Mezzanine financing

Mezzanine financing is a type of finance often used in property deals and complex transactions such as management buy-outs. It’s a hybrid of debt and equity funding where you use your shares as ultimate security for money borrowed. The finance starts off as a loan then may convert to equity at a certain point.

This guide explores how mezzanine finance works so you can decide if it’s right for your business.

What is mezzanine finance?

Mezzanine finance is a type of debt that ranks behind senior debt in in payment priority if a company becomes insolvent, but ahead of trade creditors like suppliers as well as shareholders.

Mezzanine lenders sometimes take share warrants entitling them to participate in your company’s equity and thus receive dividends and benefit in any increase in value of your company.

Typically, you will only repay the principal amount of mezzanine debt after you’ve repaid all senior debt. To compensate for their subordinate position, mezzanine lenders will charge you a higher rate of interest and/or take an equity stake in your company.

When is mezzanine finance used?

Mezzanine finance is sometimes used in complex deals like management buy-outs (MBOs) or mergers and acquisitions. These deals are often ‘leveraged’ meaning that the borrowings are secured by assets or shares in the target company. For more information, read our article on leveraged acquisition finance.

Mezzanine finance is subordinate to senior debt and is often used to fill a funding gap where a borrower needs more than senior lenders are prepared to offer.

How does mezzanine debt differ from senior debt?

Mezzanine debt is more expensive than senior debt, mainly because it comes with a higher risk of not being repaid. In addition, as we’ve seen, mezzanine lenders often ask for an option to convert their debt into equity.

How is mezzanine debt repaid?

You don’t pay mezzanine finance in instalments, but the debt becomes due after a certain period has elapsed. This gives you some breathing space to concentrate on using capital to grow the business. Mezzanine loans are often repaid from cash-in-hand, where your business has expanded to the point that you can make capital payments out of current earnings, through a refinancing or through a sale of the company.

What type of interest is payable under mezzanine financing?

As a borrower, you may pay interest on your mezzanine loan, or you may make ‘payment-in-kind’ (PIK) interest. PIK interest is where you don’t pay interest in cash, but outstanding interest is added the principal amount borrowed. Two forms of PIK interest are ‘pay-if-you-can’ interest and ‘pay-if-you-want’ interest.

Pay-if-you-can interest adds the outstanding amount of interest to the principal amount of the loan if your company doesn’t meet set KPIs. This enables you to preserve your cash flow.

Pay-if-you-want interest gives you the option of converting cash interest into PIK interest. For further information read our article on PIK debt.

What kind of protections will a mezzanine lender seek?

In addition to security, mezzanine lenders may seek the right to appoint an observer to your board of directors. The observer will typically not have voting rights but will report back to the lender on how the board of directors is managing your company.

What is warrantless mezzanine finance?

Historically, mezzanine lenders would require a performance-related reward that give the lenders the right to subscribe for shares at the time of a sale or IPO. However, share warrants are now only common in mid-market and smaller deals. Many modern mezzanine lenders are institutional investors who do not require warrants.

If warrants are used, a warrant instrument will specify when and how the warrants may be exercised. Typically, they can be exercised on an IPO, company sale, liquidation or change of control (a ‘relevant event’).

Normally, you need to tell warrant holders of the relevant event and this notification will trigger the right to exercise the warrants.

Warrant instruments may grant a lender a fixed number of shares, or they may require a certain percentage of your share capital. Lenders often prefer the latter, as it guarantees that their shareholding isn’t diluted.

What are the key issues for mezzanine finance?

Senior lenders will want to ensure that they are repaid before mezzanine lenders. The priority of senior loans can be achieved through loan documents that make sure they’re paid first.

Senior lenders will also want to restrict mezzanine lenders from amending the mezzanine contractual documents, for example to increase the interest rate payable, as this could put financial strain on your business and impact your ability to make payments on the senior loan.

They may also want to restrict the ability of mezzanine lenders to waive what would otherwise be a breach of the lending conditions. They may also reserve the right to block payments to mezzanine lenders, if certain events occur.

Mezzanine lenders on the other hand will want to prevent senior lenders from taking additional security or guarantees. They may also wish to prohibit increases in the principal amount of the loan, the interest rate or repayment conditions to protect their position.

Why use our mezzanine finance solicitors?

Our banking and finance solicitors have advised borrowers who have used mezzanine finance, and can help you achieve a smooth transaction.

We regularly give legal advice throughout all stages of a transaction to a wide range of clients, including investors, arrangers and finance companies.

We offer expert advice on financing for private acquisitions, asset purchases and takeovers.

Our finance solicitors will also work closely with our corporate and tax teams to cover all aspects of your deal, so you won’t need to use a range of different advisors for your mezzanine deal.