Mezzanine Loans - An Alternative to Conventional Subordinate Financing

Subordinated debt, also known as mezzanine or junior debt, is a second-level of debt. Such debt is referred to as subordinate, because the debt providers (lenders) have subordinate status in relationship to the senior debt.

Senior debt refers to debt that is in first-lien position. In the event of a default and subsequent liquidation, the senior lender (often a commercial bank), has first priority in recouping its investment. When a company goes bankrupt, stake holders divide the proceeds from selling the company's assets. The senior lender is first to be re-paid, followed by the subordinated debt holders, followed by equity holders. Because senior debt's first priority repayment presents a lower-risk position compared to subordinated debt or equity investors, this debt is expected to have more favorable interest rates associated with it, commensurate with the lower risk assumed.

PURPOSE OF MEZZANINE FINANCING

Mezzanine loans fill the gap between equity and senior debt and are often used to finance leveraged buyouts, to recapitalize a company's balance sheet or to fund internal growth strategies. Mezzanine loans have thus become a common alternative to conventional subordinate financing where the terms of a first position loan prohibit junior liens.

MEZZANINE FINANCING STRUCTURE AND TERMS

Mezzanine loans are typically utilized in conjunction with equity capital and senior debt and would rank second below first-lien debt, but above equity in the event of bankruptcy. Mezzanine loans are therefore a more expensive source of financing than senior debt because of the increased credit risk. Consequently, a mezzanine financier is generally looking for a 16 to 30 percent return on investment.

Most mezzanine deals have a life of about three to seven years with the bulk of the principal often paid toward the back-end of the loan. In addition to an interest payment normally associated with debt, mezzanine loans will often include an option for an equity stake in the company in the form of warrants to convert the debt to equity much like that of a convertible bond.