Mezzanine is a loan instrument that sits between senior debt and equity in the capital structure. It is often used in situations where bank financing is not adequately available, thus replacing part of the equity need. Mezzanine financing shares characteristics of both equity and debt. It includes a subordinated loan component, which is complemented by some form of equity-related feature such as warrants.
Uses of Mezzanine
Mezzanine is mostly used in private equity sponsored acquisitions, management buy-outs and recapitalizations, and in financing of both organic and acquisition-led growth of individual companies. In a buy-out transaction where Mezzanine financing is involved, the instrument typically amounts to 10-30% of the total capitalization.
The main benefits Mezzanine capital provides are:
- Enhanced return for equity investors due to reduced amount of equity required in the transaction
- Fills the financing gap caused by limited access to senior debt or equity
- Minimized equity dilution for shareholders and lower cost of capital relative to equity
- Flexible financing structure, meeting the specific needs of borrowers
- Promotes growth and reinvestments of cash flows in the business via typically non-amortizing feature and use of possible PIK-interest (“capitalized interest”, “payment -in kind-interest” )
Structure of Mezzanine
Typically Mezzanine financing is structured through three components:
- Cash interest payable to the lender e.g. every six months. Typical cash interest comprises Euribor plus an agreed margin.
- Capitalized interest, which becomes payable at maturity or when the mezzanine debt is prepaid. Such capitalized interest is also known as ‘payment-in-kind-interest’ (PIK-interest).
- The third component consists of warrants or other forms of equity instruments. Warrants typically constitute right to subscribe shares of the company at a point in the future.
Mezzanine loans are generally bullet loans, i.e. payable in one amount at final maturity or at exit, whichever occurs first, and have maturities typically ranging between 5 and 8 years.
The pricing of Mezzanine capital reflects its position in the capital structure. In compensation for the increased risk, due to the weaker position relative to senior lenders, Mezzanine debt investors require a higher return for their investment than senior debt providers.
The subordination is normally executed contractually between the parties, whereby the senior lender and the Mezzanine lender sign an ‘Intercreditor Agreement’ that regulates their relationship. It is usually agreed that all claims of the bank, i.e. loan principal and interest, shall rank ahead of the Mezzanine loan. Both parties make their independent loan agreements but often the document and terms are harmonized. The covenants of the Mezzanine lender are, however, usually less restrictive than those of the senior lenders.