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mezzanine debt

Page history last edited by Brian D Butler 15 years, 2 months ago

 

Bridge, mazzanine financing of a business

 

Financing for a company expecting to go public usually within a year. Often, bridge financing is structured so that it can be repaid from proceeds of a public underwriting.

 

Mezzanine financing, a source of funding that lies between debt and equity, has joined the fight against the credit crunch. Private-equity firms are increasingly relying on these types of funds to finance their acquisitions.

 

returns:  mezzanine lenders will seek a return of 14% to 20%

 

The term mezzanine is derived from the Italian word meaning half, in the middle or lower.

 

 

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Subordinated Mezzanine Debt:

 

Subordinated Mezzanine Debt

Subordinated debt financing typically includes both debt and equity. There are dramatically fewer sources of subordinated debt than there are of senior debt or equity, so it is often considered to be specialty financing. Subordinated debt is substantially riskier than senior debt since the lender generally has less right over collateral and cash flow than the senior lender. As a result, subordinated debt is more expensive financing than either revolving lines of credit or term debt. Lenders usually require equity, generally in the form of warrants, to augment what they earn in interest income.

 

subordinated mezzanine debt

see cost of capital, (WACC) for more info

 

 

 

WikiPedia Definitions:

 

Mezzanine capital, in finance, refers to a subordinated debt or preferred equity instrument that represents a claim on a company's assets which is senior only to that of a company's common shareholders. Mezzanine financings can be structured either as debt (typically an unsecured and subordinated note) or preferred stock.

 

Mezzanine capital often is a more expensive financing source for a company than secured debt or senior debt. The higher cost of capital associated with mezzanine financings is the result of its location as an unsecured, subordinated (or junior) obligation in a company's capital structure (i.e., in the event of default, the mezzanine financing is less likely to be repaid in full after all senior obligations have been satisfied). Additionally, mezzanine financings, which are usually private placements are also often used by smaller companies and may also involve greater overall leverage levels than issuers in the High Yield market and as such involve additional risk. In compensation for the increased risk, mezzanine debt holders will require a higher returns for their investment than secured or other more senior lenders.

 

 

Structure

 

Mezzanine financings can be completed through a variety of different structures based on the specific objectives of the transaction and the existing capital structure in place at the company. The basic forms used in most mezzanine financings are: subordinated notes and preferred stock. Mezzanine lenders, typically specialist mezzanine investment funds, look for a certain rate of return which can come from four sources: (each individual security can be made up of any of the following or a combination thereof):

 

  • Cash interest – A periodic payment of cash based on a percentage of the outstanding balance of the mezzanine financing. The interest rate can be either fixed throughout the term of the loan or can fluctuate (i.e., float) along with LIBOR or other base rates.
  • PIK interestPayable in kind interest is a periodic form of payment in which the interest payment is not paid in cash but rather by increasing the principal amount of the security in the amount of the interest (e.g., a $100 million bond with an 8% PIK interest rate will have a balance of $108 million at the end of the period but will not pay any cash interest).
  • Ownership - Along with the typical interest payment associated with debt, mezzanine capital will often include an equity stake in the form of attached warrants or a conversion feature, similar to that of a convertible bond. The ownership component in mezzanine securities are almost always accompanied by either cash interest or PIK interest and in many cases by both.

 

Mezzanine lenders will also often charge an arrangement fee, payable upfront at the closing of the transaction. Arrangement fees contribute the least return and are aimed primarily to cover administrative costs and as an incentive to complete the transaction.

Illustration. The following are illustrative examples of mezzanine financings:

 

  • $100,000,000 of senior subordinated notes with warrants (10% cash interest, 3% PIK interest and warrants representing 4% of the fully diluted ownership of the company)[1]
  • $50,000,000 of redeemable preferred stock with warrants (0% cash interest, 14% PIK interest and warrants representing 6% of the fully diluted ownership of the company)[1]

 

In structuring a mezzanine security, the company and lender work together to avoid burdening the borrower with the full interest cost of such a loan. Because mezzanine lenders will seek a return of 14% to 20%, this return must be achieved through means other than simply cash interest payments. As a result, by using equity ownership and PIK interest, the mezzanine lender effectively defers its compensation until the due date of the security or a change of control of the company.

 

Mezzanine financings can be made at either the operating company level or at the level of a holding company (also known as structural subordination). In a holding company structure, as there are no operations and hence no cash flows, the structural subordination of the security and the reliance on cash dividends from the operating company introduces additional risk and typically higher cost. This approach is taken most often as a result of the structure of the company's existing capital structure

 

 

 

 

 

 

 

Uses of mezzanine capital

 

Leveraged buyouts

 

In a leveraged buyouts, mezzanine capital is used in conjunction with other securities to fund the purchase price of the company being acquired. Typically, mezzanine capital will be used to fill a financing gap between less expensive forms of financing (e.g., senior loans, second lien loans, high yield financings) and equity. Often, a financial sponsor will exhaust other sources of capital before turning to mezzanine capital.

 

Financial sponsors will seek to use mezzanine capital in a leveraged buyout in order to reduce the amount of the capital invested by the private equity firm. Because mezzanine lenders typically have a lower target cost of capital than the private equity investor, using mezzanine capital can potentially enhancing the private equity firm's investment returns. Additionally, middle market companies may be unable to access the high yield market due to high minimum size requirements, creating a need for flexible, private mezzanine capital.

 

 

Real estate finance

 

In real estate finance, mezzanine loans are often used by developers to secure supplementary financing for development projects (typically in cases where the primary mortgage or construction loan equity requirements are larger than 10%). These sorts of mezzanine loans are often collateralized by the stock of the development company rather than the developed property itself (as would be the case with a traditional mortgage). This allows the lender to engage in a more rapid seizure of underlying collateral in the event of default and foreclosure. Standard mortgage foreclosure proceedings can take more than a year, whereas stock is a personal asset of the borrower and can be seized through a legal process taking as little as a few months.

 

 

See also

 

External links

 

 

Other Definitions

 

Debt that incorporates equity-based options, such as warrants, with a lower-priority debt. Mezzanine debt is actually closer to equity than debt, in that the debt is usually only of importance in the event of bankruptcy. Mezzanine debt is often used to finance acquisitions and buyouts, where it can be used to prioritize new owners ahead of existing owners in the event that a bankruptcy occurs.  source

 

Definition from Investopedia:

 

A general term describing a situation where a hybrid debt issue is subordinated to another debt issue from the same issuer. Mezzanine debt has embedded equity instruments (usually warrants) attached, which increase the value of the subordinated debt, and allows for greater flexibility when dealing with bond holders. Mezzanine debt is frequently associated with acquisitions and buyouts where it may be used to prioritize new owners ahead of existing owners in case of bankruptcy.

 

Some examples of embedded options include stock call options, rights and warrants. In practice, mezzanine debt behaves more like stock then debt because the embedded options make the conversion of the debt into stock very attractive.

Under U.S. generally accepted accounting principles (GAAP), how a hybrid security is classified on the balance sheet depends on how the embedded option is influenced by the debt portion. If the exercising of the embedded option is influenced by the structure of the debt portion in any way, then the two parts of the hybrid (debt and the embedded equity option) must be classified in both of the liability and stockholder's equity sections of the balance sheet respectively.

 

 

 

 

 

 

 

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