Mezzanine Funding Explained
Mezzanine financing is a method of raising capital that is used in many different applications including real estate purchases, leveraged buyouts, recapitalizations, acquisitions or expansions. Mezzanine financing is typically financing that lies between the debt and equity in the capital structure of a firm or project, and it can come in different forms including subordinated debt, preferred stock or some other form of equity participation by the lender.
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Types of Mezzanine Financing
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A supplier of mezzanine financing will provide capital in return for a note that is junior to any senior debt or bank loans. The lender will receive a higher yield due to its junior position, and increased leverage on the deal. The loan is typically not secured by the property, but by the additional equity of the buyer or builder in the case of real estate. In other cases, the lender will receive preferred stock, or convertible notes.
Advantages for Lender
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Since the mezzanine financing is not secured by the property, the mezzanine lender can take control of the project in the event of default without going through an extensive foreclosure process. The mezzanine lender will have an agreement with the senior lender that allows the mezzanine lender to cure of fix any defaults prior to the senior lender seizing the property. Since suppliers of mezzanine financing are exposed to more risk, they require a higher return to compensate itself for the higher risk.
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Advantages for Borrower
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Mezzanine financing can be used to finance a project when the borrower has reached the borrowing limit from the primary lender and does not want to give up any more equity in the project. The terms of the financing are also flexible, and structured for the needs of the borrower. This includes the timing of principal payments.
Nomenclature
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The term mezzanine comes from an architectural layout in a theater, where the second level of the audience, in between the orchestra and the balcony, is called the mezzanine. The word is derived from the Italian word "mezzanino."
Mezzanine Financing Example
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A private Real Estate Investment Trust (REIT) is seeking financing to build a hotel. The REIT secures financing from a bank for 80 percent of the project cost, but finds the bank won't lend any more. The REIT turns to a mezzanine lender for 15 percent of the project cost, bringing its loan to value for the hotel project to 95 percent. The REIT pays a higher interest rate or gives up some equity in the project, but it is now funded to its satisfaction.
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