A specific form of financing, mezzanine financing can be structured as debt or as preferred stock. Used by companies seeking unsecured financing, it is a more expensive form of acquiring (debt) capital.
Due to the higher cost of the financing, and the typically large amounts invested, mezzanine financing is most often handled through specialized lenders who are familiar with the exacting requirements mezzanine lenders expect.
To compensate for the high level of risk involved, mezzanine lenders look for a higher return (typically 14 to 20%). To offset the full interest cost of the loan, the borrower and the lender work together to structure a payment plan that includes a variety of methods.
Cash interest: As in any investment, a borrower has to cover all periodic interest payments based on the balance of the investment. This interest payment can be based on either a fixed or a variable rate over the life of the investment.
Payment in kind (PIK) interest: This payment method involves no cash payments during the course of the investment, but increases the amount of the principal by the amount of the interest.
Ownership: In addition to interest payments, an ownership feature (in a form of a warrant) is usually included in a mezzanine financing contract.
These methods of payment effectively defer compensation until the investment due date, or until the company changes hands.
Mezzanine financing can be used effectively during leveraged buyouts, when private equity funds want to minimize the amount of capital being invested. It can also be used by real estate developers who want a faster and less expensive means of securing financing.
In the event of default of a company, mezzanine investors would be repaid after all of the senior financing types are paid. This higher level of risk is one of the reasons why mezzanine investors require such larger interest payments (than senior debt). In addition, mezzanine investors typically invest with very little due diligence, and complete the investment quickly. A company seeking investment by a mezzanine investor should have a proven track record in the industry and have a history of profitability.
Mezzanine financing is not for every investor, nor is it the solution for every company seeking investors. When it works, however, the benefits to both investor and company can be substantial.