Mezzanine, meaning "in the middle," is a type of capital that falls between senior debt and equity financing in a company's capital stack. It is typically used as solution-oriented capital, meaning that the business owner is looking for an infusion of cash to solve a specific problem.
For example, a founder might turn to mezzanine financing:
- During an economic downturn
- When growth has stalled, and the company needs a cash infusion to reach the next level
- If regulatory challenges are impeding the company's ability to raise equity financing
Mezzanine lenders tend to be more flexible than banks and other senior lenders and often offer more attractive terms. Limited Partners (LPs) considering an investment in a mezzanine fund should be aware that private debt sits higher in the capital structure than equity, which will prioritize distributions and liquidation.
The capital stack defines who has the rights and the order of claims to a company's payouts and returns. A company's equity is the residual interest in its assets after all debts have been paid. The capital stack, then, is a way of representing a company's equity and debt obligations.
In general, the higher up on the capital stack an instrument is, the more risk and cost it bears and the lower its priority in a liquidation event.
Why Businesses are Looking to Mezzanine Financing
Mezzanine financing allows companies to raise capital without giving up equity or incurring too much debt.
For lenders, mezzanine financing is attractive because it carries a higher interest rate than senior debt, typically 20% to 30%, and is often structured with warrants, giving the lender the option to convert the debt to equity if the company defaults.
Mezzanine financing is also attractive to businesses because it is typically easier to obtain than equity financing and does not require the same level of commitment as debt financing.
LPs considering an investment in a mezzanine fund should know this type of investment's potential risks and rewards. Mezzanine financing can be an excellent way for companies to raise money without giving up equity or taking on too much debt. However, LPs should be aware that mezzanine financing is a higher-risk investment than senior debt or equity and should only be considered part of a diversified portfolio.
Strong Outlook For Mezzanine
Despite the current economic uncertainty, the outlook for mezzanine financing is vital. Indeed, this market volatility is causing some senior lenders to withdraw from the market, making mezzanine financing an attractive option for companies needing capital.
The demand for mezzanine financing is driven by businesses of all sizes, from small startups to large public companies. Mezzanine funds are well-positioned to take advantage of this demand and provide businesses with the capital they need to grow and succeed. In a 2017 Preqin survey, most private debt investors planned to target mezzanine strategies in the next 12 months.
Today's macroeconomic environment is set to increase that demand further as businesses look for ways to weather the current economic uncertainty and position themselves for future growth. For these reasons, mezzanine financing is an attractive option for businesses and investors.