Mezzanine financing

What it means

Mezzanine financing sits between a bank loan and equity. It most often takes the form of a subordinated loan repaid only after bank loans, or a loan carrying a right to equity, such as a convertible loan or a loan with warrants.

The name comes from architecture: a mezzanine is a floor between the ground floor and the first floor. In the capital structure it also sits “in between”: the mezzanine lender takes more risk than a bank because it is repaid later and often unsecured, so it demands higher interest, usually combined with a share in the growth in value.

Mezzanine is used where a bank will not lend enough and the founders do not want to sell equity cheaply, for example in acquisitions, management buy-outs, rapid growth or restructuring. It is provided by specialised funds and sometimes by private equity funds.

How it works in practice

In the accounts a mezzanine loan is usually shown as a liability, part of borrowed funds, although banks sometimes treat it as quasi-equity when calculating ratios. Where there is a conversion right, it must be assessed whether an equity component or a derivative needs to be separated.

Mezzanine interest is high, and part of it is often not paid currently but rolled into the principal and repaid at the end. For tax, thin capitalisation rules and the interest limit apply to loans from related parties; with an independent lender, interest is deductible under the ordinary rules.

Mezzanine agreements contain strict covenants, restrictions on dividends and lender rights to information or even a seat on the supervisory board. Before signing we recommend modelling cash flow and the total cost of the financing, including the share of value the lender will take on exit.

What to watch out for

The most common mistake is underestimating the real cost of mezzanine. The headline rate may look acceptable, but with capitalised interest, fees and the share of value on a sale, mezzanine is usually more expensive than a bank loan and sometimes more expensive than selling a minority stake to an investor.

The second risk is breaching covenants. In a weaker year the mezzanine lender may gain far-reaching rights, such as replacing management or taking over equity. The financing plan should allow for a pessimistic scenario, not just the growth the mezzanine was taken on for.