Mezzanine Loan: What Is It? – Definition & Overview

Loans help companies to make decisions and resolve current affairs.

Usually, companies take loans to process current activities. That needs money like adding equipment to the building.

Because they do not want to use their capital. But some companies plan to increase their capital by taking a loan.

In such a case, a mezzanine loan is the best option. As it helps organizations to generate revenue and boost capital.

Want to know the best part?

You can get the maximum returns on mezzanine loans. To be precise you can get a benefit of 12 to 20% per year.

In addition, this return amount can be increased up to 30%. Isn’t it amazing?

Therefore, companies prefer to make mezzanine loans. When they want to expand their business on a large scale.

But these loans come with some risks. You might be wondering what are the risks that mezzanine loans have.

No need to worry. Because, in this article, we will tell you all the important features of mezzanine loans.

Also their advantage and disadvantages.

Moreover, we will tell you the working of mezzanine loans.

So let’s start the discussion!

What Is Mezzanine Financing?

Mezzanine Financing

It is a non-traditional form of financing. Mezzanine financing fills the gap between equity and senior debt in the company.

It can have the structure of unsecured debt and or preferred stock.

Also, a mezzanine loan gives investors an option to convert to equity interests.

The main purpose of mezzanine financing is to grow more funds for business expansion.

Here’s the kicker:

Here lenders provide subordinated loans. And potentially they receive equity interests too.

In addition, as compared to other loans. Mezzanine loans have flexible payment terms and high-interest rates.

Usually, when a business needs funds to grow the business. Lenders hesitate to all the money that is needed.

Therefore, with creative financing like a mezzanine loan, gaps can be filled.

Want to know more:

These loans are attached with the embedded equity instruments called warrants.

Such instruments increase the value of subordinated debt. And provide high flexibility when working with bondholders.

Moreover, mezzanine loans are associated with buyouts and acquisitions frequently.

Therefore, in case of bankruptcy. They can be used to prioritize new owners more than existing ones.

Following are the reasons for the gap between equity financing and senior debt:

  • Fixed assets, inventory, and accounts receivable are discounted at a higher rate.
  • Due to fear of non-recognition of their original value.
  • On balance sheets, there is a huge volume of intangible assets are recorded.
  • Banks put militias on the total debt amount that a business can obtain.
  • So that they can address the rise in regulatory pressure and defaults.

Also Read: Sezzle Review: Buy-now, Pay-later App For Online Shopping

How Mezzanine Financing Works:

Mezzanine Financing Works

A mezzanine loan is the riskiest form of debt. But it works as a bridge to fill the gap between equity financing and debt.

Because these loans are hybrid to both equity and loan. They depend on how events unfold and the terms of the agreement.

So that they can arrange to provide an equity interest to lenders.

This loan is subordinate to pure debt and senior to pure equity. However, it still manages to give the highest rate of returns as compared to other debt types.

Therefore, it usually receives a rate between 12 and 20% per year and the highest rate is 30%.

Companies take mezzanine loans when they want to grow their funds and expand a business. Long-term investors and funders of the capital of the company give these loans.

Following are some characteristics of the structure of mezzanine loans.

  • These loans are subordinate to senior debt.
  • But still, they have priority over common and preferred stock.
  • Mezzanine loans have higher yields than ordinary debt.
  • These loans are unsecured debts.
  • They do not have the amortization of the loan principal.
  • It has a structure of both variable and fixed interest.

Here’s the deal:

Mezzanine loans only work with companies that have a successful track record.

Repayment And Interest:

As compared to traditional loans, mezzanine loans have higher costs. They come with double digits interest rates.

And lenders can demand equity exposure so that they can supplement interest income.

Borrowers may have multiple options for repayment. According to the terms of an agreement.

Companies usually, take mezzanine loans. If the cash flow is not available or if they want to reinvest money instead of paying interest.

Subordinated Loans:

When borrowers go bankrupt, mezzanine debt has a lower priority than senior debts.

To generate cash and pay off debt, it may need to sell assets like equipment and buildings, if the business fails.

If still there is not enough money, then creditors get in line. Senior bondholders and banks are near the front of the line.

So that they can receive payments in a liquidation. Mezzanine loans are above equity but they are farther back in priority.

Advantages of Mezzanine Financing:

Mezzanine Financing

Here are some advantages of taking mezzanine loans. have a look at them to know why you should take them.

1. Boost Total Capital:

Mezzanine loans help in increasing the capital. And allow the company to expand itself.

These loans have flexible payments terms. And high interest rates as compared to other loan types.

It is a long-term loan, and only long-term investors can give mezzanine loans.

The best thing about mezzanine loans is that. You can get the desired amount of money without any collateral.

Also, on the balance sheet, mezzanine financing comes as equity.

Therefore, it enables borrowers to lower the levels of debt. And qualify for the other financing types easily.

2. Increase In Equity Returns And Reduction Of Capital Cost:

Capital Cost

The costliest source of capital is equity because it dilutes the current shareholders.

Therefore, for accessing the much-needed capital. Mezzanine debt is an attractive alternative to all other loans.

Companies use an efficient combination of mezzanine debt, equity, and senior debt.

So that they can reduce the cost of capital and the assets rate of return.

In addition, borrowers can minimize their equity dilution. Instead of trading enough amount of equity for capital.

Also, borrowers can take the money more than what traditional banks lend.

Moreover, if borrowers want. They can pay interest charges with cash, or give equity-like instruments to lenders.

And can add these charges to the loan balance.

3. Safe And Attractive Investment:

The investors of mezzanine loans get the benefits of equity investment. In the form of a diverse portfolio and high returns.

The mezzanine investors can practice the equity option. And get the benefits if the borrowing company becomes successful.

Moreover, the mezzanine investors can get at least the interest payment. Even in the worst case.

The investors that take mezzanine loans can take more benefits. Then the people who do traditional financing.

Because interest payment may be deductible to the organization.

4. Warrant Option:

Mezzanine loans come with convertible equity options or warrants.

The investor can practice these warrants to earn a company’s stake. According to the specified date or the event in the agreement.

An investor can exercise the rights.

Disadvantages of Mezzanine Financing:

Disadvantages of Mezzanine Financing

Here are some disadvantages of mezzanine loans. So have a look at them and decide whether you should take a mezzanine loan or not.

1. High Risk:

Investors give mezzanine loans with collateral. Also, the investment yields a good output but the projects are risky.

The investor will face a huge loss on the investment if somehow the company goes bankrupt.

2. Long Time Wait To Get Return On Investments:

Investments

Usually to increase the capital company takes mezzanine loans. This is a time taking process as you can not boost the capital in a short time.

Also, investment takes time to produce a good output. Therefore, mezzanine loans are not for investors who want to make money in a short time.

In addition, mezzanine loans are only given to those investors. Who agrees with a long-term process.

3. Failure Probability:

You can easily take a mezzanine loan. Because they are easily available at different interest rates.

But in case if the project crashes, the creditor will have to pay back all the money with interest. This can make the creditor bankrupt.

4. Potential Loss Of Freedom And Control:

Loss

Investors sacrifice their control and freedom when they take a mezzanine loan. Because equity conversion is a possibility in most cases.

In addition, when investors practice equity options. It usually results in triggering a negative reaction and in dilution of EPS.

Wrapping It All Up!!

That’s all folks. In conclusion, we will say that you should learn about mezzanine loans before you apply for them.

Also, make sure your company is making a huge benefit. So that if in some cases, your project crashes you will not go bankrupt.

In addition, try to take loans from the best long-term investments. That gives you mezzanine loans on low-interest rates.

Because this will help you return the loan amount easily. The reason why companies prefer to take a mezzanine loan is that it gives high rates of return.

So make sure you invest the amount in the right project and you are sure that project will make a profit.

To do this you need to make a good financial plan.

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