Speed read:
- Mezzanine operations are a way for companies to raise funds for specific projects. Mezzanine constructs are normally a hybrid of debt and equity.
- Mezzanine lending can occur via mezzanine funds which pool the funds from investors with the aim to finance highly qualified businesses.
- This type of financing can provide more generous returns to investors compared to typical corporate debt, often paying between 12% and 20% a year.
- Mezzanine loans are most commonly utilized in the expansion of established companies rather than as start-up or early-phase financing.
- Both mezzanine financing and preferred equity are subject to being called in and replaced by lower interest financing if the market interest rate drops significantly.
Traditional mezzanine financing involves investors seeking to deploy junior capital. Most often, the purpose of the transaction is to finance buyouts, acquisitions, or an acceleration of business expansion of existing establishments with a given track-record.
Mezzanine investors tend to make subordinated loans to lower-middle-market and upper-middle-market borrowers and generate most of their return from current cash pay coupons in excess of 10%. These funds also generate returns from prepayment penalties and paid-in-kind (PIK) interest, although to a much lesser extent than funds pursuing capital appreciation strategies.
Mezzanine investors can also capture equity appreciation through a combination of debit and equity (most often geared-up with warrants and options). In these circumstances, compliance on documentation is key; constrains can occur by specific demands of equity owners and senior lenders. Pricing frequently is another key issue as more complex projects may have lock-up periods of multiple years (usually 8-10 years) during which only very limited liquidity is available.