Mezzanine capital in finance refers to a subordinated debt or preferred equity instrument that represents a claim on a companys assets which is senior only to that of the Stock Mezzanine financings can be structured either as debt (typically an unsecured debt and subordinated debt note) or preferred stock Mezzanine capital is often a more expensive financing source for a company than secured debt or senior debt The higher cost of capital associated with mezzanine financings is the result of its location as an unsecured, subordinated (or junior) obligation in a companys capital structure (i.e., in the event of default (finance) the mezzanine financing is less likely to be repaid in full after all senior obligations have been satisfied). Additionally, mezzanine financings, which are usually private placements are often used by smaller companies and may involve greater overall leverage levels than issuers in the high-yield debt as such, they involve additional risk. In compensation for the increased risk, mezzanine debt holders require a higher return for their investment than secured or other more senior lenders.

Structure

Mezzanine financings can be completed through a variety of different structures based on the specific objectives of the transaction and the existing capital structure in place at the company. The basic forms used in most mezzanine financings are [[subordinated debt|subordinated notes]] and preferred stock Mezzanine lenders, typically specialist mezzanine investment funds, look for a certain internal rate of return which can come from (each individual security can be made up of any of the following or a combination thereof): * Cash interest — A periodic payment of cash based on a percentage of the outstanding balance of the mezzanine financing. The interest rate can be either fixed throughout the term of the loan or can fluctuate (i.e., float) along with LIBOR or other base rates. *PIK interest — PIK loan interest is a periodic form of payment in which the interest payment is not paid in cash but rather by increasing the principal amount by the amount of the interest (e.g., a $100 million bond with an 8% PIK interest rate will have a balance of $108 million at the end of the period but will not pay any cash interest). *Ownership — Along with the typical interest payment associated with debt mezzanine capital will often include an Stock stake in the form of attached warrant (finance) or a conversion feature, similar to that of a convertible bond The ownership component in mezzanine securities is almost always accompanied by either cash interest or PIK interest and in many cases by both. Mezzanine lenders will also often charge an arrangement fee, payable upfront at the closing of the transaction. Arrangement fees contribute the least return and are aimed primarily to cover administrative costs and as an incentive to complete the transaction. The following are illustrative examples of mezzanine financings: * $100,000,000 of senior subordinated notes with warrants (10% cash interest, 3% PIK interest and warrants representing 4% of the fully diluted ownership of the company)This is an illustrative example based on a real financing * $50,000,000 of redeemable preferred stock with warrants (0% cash interest, 14% PIK interest and warrants representing 6% of the fully diluted ownership of the company) In structuring a mezzanine security, the company and lender work together to avoid burdening the borrower with the full interest cost of such a loan. Because mezzanine lenders will seek a return of 14% to 20%, this return must be achieved through means other than simply cash interest payments. As a result, by using equity ownership and PIK interest, the mezzanine lender effectively defers its compensation until the due date of the security or a change of control of the company. Mezzanine financings can be made at either the operating company level or at the level of a holding company (also known as structural subordination). In a holding company structure, as there are no operations and hence no cash flows, the structural subordination of the security and the reliance on cash dividends from the operating company introduces additional risk and typically higher cost. This approach is taken most often as a result of the structure of the companys existing capital structure.

Uses of mezzanine capital

Leveraged buyouts

In leveraged buyout , mezzanine capital is used in conjunction with other securities to fund the purchase price of the company being acquired. Typically, mezzanine capital will be used to fill a financing gap between less expensive forms of financing (e.g., senior debt second lien loan high-yield debt and stock Often, a financial sponsor will exhaust other sources of capital before turning to mezzanine capital. Financial sponsor will seek to use mezzanine capital in a leveraged buyout in order to reduce the amount of the capital invested by the private equity firm Because mezzanine lenders typically have a lower target cost of capital than the private equity investor, using mezzanine capital can potentially enhance the private equity firms investment returns. Additionally, middle-market company may be unable to access the high-yield debt due to high minimum size requirements, creating a need for flexible, private mezzanine capital.

Real estate finance

In real estate finance mezzanine loans are often used by Real estate developer to secure supplementary financing for development projects (typically in cases where the primary mortgage or construction loan equity requirements are larger than 10%). These sorts of mezzanine loans are often collateralized by the stock of the development company rather than the developed property itself (as would be the case with a traditional Mortgage loan . This allows the lender to engage in a more rapid seizure of underlying collateral in the event of default and foreclosure Standard mortgage foreclosure proceedings can take more than a year, whereas stock is a personal asset of the borrower and can be seized through a legal process taking as little as a few months.

See also

*Private equity *Growth capital *Senior debt *Subordinated debt *Hybrid security *PIK loan *High-yield debt *History of private equity and venture capital *Private equity secondary market

References

External links

*http://www.investopedia.com/terms/m/mezzaninefinancing.asp Mezzanine Financing] *http://www.preconstructionprograms.com/real_estate/mezzanine_financing.php Additional info on Mezzanine Financing & Mezzanine Loans] *http://www.bondcapital.ca/media/pdf/Bond_Capital_Mezzanine_Finance.pdf Corporate Mezzanine Debt Primer] *http://www.attractcapital.com/glossary.html#_Toc160278569 Mezzanine capital] *http://www.attractcapital.com/mezzanine_debt.html Mezzanine debt]
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