What is Mezzanine Capital? The Complete Guide

Mezzanine capital is a type of financing that involves both debt and equity. It gives the lender the right to convert a loan into equity if the borrower doesn’t repay it. The unique feature of Mezannine capital is that it carries a warranty. Mezzanine capital is generally used for acquisitions and prioritises new owner's priority in case of bankruptcy. They can be a useful tool for companies with low working capital. Let’s learn the inner workings of mezzanine capital.

Key Highlights

• Mezzanine capital combines debt and equity, allowing lenders to convert loans into equity if the borrower defaults.

• Lenders levy a higher interest rate on mezzanine capital due to the high-risk nature of the investment.

• Benefits of mezzanine capital include access to funds, protection of equity ownership, improved credit ratings, and additional working capital.

• High interest rates, less control in the company, and higher priority for mezzanine lenders in case of default are some risks of mezzanine capital.

Understanding Mezzanine Capital

The term ‘mezzanine’ means middle. So, mezzanine capital is a debt whose features lie between two types of debt. Experts define mezzanine capital as a combination of debt and equity. It is a debt as it’s a loan that must be repaid. However, it is also equity because it has priority over common stock during the liquidation of a company. The key features of mezzanine capital funds include the following:

• Investments are based on cash flow
• Regular cash distributions
• Low volatility
• Downside protection
• High profits
• Warrants for the purchase of equity in property

Companies can raise mezzanine capital in several ways. They can do so by contacting a bank, private equity company or other financial organisations. Moreover, companies can offer bonds too.

How Does Mezzanine Capital Work?

When a company raises mezzanine capital, it enters into a loan arrangement with the mezzanine lender. The loan agreement will explain the loan's terms and conditions like the interest rate, due date, and collateral. Compared to banks and other lenders, mezzanine lenders are often more flexible. However, they often charge a higher interest rate than a standard bank loan. This is because mezzanine capital is a high-risk investment. In case of a liquidation, the mezzanine lender normally gets priority over other investors.

Reasons for Mezzanine Capital

Mezzanine financing is commonly used to fund companies that cannot receive bank loans. This may be due to the risky nature of the business or the absence of collateral. It can be useful in the following scenarios:

• During economic downturns or stagnant growth

• Businesses may require cash to expand their operations.

• The existing regulations make it difficult for the company to get funding in the form of equity.

Benefits Of Mezzanine Capital

Now that you know the mezzanine capital meaning and how it works, let’s look at its advantages. It offers several benefits, as mentioned below.

• Access to funds: Mezzanine capital gives firms access to funds that cannot be obtained from traditional lenders like banks.

• Expansion and growth: Companies can use mezzanine capital to expand their business operations and achieve better growth targets.

• Working capital: It can be used as working capital for a business.

• Lower the risk: Mezzanine capital may lower the risk of a company by providing additional funds during a financial collapse.

• Protects equity ownership: Mezzanine capital can help firms which don’t want to sell their equity ownership in the company.

• Improve the company's credit rating: It can help boost a company's credit rating, making it easy to get funding in future.

Risks Of Mezzanine Capital

Although raising mezzanine finance has certain advantages, there are some risks too. They are as follows.

• High interest rate: Mezzanine capital often has a higher interest rate than bank loans.

• Dilution: Mezzanine lenders usually need more equity ownership than traditional lenders.

• Less control: Mezzanine lenders generally want to influence the ways of working of a company.

Conclusion

Mezzanine capital is a type of debt that contains both equity and debt and has the features of both these instruments. Mezzanine capital benefits a company that needs funding but cannot meet the eligibility criteria of traditional lenders. It may also help businesses grow and meet their goals. However, the flip side is it has a higher interest rate than regular loans and may allow the lender to influence the company’s working. Thus, companies must consider the pros and cons of mezzanine capital before approaching a lender.

Disclaimer: This article is for informational purposes only and does not constitute financial advice. It is not produced by the desk of the Kotak Securities Research Team, nor is it a report published by the Kotak Securities Research Team. The information presented is compiled from several secondary sources available on the internet and may change over time. Investors should conduct their research and consult with financial professionals before making any investment decisions. Read the full disclaimer here.

Investments in the securities market are subject to market risks, read all the related documents carefully before investing. Please read the SEBI-prescribed Combined Risk Disclosure Document before investing. Brokerage will not exceed SEBI’s prescribed limit.