Mezzanine Debt: What is it, Uses, Benefits,
Risks and Example
First things first
To understand mezzanine debt, you first need to grasp the concept of alternative investments, which I will explain shortly. However, let’s first understand the differences between traditional investments and alternative investments.
Basically, investments are divided into two parts, i.e., Traditional investment and alternative investment.
Traditional investment refers to investment in stocks, bonds, and cash, while all other investments, excluding stocks, bonds, and cash, are known as alternative investments.
Alternative investments are divided into three parts:
- Private Capital
- Real Assets
- Hedge Funds
Let’s dive a little deeper, and we will reach our concept of mezzanine loans.
Private capital investment means investing in:
- Equity of private companies or in public companies that want to become private.
- Debt provided to private entities.
So, mezzanine debt falls under the category of Private debt, which is provided to private entities. Private debt includes:
- Direct lending
- Mezzanine loans
- Venture debt
- Distressed debt
Definition and Characteristics
Mezzanine loans combine elements of both debt and equity. Positioned between senior debt and equity in a company’s capital structure, this means it can claim its money after senior debt holders but before equity holders during bankruptcy. However, this positioning also implies that this instrument can yield more returns compared to pure debt.
It typically takes the form of subordinated debt, preferred equity, or convertible debt. Subordinated debt ranks below senior debt in terms of priority during bankruptcy or liquidation, while preferred equity gives investors certain preferential rights over common equity holders. Convertible debt allows lenders to convert their debt into equity under specified conditions.
Uses and Benefits
Mezzanine debt is often used:
- To acquire other businesses.
- For funding expansion projects.
- To support other strategic initiatives that might not be possible with the current capital structure.
Benefits include:
- Maintaining ownership control and avoiding immediate dilution.
- Providing business owners with a source of capital when it is challenging to raise funds or secure senior debt.
- Not requiring business owners to sell shares of their company, thereby helping maintain ownership control.
Risk and Return Profile
Mezzanine debt carries higher risk than senior debt but less than equity. During a company’s bankruptcy, mezzanine debtholders receive their funds after senior debtholders but before equity holders. Mezzanine debtholders receive a higher interest rate than senior debtholders because they are taking higher risks and can also participate in equity.
Example
Play Monster Co. is the designer and manufacturer of toys and games for children, including puzzles, preschool toys, creative activities, etc., distributed throughout the US and UK.
In June 2021, the company raised an undisclosed amount of mezzanine debt from Patriot Capital and Spring Capital Partners. The company also received $9 million of debt financing from WhiteHorse Finance. The funds were used to support the acquisition of Ann Williams Group.
