Mezzanine Financing

Who Qualifies

Mezzanine lenders rely on cash flow more than collateral, so they focus on established businesses. They generally look for:

• A history of stable or growing operating profit, usually measured as EBITDA.

• Enough cash flow to cover both senior and mezzanine payments with a margin of safety.

• An experienced management team, often backed by a private equity sponsor or a meaningful owner investment.

• A believable way to repay at maturity, typically through refinancing, a sale or a recapitalization.

Early-stage companies and businesses with volatile or negative earnings rarely qualify.

The Intercreditor Agreement

When a company has both senior and mezzanine lenders, they sign an intercreditor or subordination agreement that sets the rules between them. Key terms include:

• Payment blockage. The senior lender can stop mezzanine payments if the company defaults on the senior debt.

• Standstill periods. The mezzanine lender must wait a set period before taking enforcement action.

• Cure and purchase rights. The mezzanine lender may be able to fix a senior default or buy out the senior loan.

• Lien priority. Which lender is paid first from each class of collateral.

The company is often a party to this agreement or acknowledges it, and its terms shape what happens if the business underperforms, so review it with counsel.

Pros and Cons for Owners

• Pro: less dilution. Owners give up far less ownership than with a straight equity raise.

• Pro: flexible payments. Interest-only periods and PIK interest protect cash flow.

• Pro: larger deals. Mezzanine debt can close the gap between what banks will lend and the purchase price.

• Con: higher cost than senior debt. Interest, PIK, warrants and fees add up.

• Con: more leverage. Additional debt raises the risk if earnings fall.

• Con: refinancing risk. A large balance due at maturity must be refinanced or repaid from a sale.

Frequently Asked Questions

Is mezzanine financing debt or equity?
It is usually structured as debt, but its equity features and its place below senior loans give it traits of both. That is why it is often called hybrid capital.

Who provides mezzanine capital?
Common sources include dedicated mezzanine funds, business development companies, insurance companies and Small Business Investment Companies, which are licensed and regulated by the U.S. Small Business Administration.

How long does a mezzanine loan last?
Terms commonly run several years, often longer than the senior loan, with most of the principal due at maturity.

Can a company prepay mezzanine debt?
Usually, but many agreements include a no-call period or a prepayment premium, so early repayment can cost extra.

Explore Mezzanine and Other Growth Options

Mezzanine financing can help an established company close a deal or fund a major project without giving up control. Before choosing it, compare the full cost against senior debt, seller financing and equity, and make sure your cash flow can carry the extra leverage.

Mezzanine financing is a layer of capital that sits between a company's senior debt and its equity, usually in the form of a subordinated loan with an equity feature attached. Companies use it to fund buyouts, acquisitions and large expansion projects when senior lenders have reached their limit and the owners do not want to sell a large stake to cover the gap.

Because mezzanine lenders are paid after senior lenders and often have no hard collateral of their own, they charge more than a bank. But they usually cost less than selling equity, and they leave control with the owners. This guide explains how a deal is structured, who qualifies and what to watch for in the documents.

Where It Sits in the Capital Stack

A company's capital stack ranks claims on its cash flow and assets from first to last:

1. Senior secured debt. Bank loans and asset-based lines with first liens on collateral. Lowest risk and lowest cost.

2. Mezzanine debt. Subordinated loans, often unsecured or holding a second lien, paid only after senior lenders are current.

3. Preferred equity. Ownership with priority over common shares, sometimes used in place of or alongside mezzanine debt.

4. Common equity. The owners' stake, paid last and holding the most upside.

Each layer takes more risk than the one above it and expects a higher return.

How a Mezzanine Deal Is Structured

Mezzanine loans combine several sources of return so the lender is paid for its extra risk:

• Cash interest. A fixed or floating rate paid monthly or quarterly.

• Paid-in-kind interest. Often called PIK, this interest is added to the loan balance instead of being paid in cash, which preserves cash flow during the term.

• Equity kicker. Warrants or a conversion right that let the lender buy a small stake in the company, giving it a share of the upside.

• Fees. Closing fees and, in many deals, prepayment premiums if the loan is repaid early.

Terms typically run longer than the senior loan, with little or no principal due until maturity. The all-in cost generally lands between senior bank debt and equity.

A Worked Capital Stack Example

A hypothetical buyer wants to acquire a company for $20 million. A bank agrees to lend $10 million of senior debt, half the price. Without another layer, the buyer would need $10 million of equity.

With mezzanine financing of $5 million, the stack becomes $10 million of senior debt, $5 million of mezzanine debt and $5 million of equity, cutting the buyer's cash requirement in half. If the mezzanine note carries a hypothetical 12% cash interest rate plus 2% PIK interest, the company pays $600,000 in cash interest in the first year, and the loan balance grows by $100,000. The lender might also receive warrants for a small percentage of the company's shares.

Common Uses

• Leveraged and management buyouts where the buyers want to limit the equity they put in.

• Add-on acquisitions that are too large for the existing bank facility.

• Recapitalizations that let owners take some money off the table while keeping control.

• Growth projects such as new plants or major expansions with a clear payback.

• Commercial real estate, where a mezzanine loan is often secured by a pledge of the ownership interests in the property-holding entity rather than by a mortgage.