Mezzanine debt: What Is It?

What is mezzanine debt? This type of debt takes place as hybrid debt gets subordinated by the same issuer into another debt issue. Equity instruments are generally embedded with such debts referred to as warrants. This again may increase the subordinated debt’s value. This allows greater flexibility while dealing with bondholders. Often, this debt is associated with buyouts & acquisitions. Bankruptcy related situations may require this debt to be used for prioritizing new owners before existing owners.

About Mezzanine Financing

This type of debt helps to bridge the gap occurring between equity financing debt. It is also stated to be among the highest debt risk forms. To pure equity, it is considered to be subordinate and senior to that of pure debt. It also offers very high returns than other debts present, since the rates received is approximately 12-20 percent annually.

Types

Mezzanine Loan can have several equity types included in it. Few embedded options related examples include warrants, rights & stock call options. This debt, in practice, behaves like a stock instead of a debt since embedded options make debt conversion to stock quite attractive.

In leveraged buyouts, this debt structure is quite common. The private equity company, for example, maybe eager to purchase a firm with a debt of $100 million. However, the lender may be interested to provide just 80% of the total value, on a loan of about $80 million. The rest $20 million, in this case, is not put by the private equity company. They may rather search for a trustworthy mezzanine investor to provide $15 million. Hence, the firm is required to invest the remaining small amount of $5 million to complete the total of $100 million. Since mezzanine debt is availed by the investor, the debt can be converted into equity on meeting certain requirements. Such financing concepts do help to leverage the potential returns on investments for the buyer. It also effectively reduces the capital amount to be met to complete the transaction.

The hybrid security classification under U.S. GAAP (Generally Acceptable Accounting Principles) on the BS (Balance Sheet) is specified. This relies on how the debt portion influences the embedded option. The debt structure might influence the embedded option in some manner. In such a case, the hybrid’s two parts, namely, the embedded equity & debt option needs to be classified. This is to be done in both the stockholders’ equity & the liability section of the BS.

Some examples of Mezzanine Financing

Often it is used in M&A (Mergers & Acquisitions). Olympus Partners, a Conn. based private equity firm for example, in 2016 was provided debt financing by Antares Capital. This was to acquire a company named AmSpec Holding Corp. This company offered Certification, Inspection & Testing services to petroleum refiners & traders.

The total finance amount was about $215 million. This amount included delayed draw-term loan, term loan & revolving credit facility. Total capital was offered by Antares Capital in the Mezzanine Loan form, thus providing equity options.

Why borrowers prefer such debts?

Borrowing at high-interest rates at about 20% annually makes no sense. However, the borrower can benefit from mezzanine debt. Interest charged on debt is considered to be tax-deductible interest. Hence, at the standard 35% corporate tax rate, 20% of pre-tax interest rates are just 13% after deducting taxes. Such debts do come with unique features, thus making debt servicing more manageable. Occasionally, mezzanine lenders include features such as PIK toggles. Using this, borrowers can pay interest simply by rolling the same into the loan balance. If the company is unable to pay normally scheduled interest payments, then it may defer all or some of the interest. This is done for a certain time period. This feature is not present on senior debt.