What Does Mezzanine Fund Mean?
A mezzanine debt fund is a financing procedure that is a mix of equity and debt together. It’s a type of financial arrangement that gives the lender an option to convert the debt into equity on certain terms and conditions specified and agreed upon by both parties. This pool of capital invests in mezzanine debt opportunities such as capital for organic growth, acquisitions, recapitalizations or management buyouts. As a comparison, a private equity fund will provide capital to a company in the form of equity.
This type of financing is used when there is a need for expansion for an existing organization. The main idea of raising the mezzanine debt fund is to lower the risk of losing capital assets and equity. This kind of fund is generally provided by a venture capital company and the senior debt lender of the organization. In this type of fundraising, the borrowers get the funding very easily with little or no due diligence and the lender provides the fund with insignificant collateral securities.
Mezzanine loans often give the mezzanine fund lender a chance to convert to equity if the agreed amount of the loan is not paid back within the stipulated time period or terms.
Divestopedia Explains Mezzanine Fund
Mezzanine debt is the middle layer of capital that falls between secured senior debt and equity. This type of capital is usually not secured by assets, and is lent strictly based on a company's ability to repay the debt from free cash flow.
Mezzanine debt funds are mainly used to fund an opportunity for growth such as mergers and acquisitions (M&A), a new sale process or products, an expansion of production facilities, or other growth activities. In mezzanine funding, the ratio between equity and debt is calculated first by evaluating the expected revenue from the growth and the costs to be incurred.
Mezzanine financing bridges the gap between senior debt funding and equity funding. The reasons why such a gap may exist are as follows:
- There is a chance of not realizing the appropriate amount due to accounts receivables, fixed assets and inventories. This is why they are discounted at greater rates than in the past.
- There may be a significant amount of intangible assets in the balance sheet.
- Due to regulatory pressures, most of the banks have put a ceiling on the amount of debt capital lending allowed.
Mezzanine funds earn a return on investment in three ways: cash interest, equity ownership or interest that is payable in kind (PIK). Cash interest is an agreement where cash is paid back to the mezzanine fund in periodic installments. PIK is a form of interest that is not paid in cash, but added to the total balance of the principal, thereby increasing its value. The final form of interest is through equity ownership of a company at the end of the stipulated period or in the case of a default. Regardless of which type of return is chosen, mezzanine funds are targeting an overall return of investment between 13 and 25 percent.
To reduce the true cost of capital and to earn a higher return from using debt funds, companies that are properly established and have goodwill in the market follow some capital structures. Many companies that have good capital structures earn between 5-12 percent from their senior debt funds, 13-25 percent from mezzanine funding and more than 25 percent from their equity funding. This is done because it is generally seen in leveraged financing that the true cost of capital is low and the percentage earned on equity is high when there is a hybrid financing of capital for growth opportunities for existing firms. Since a lender asks for about a 15 percent return, whereas an equity holder asks for 25-30 percent, this is a method of cost control and increasing the return on equity.
Mezzanine loans can often be converted to equity if the agreed amount of the loan is not paid back within the stipulated time period or terms. There is a reasonable protection for the fund in its investments unless the company itself files for bankruptcy. Even in such a case, mezzanine fund holders get precedence over equity shareholders during the liquidation process.