Companies usually incorporate two types of finance in their capital structure. These comprise debt and equity. However, companies may also receive funds from hybrid instruments. These may include features of both equity and debt finance. One of the most common types of hybrid finance comes through mezzanine financing. Therefore, it is crucial to understand what it is.
What is Mezzanine Financing?
Mezzanine financing refers to a hybrid instrument that companies use as funds. It possesses features of both equity and debt finance. Usually, mezzanine financing starts as a debt but gives the lender the right to convert the debt into equity in the future. However, it receives a lower priority than other forms of debt. Mezzanine financing also falls between senior debt and equity in its risk profile.
Specific conditions must apply to allow the lender to exercise the conversion option. Usually, a default by the borrower triggers it. The most common use for this form of financing is during acquisitions or buyouts. Some companies also use mezzanine financing for specific projects when a combination of debt and equity finance is required.
How does Mezzanine Financing work?
At its core, mezzanine financing is a type of debt. For a company, it is like a loan received from third parties. However, it includes an option for the lender to convert the debt to equity in the future. Therefore, it combines the effects of both equity and debt finance simultaneously. It usually has a higher priority over equity but is lower than debt.
Mezzanine financing comes in different forms. For example, it includes convertible bonds and preferred stock. Due to its combined features, mezzanine financing comes with a higher risk to lenders. However, it also yields a higher return on their investments. In most cases, borrowers prefer debt finance over mezzanine finance due to the lower risks and costs.
What are the advantages and disadvantages of Mezzanine Financing?
Mezzanine financing can have advantages and disadvantages for both parties involved. For the lender, it provides the additional benefit of receiving equity instruments on conversion. Similarly, it comes with a better return, allowing the lender to earn more from their investment. However, mezzanine financing is riskier due to its associated features and the lower priority than debt.
For the borrower, a crucial advantage of mezzanine financing is receiving additional finance. Usually, borrowers use this finance when debt financing is not available. Since mezzanine financing is cheaper than debt but more expensive than equity, it provides a decent alternative. However, it comes with the disadvantage of being more costly and difficult to obtain.
Is Mezzanine Financing Subordinated Debt?
Subordinated debt is a type of unsecured financing that receives a lower priority than senior debt. Due to this feature, mezzanine debt also falls under the definition. Therefore, mezzanine financing is a type of subordinated debt. It usually differs from senior debt, which receives a higher priority than equity and junior debt.
Conclusion
Mezzanine financing is a hybrid debt that includes debt and equity features. It comes with advantages and disadvantages for both lenders and borrowers. Usually, borrowers use it for specific projects and acquisitions, and buyouts. Mezzanine financing is a type of subordinated debt. It receives a lower priority than senior debt.
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