What Is a Mezzanine Lender?
Mezzanine or “mezz” financing basically gives a lender the right to convert a loan to an ownership equity interest in a business if the borrower does not pay the loan back as agreed. “Mezzanine” derives from the Italian word meaning “in the middle.” It is an apt moniker for this hybrid type of financing that hovers between debt and equity in terms of risk, cost and convenience. Savvy businesspeople consider it an alternative to borrowing from a bank or raising equity in the market when seeking to finance internal growth or acquisitions.
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Who Does Mezzanine Lending?
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The major players are mezzanine funds, venture capital funds, insurance companies, small business investment companies (SBICs), commercial banks and deep-pocket private investors.
What Is It Used For?
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Mezzanine financing plays a role in management/leveraged buyouts for financing an established company's expansion, either through internal growth or acquisitions and in recapitalizations and divestitures. In real estate, mezzanine lenders provide all or part of the down payment for buying commercial or multifamily properties.
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How Does It Work?
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Typically, mezzanine financing is structured as unsecured long-term debt with an "equity kicker" in the form of warrants to purchase equity or conversion rights into common stock. The debt will amortize over five to seven years and contain bank-type covenants and some equity conditions. A “put,” giving the investor the right to ask for repayment in full, typically at the end of years five to seven, may be included, as may be a “call”, allowing the borrower to repay before the debt converts to equity.
In real estate, mezz lenders provide high loan-to-value second mortgages on a commercial or multi-unit residential property, usually to finance all or part of the down payment. Loan-to-values often go up to 100 percent. The loan is made to a company, usually a limited liability company (LLC), that owns the property. If there is a failure to repay the loan, the mezzanine lender forecloses on the stock to take over the company and control of the property.
Pros and Cons
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Borrowers benefit because mezz finance tends to be readily available when other sources of capital, such as bank loans, dry up or when they are too expensive, as when raising equity capital. Because it is counted as quasi-equity, it strengthens borrowers' balance sheets, making it easier to obtain credit from banks. Mezz lenders work quickly, with little due diligence performed, and they require little or no collateral. On the other hand, mezz finance is expensive. Interest rates are in the 13 to 15 percent range and, if converted to equity, the company owners will see their ownership percentage diminished.
From the lender's perspective, mezz finance carries moderate risk–higher than senior debt but lower than equity. In a court-ordered liquidation, commercial banks' so-called senior debt ranks first for repayment, investors' equity capital ranks last, with mezzanine lenders' debt is in between. The lender receives current income through the loan interest payments and can earn up to a 30 percent or higher total return if the loan eventually converts to equity. In real estate, by foreclosing on the borrower's stock instead of the mortgage, the lender obtains control of the financed property much more quickly than by foreclosing on a mortgage.
How to Find a Mezzanine Lender
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Consult free online directories such as the National Association of Small Business Investment Companies (NASBIC) to find mezzanine lenders among the 400 SBICs licensed by the Small Business Administration.
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