Corporate Finance
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Debt Financing
Mezzanine (Subordinate Debt) Financing
A mezzanine (or subordinate debt) loan is a hybrid facility that falls between senior debt and equity on a company’s balance sheet. Structurally, it is subordinate in position to senior debt, but senior to preferred or common stock.
Although mezzanine debt typically makes up only a small percentage of a company’s total debt, it has become extremely critical to many middle-market companies in recent years, because it can often determine whether or not a transaction closes. For example, many asset-based loans only finance a portion of the transaction’s total price, and equity may not be available to finance the remaining need. Mezzanine debt can be used to fill the hole.
Typically, mezzanine facilities include both debt and equity components. In addition to a higher interest rate, which compensates for the additional risk that the subordinate lenders are taking on, mezzanine lenders are often granted warrants to buy common stock, which the lender values based on the outlook of the company, or incremental interest paid on a paid-in-kind or “PIK” basis. The use of a PIK is becoming more and more prevalent as company valuations have grown more complex and subjective, especially when dealing with private companies.
Mezzanine debt is more flexible than senior debt. It typically shares the same covenant package as senior bank debt, but the terms are generally looser. For example, a bank may limit its maximum leverage to three times EBITDA, but a mezzanine facility may allow four times.
Mezzanine debt is typically used to fund growth opportunities such as acquisitions, new product lines, expansion through new distribution channels, or plant extensions.
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