money from the banks and they usually have to provide collateral for these bank loans. These bank loans are secured senior debt, which is given a high priority for repayment. In other cases, the business owner may not have enough assets to get a bank loan. In this case, the business owner may raise funds by offering others a stake in the business. This stake in the business is in the form of equity, and the investor is given shares in the business. If the business is making a profit, the investor will get a dividend.
Let us define Mezzanine financing in simple words.
Mezzanine financing is a cash flow based finance where mezzanine fund (investment fund, lender) invests in the company for acquisitions, growth, recapitalization, or management/leveraged buyouts. Mezzanine financing is a hybrid of debt and equity that ranks below senior debt but above common stock in a capital structure.
In some cases, the business does not have enough assets to get a secured loan and the business owner does not want to give others an equity stake in the business, reducing his control over the business. In this case, he can raise capital using Mezzanine debt, which is typically not secured using the assets of the business. The company can raise Mezzanine debt if the business can prove that it is generating enough free cash flow (FCF) from its daily operations, to repay the debt. Most businesses are receiving cash payments from their customers for the products or services they sell. The FCF is the cash flow of the business after deducting its cash expenses like salaries, business expenses, rents.
Many growing businesses require funds or capital for a new acquisition or project which will help their business grow faster. They will usually approach the bank for a loan for the amount. However, banks are conservative lenders and they will usually only lend to the business against the assets which it has. In case the business is unable to repay the loan the bank can seize the assets, and sell them to recover the loan amount. This makes lending with assets as collateral less risky for the bank. However, if the business cannot raise the amount required for the new project, the alternatives are equity and mezzanine debt.
Mezzanine debt and Equity disadvantages
There are many disadvantages of issuing equity shares in a business to raise capital for the business owner. The business owner will be now accountable to the shareholders of the business, who now own part of the business. He may have to provide them information about the business, including confidential information. They may question the decisions of the business owner. In some cases, if these shareholders have a large stake in the business, they may sell their stake to business rivals, who may take over the business. Hence instead of losing control of the business, the business owner should consider mezzanine debt for a business with stable FCF.
Mezzanine debt and applications
Most businesses are able to predict the cash flow for their business since the source of revenues is usually known. The mezzanine debt are the funds which the business obtains against the FCF. Typically mezzanine debt is used for acquisitions, business expansion projects, and other recapitalizations. In some cases, the management of a business may wish to take over the business from the owner for a management buy out (MBO). In other cases, investors may borrow money to acquire a business in a leveraged buy out (LBO). For both LBO & MBO, the mezzanine debt can be considered for fundraising.
Mezzanine debt and cost
The mezzanine debt for a business is usually more expensive than the senior debt due to the bank but will cost less than equity. Typically the cost for this kind of funding is between 13% and 25%. Banks who are given higher priority for repayment of their loans will usually consider mezzanine financing for a business similar to equity when they calculate the debt owed by the business to which they have given loans. For repayments, the mezzanine debt is given lower priority when compared to the repayment of the senior bank debt. However, this mezzanine debt will be repaid first, before any payments are made to those who have any equity in the business.
Mezzanine debt and payment preference
The preference of payment to all those who provided funds for a business should be understood. Usually, bank loans get top priority for repayment, followed by mezzanine lenders, preferred shareholders, and the common shareholders. Organizations, individuals involved in LBO, MBO should understand the repayment sequence. Since the non-repayment risk increase for organizations with lower priority, the interest rate for mezzanine debt is higher.
Some trading companies can raise funds using Mezzanine financing as well.