Mezzanine loans are an important tool for growing mid-sized companies to overcome the financial constraints of their existing lines of credit. Often, existing lines of credit have strict loan covenants that tie the borrowing company’s hands. These loan covenants are important to the bank but they are also restrictive and limiting to the borrowing company. Mezzanine lending solves this problem by providing a line of credit that can be used for other purposes, such as business expansion.
Problems with mezzanine loans
The disadvantages of mezzanine loans are largely related to their high interest rates and strict loan covenants. In addition to this, the mezzanine lender may not have any say in how the company operates. In such a scenario, he might be forced to sell his equity stake and transfer it to another entity. As with any loan, it is risky to take out mezzanine loans.
ICAs often require mezzanine lenders to incorporate restrictive covenants into their loan documents. Such covenants prohibit the borrower from taking out more debt, refinancing senior debt, creating additional security interests in its assets, and meeting certain financial ratios. Nevertheless, this restriction can be problematic. Nevertheless, it may be the only solution for some distressed properties. In addition to these disadvantages, mezzanine loans may still have some relevance in the future.
As a hybrid financial instrument, mezzanine loans are a good choice for many midsize companies that want to expand their operations or diversify their portfolios. This type of loan often pays a 12 to 20 percent annual return to the investor. The benefits of mezzanine financing are its flexibility and ability to bridge the gap between debt and equity. In addition, mezzanine loans can provide a company with the much-needed financing it needs to expand and maintain its growth.
A mezzanine loan is a form of hybrid financing, where the lender provides the capital and then collects interest. They also have an option to exercise their warrant to obtain equity in the company. Mezzanine financing can help companies expand and grow in a controlled environment, as opposed to a rapid expansion. So, mezzanine loans are a great option for some companies that are not publicly-traded.
A mezzanine loan is usually structured as debt, with mezzanine lender consent rights and equity interests differing. Despite its flexibility, mezzanine lenders have to squeeze their way between established layers of capital. A senior loan, on the other hand, is secured by equity interests of the owner of the property. Those equity interests will need to be restructured to avoid the risk of default.
Characteristics
In the past, mezzanine funds focused on achieving blended returns of 20% to 30%, with the expected interest rate ranging from 10% to high teens. Today, mezzanine funds vary in expected returns depending on borrower characteristics. The expected return depends on EBITDA, with the higher the EBITDA, the lower the pricing brackets. To achieve their return goals, mezzanine lenders often request equity co-investments.
The risk of mezzanine lending is a lot lower than that of senior debt, as borrowers are not required to meet certain criteria, such as being a venture-capitalist. Additionally, mezzanine lenders are less concerned about collateral and prefer a business with a solid track record and long-term customers. Thus, these loans can supplement existing bank loans and provide all the necessary funding. The best part is that mezzanine lenders are not limited in how they use their loan proceeds, unlike traditional banks.
As a result, mezzanine debt is a tax-efficient source of long-term capital for privately held companies. Because traditional senior bank credit has decreased over the past decade, mezzanine financing has emerged as one of the most effective liquidity vehicles for privately held companies. Because it is subordinate to common equity and senior debt, mezzanine financing is a good source of liquidity. A company’s debt can be very large, but mezzanine loans can provide liquidity for a dividend, and a one-time dividend. In addition, mezzanine financing helps a company diversify its holdings by allowing it to monetize past reinvestment.
Another characteristic of mezzanine loans is their subordination to senior debt. They are typically unsecured and offer a much higher yield than common debt. Because they are more flexible than senior debt, mezzanine loans are less dilutive than common equity. They can also be structured with a variable interest rate, making them less dilutive than common debt. This type of financing is typically a high touch relationship process with high risk and reward for borrowers.
In order to obtain mezzanine loans, businesses must have a revenue stream that can sustain them through the term of the loan. A minimum revenue level of at least $20 million is necessary to attract mezzanine lenders. In addition to revenue and profitability, mezzanine funds also usually require that borrowers retain certain management positions. In some cases, mezzanine lenders require board seats or other participation in governance. This will depend on the level of ownership that the lender has.
Risks
Mezzanine loans are a common form of debt financing that allows a borrower to get access to capital at a lower interest rate than they would otherwise be able to find elsewhere. The downside is that lenders may require the borrower to pay interest charges as part of their loan balance, and some may even have little say in how the company operates. In these cases, the risk of defaulting on the loan increases, and the lender may have to sell its equity in the company or transfer its equity to another entity.
Although the risk of default is higher than other forms of debt, mezzanine loans generally have minimal financial maintenance covenants. Lenders may require borrowers to comply with various rules, including taxes, financial records, and insurance. Negative covenants will generally limit the borrower’s ability to take action without the lender’s consent. Furthermore, some mezzanine funds may require board seats and direct involvement in the company’s governance. However, this depends on the lender’s ownership percentage.
Another drawback to mezzanine loans is that they come with high fees. Origination fees can be as much as 3% of the loan amount, which makes them a more expensive form of capital. Furthermore, the property needs to perform well to service the debts. Those risks make mezzanine financing less desirable as a primary source of investment. And since lenders are usually more concerned about risk, mezzanine loans should only be pursued by those who have significant experience in the industry.
The benefits of mezzanine financing outweigh these downsides. The risk of property foreclosure is less for the lender than it is for the borrower. And the lender has less control over the property’s equity than do the common equity holders. And mezzanine investors have little or no equity cushion. But mezzanine loans are a great way to fill the void between common equity and senior first-lien mortgage debt.
Because mezzanine debts are subordinate to senior debt, they typically have higher interest rates. Senior debts have priority over mezzanine debts in the event of a borrower going bankrupt. But mezzanine debts are usually more expensive than bank debt, and their repayment terms can be flexible. A mezzanine loan may even be secured with equity. However, it may be less desirable than senior debts in terms of liquidity.
Structure
One of the key differences between mezzanine loans and equity is the structure of mezzanine debt. These investments require positive cash flow and are generally structured as subordinated, unsecured term loans with warrants. Interest payments are typically due monthly or quarterly. Some loans accrue interest during the initial period and the principal balance may increase during the final maturity. However, mezzanine debt has faced increasing competition from other forms of debt financing. Because of this, mezzanine lenders have had to lower their interest rates and have limited their demand for warrants.
The key benefit of mezzanine debt is the security of the lender’s investment. Traditional lenders are at the mercy of the market and are less protected if operations go south. However, mezzanine lenders can mitigate this risk by evaluating the borrower’s history and presenting a detailed plan of use. As with any investment, mezzanine loans are not without risk. As a result, companies should carefully consider the pros and cons of this financing method.
Despite the benefits of mezzanine loans, borrowers should note that they have the risk of equity dilution. However, mezzanine loans can provide access to capital while minimizing equity dilution. In addition, borrowers can choose to pay the interest charges with cash rather than adding them to the loan balance. This can also be beneficial for borrowers, as a mezzanine loan allows them to provide equity-like instruments to their lender. While leverage always comes with risk, mezzanine loans can help you avoid such issues.
Mezzanine financing can be useful for many businesses. For example, mezzanine loans are an excellent option for hotel chains that need working capital. Because mezzanine funding is secured by a lien on the property owner, mezzanine loans can be easier to obtain than conventional debt financing. Moreover, these loans come with favorable tax implications. Therefore, you should consider mezzanine financing when you need to finance your hotel project.
Mezzanine financing is a relatively new technique for real estate financing. Instead of collateralizing the loan with the underlying land or real estate, mezzanine loans are secured by a borrower’s equity in other entities. This indirect ownership of the underlying property is the value of collateral in mezzanine loans. Besides, mezzanine loans offer highly flexible financing. But it is important to make sure you do your homework before investing in mezzanine financing.
