What Does Mezzanine Debt Mean?
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. It is usually a great way for growing businesses to bridge the gap between what conventional banks will lend against assets, and the total value of a new project or acquisition. A company owner should consider mezzanine debt instead of equity when the business is producing stable free cash flow, since this allows him/her to obtain financing without issuing equity and diluting the ownership of the business. Mezzanine debt can be used as a financing source for corporate expansion projects, acquisitions, recapitalizations, management buy-outs (MBO) and leveraged buy-outs (LBO).
Divestopedia Explains Mezzanine Debt
Mezzanine debt is more expensive that senior debt, but less expensive than equity. The cost for this type of financing is in the range of 13% to 25%. Senior banks usually view mezzanine financing as equity for the purpose of calculating debt covenants. This is because the repayment of mezzanine debt is subordinated to the repayment of senior debt, but ranks above any repayments to equity holders.
The preference of payment to debt holders is an important concept to understand. As a general rule, senior banks always get paid first, then mezzanine lenders, then preferred shareholders, and then common shareholders. Participants in MBO or LBO transactions need to understand their position in this repayment line-up. The risk of repayment increases as you move down the line, which is why mezzanine debt commands a higher interest rate for its holders.