Mezzanine financing is an interesting option for investment that can provide you with a new instrument for your portfolio. "Mezzanine" is a word of Italian origin that refers to a middle portion of architecture. When it comes to finance, the term refers to financing that is halfway between equity (stocks) and senior debt (senior bonds). I will explain what all of that means later on, but for now, the key thing to know is that mezzanine investment is a little riskier than many other forms of investment and carries less legal protections for you, the investor.

Deciding to Invest in Mezzanine Debt

There are a lot of reasons to invest in mezzanine debt. Although this type of investment is only for seasoned investors, one of the main advantages for investing in this type of debt would be because it offers a much higher return than a typical investment. Mezzanine investors will often get higher yields than the typical equity investor. Moreover, they also have a higher position on the totem pole than an equity investor. For example, they will usually get paid on their investment before an equity investment. In this regard, as long as you thoroughly understand the nature of a mezzanine investment, you can minimize your risk. Finally, it is important to remember that mezzanine investors usually do not benefit from the upside returns that equity investors do.

Mezzanine Debt Compared to Stocks and Bonds

In general, when a business needs financing for an expansion, project or other other reason, there are two methods available. It can sell bonds, which is equivalent to taking out loans; or it can sell equity, which are its shares. From an investor's perspective, equity is more volatile because you buy it at one point and sell it at another, so your return will depend partly on market forces and how they affect the price of the stock. Stocks also provide higher returns. Bonds offer less returns but are more reliable, because they entitle you to regular payments for as long as you hold the bond until it matures.

Mezzanine loans are debt, just like bonds. They are junior to most bonds, which means that in the event of a bankruptcy, the bondholders get paid back first, then mezzanine investors, then owners of stock. Unlike bonds, mezzanine debt can be traded like a stock. This makes it more liquid as well as more risky.

Common Users of Mezzanine Financing

Most industries do not use mezzanine financing because they can get everything they need from traditional stocks and bonds. The areas where it is most common are where the companies are unable to borrow as much as they need and do not want to sell much equity. A typical example is real estate. Funding property development requires up-front investment, but banks are often unwilling to fund the whole amount for a development project. That pushes developers into the mezzanine market.

In general, when companies issue mezzanine debt, they have a set plan for how much of their financing they need from mezzanine and from stocks and bonds. It is not a haphazard process, but rather a careful compromise between stocks and bonds. Many companies would prefer to use bonds instead of any mezzanine loans. This is because they usually need to set a higher interest rate on the mezzanine loans to attract investor interest.

Mezzanine Debt in Your Portfolio

Mezzanine debt rates are higher than most loans in the bond market. This is because the company issuing the debt needs to give investors a reason to lend money to them, and this higher rate is an effective incentive. This is more costly to the company, of course. It is a sign that the company is unable to secure financing from banks, who might ask for lower rates. For example, if banks are uncomfortable with how much debt the company already has, they might not want to lend them money at the market rate for bonds. As an alternative, the company sells mezzanine debt at a higher rate.

This means mezzanine investments are different from either stocks or bonds. They involve a better rate of return because of the higher interest rate, but they also carry more risk than bonds. This is because bonds are more senior to them in the bankruptcy proceedings hierarchy, so if the company goes bankrupt, bondholders are the first in line to get their money back. Mezzanine debt holders come second.

Basic Strategies for Investing in Mezzanine Debt

Of course, there are some strategies the beginner should know in order to fully utilize this investment. First of all, they need to thoroughly study the company in order to make sure it has an established product and reputation in their given industry. They must also study the company to make sure it has a good history of profitability. Finally, most investors in mezzanine financing will want the company to provide them with a detailed synopsis that explains their plans for expansion. If the company cannot provide an organized template in this regard, then it might be a red flag that would frighten a seasoned mezzanine investor off.

In other words, mezzanine debt has higher rewards, but also higher risk than bonds. If the company does go bankrupt, you may not get your money back if there is nothing left after the company pays its bondholders. This is a notable risk. In real estate, for example, the borrower might include some language in the mezzanine paperwork describing what happens when the company goes bankrupt or the project does not work out, so be sure to read up on the nature of the risk you face. If the company cannot tell you this information, they are not a good choice. Mezzanine lending is exciting, but that is a good reason to view these investments with a cool eye.

Mezzanine debt providers offer you something between stocks and bonds, an exotic third option. It can help you add a better return to your portfolio, but be sure that you know and understand both the business and what happens in case the project does not go as expected.