What Is Mezzanine Debt (Explained: All You Need To Know)

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What is Mezzanine Debt?

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What Is Mezzanine Debt

Mezzanine debt refers to a type of debt issue that is subordinated to another debt instrument issued by the same company.

Also, when subordinated debt is issued, the bondholders will also obtain some warrants representing an embedded debt issue.

In essence, mezzanine debt is subordinated to pure debt instruments issued by the same company but senior to equity securities.

Mezzanine debt allows companies to provide investment instruments that are in between pure debt instruments and pure equity instruments thus giving investors with greater investment flexibility.

Those who invest in subordinated debt are attracted by the higher returns offered by subordinated debt since they are riskier than pure debt instruments.

Quite often, mezzanine debt is used in the context of mergers, acquisitions, and buyouts where the company offers a hybrid debt issue to satisfy different stakeholders and investors.

Keep reading as I will further break down the meaning of mezzanine debt and tell you how it works.

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Why Is Mezzanine Debt Important

Mezzanine debt is important as it is a type of debt issue that is subordinated to pure debt but senior to equity.

In other words, companies use mezzanine debt to provide an investment option where the investor takes more risk than investing in pure debt instruments and getting a higher return but is not providing equity financing.

To attract investors when issuing subordinated debt, companies will typically provide the debtholder certain rights to obtain equity securities offering warrants, call options, or rights.

As a result, although the debt is subordinated to other debt issued by the company, the investor’s ability to convert warrants, rights, or call options into equity securities makes the investment attractive.

Mezzanine debt can be quite effective for companies that are able to optimize their capital structure to fund their business.

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When Is Mezzanine Debt Used

Mezzanine debt can be used in a variety of situations.

The most common scenario when mezzanine debt is used is in the context of leveraged buyouts.

In leveraged buyouts, companies will use mezzanine debt to fill the financing gap between less expensive forms of financing and equity.

This way, the company can access the required amount of capital it needs for the buyout and is able to keep the cost of capital as low as it possibly can.

Mezzanine debt is also heavily used in real estate financing projects by developers.

Generally, when the equity requirement for a construction project is more than 10%, companies will use mezzanine debt to bridge the gap between the loan offered by the bank and the money they need to put up front.

Mezzanine debt can also be used in the context of mergers and acquisitions (M&A), buyouts, or to fund large investments.

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Mezzanine Debt Example

Let’s look at an example of how a company can use mezzanine debt to finance its operations.

Imagine that a company is looking to purchase equipment allowing it to modernize and automate its production of goods.

The equipment will cost the company $20 million.

The company goes to the bank to obtain a loan to purchase this equipment and can only secure 60% of the value of the purchase ($12 million).

Since the company needs another $8 million to be able to purchase the equipment and it does not want to dip into its retained earnings or cash for that amount, it decides to issue debt to mezzanine investors.

In essence, the company issues subordinated debt for a total of $6 million allowing it to raise the $18 million using debt. 

The remaining $2 million will then come from the company’s retained earnings.

However, the mezzanine investors receive warrants convertible into common shares in the event the company meets certain requirements.

In this example, the company was able to use mezzanine debt to finance its business operations without having to issue shares upfront or have to come up with the entire $8 million in equity.

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Mezzanine Debt Meaning FAQ

Why do investors invest in mezzanine debt?

The main reason why investors invest in mezzanine debt is that they are able to acquire debt instruments that behave like equity.

In essence, they are providing debt subordinated to another debt issuance but with a “kicker” such as warrants, call options, or rights allowing them to purchase equity in the future.

Mezzanine debt also provides investors with a higher rate of return compared to pure debt.

Why do companies use mezzanine debt?

Although mezzanine debt is more costly than pure debt instruments, companies can use mezzanine debt to bridge the gap between equity and senior debt.

The main advantage of mezzanine debt is that it reduces a company’s need for equity allowing the company owners to maintain their ownership in the business and get the financing they need.

Also, mezzanine debt can also be cost-effective in consideration of the company’s unique capital structure.

How is mezzanine debt structure?

Let’s look at a typical example of how a company can use mezzanine debt to finance its operations.

Let’s say that a company is looking to acquire another company for $100 million.

The company is able to raise $80 million in pure debt from financial institutions and will be required to put in $20 million of its own funds.

However, the company does not want to use up $20 million for this transaction.

It issues mezzanine debt to investors allowing it to raise another $15 million.

This way, the company’s equity investors put up $5 million, mezzanine investors $15 million and the bank $80 million.

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Takeaways 

So there you have it folks!

What is the meaning of mezzanine debt?

In a nutshell, mezzanine debt refers to a capital structure where a company has debt subordinated to other debt issuance.

This means that the company has debt subordinated to another debt issuance but senior to common shares.

The idea is to use mezzanine debt to bridge the financing gap between equity capital and pure debt capital.

Companies use mezzanine debt to make large investments, purchase real estate assets, acquire other companies, merge with other companies, or fund any other business transaction.

For investors, mezzanine debt is attractive as they can earn higher rates of interest compared to pure debt and have the potential of converting certain rights, warrants, or options into equity securities.

Now that you know what mezzanine debt is all about and how it works, good luck with your research!

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