One of the fastest-growing areas of funding, development finance can often appear complex. Developments can range from land purchases and ground upbuilds, through to heavy and light refurbishments and mezzanine loans.

Mezzanine financing bridges the gap between debt and equity financing and is one of the highest-risk forms of debt. It is senior to pure equity but subordinate to pure debt. However, this means that it also offers some of the highest returns to investors in debt when compared to other debt types, as it often receives rates between 12% and 20% per year, and sometimes as high as 30%. Mezzanine financing can be considered as very expensive debt or cheaper equity, because mezzanine financing carries a higher interest rate than the senior debt that companies would otherwise obtain through their banks but is substantially less expensive than equity in terms of the overall cost of capital. It is also less diluting of the company’s share value. In the end, mezzanine financing permits a business to more capital and increase its returns on equity.

Companies will turn to mezzanine financing in order to fund specific growth projects or to help with acquisitions having short- to medium-term time horizons. Often, these loans will be funded by the company’s long-term investors and existing funders of the company’s capital. In that case of preferred equity, there is, in effect, no obligation to repay the money acquired through equity financing. Since there are no mandatory payments to be made, the company has more liquid capital available to it for investing in the business. Even a mezzanine loan requires only interest payments prior to maturity and thus also leaves more free capital in the hands of the business owner.

Mezzanine financing typically matures in five years or more. However, the maturity date of any given issue of debt or equity is frequently dependent on the scheduled maturities of existing debt in the issuer’s financing structure. Preferred equity generally does not have a fixed maturity date but may be called by the issuer as of some date after its issue. Redemption is usually exercised to take advantage of lower market rates to call in and re-issue debt and equity at lower rates.

Advantages

Mezzanine financing may result in lenders—or investors—gaining immediate equity in a business or acquiring warrants for purchasing equity at a later date. This may significantly increase an investor’s rate of return (ROR). In addition, mezzanine financing providers are scheduled to receive contractually obligated interest payments made monthly, quarterly, or annually.

Borrowers prefer mezzanine debt because the interest they pay is a tax-deductible business expense, thus substantially reducing the actual cost of the debt. Also, mezzanine financing is more manageable than other debt structures because borrowers may move their interest to the balance of the loan. If a borrower cannot make a scheduled interest payment, some or all of the interest may be deferred. This option is typically unavailable for other types of debt.

In addition, quickly expanding companies grow in value and may restructure mezzanine financing loans into one senior loan at a lower interest rate, saving on interest costs in the long term.

As an investor, the lender often receives an incentive an additional equity interest or option to obtain such interest (a warrant). Sometimes, if the venture is highly successful, the little add-ons can end up hugely valuable. Mezzanine debt also generates a much higher rate of return, important in what is still a low interest rate environment. Mezzanine debit also offers guaranteed periodic payments in contrast to the potential but not guaranteed dividends offered on preferred equity.

Disadvantages

When securing mezzanine financing, owners may sacrifice some control and upside potential due to the loss of equity. Lenders may have a long-term perspective and may insist on a board presence. Owners also pay more in interest the longer the mezzanine financing is in place. Loan agreements will also often include restrictive covenants, limiting the ability to borrow additional funds or refinance senior debt, as well as establishing financial ratios the borrower must meet. Restrictions on pay outs to key employees and even owners are also not uncommon.

Mezzanine lenders are at risk of losing their investment in the event of the bankruptcy of the borrowing company. In other words, when a company goes out of business, the senior debt holders get paid first by liquidating the company’s assets. If there are no assets remaining after the senior debt gets paid off, mezzanine lenders lose out.

Finally, mezzanine loan debt and equity can be tedious and burdensome to negotiate and put into place. Most such deals will take three to six months to finalize the deal.