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What Are the Pros and Cons of Mezzanine Financing?

Geri Terzo
Geri Terzo

Mezzanine financing is a form of nonsenior debt financing in the corporate world. It also has an equity component to it, which is why this type of debt is considered hybrid financing. Investors in mezzanine financing expect to earn unusually high profits compared with traditional returns in the financial markets and may fetch profits of up to 30 percent. In the event that the borrower defaults on a loan, mezzanine financing remains junior debt and will be repaid only subsequent to more senior lenders.

Companies that do not have access to traditional financing from banks may turn to mezzanine financing. Collateral is not required in mezzanine debt, and borrowers do not need to have physical assets backing the loan. In return for the loans, which are often provided by banks, venture capitalists, and private equity shops, borrowers pay interest rates that are somewhat higher versus traditional rates and sacrifice some equity ownership in the company. Mid-sized companies that do not have the resources to issue high yield bonds often turn to mezzanine financing as an alternative.

Man climbing a rope
Man climbing a rope

Many sectors experience mezzanine financing, including the hotel industry. A benefit to issuers is that there are tax incentives tied to this type of debt financing. Borrowers may be able to make tax deductions for the interest paid on loans, according to Hotel and Motel Management.

A benefit to the borrower in mezzanine financing is that the life of the loan is designed to last for the long term. For the first several years, a borrower pays only interest on the loan, after which time the principal begins to dwindle. A borrower is able to use the money from the debt financing for a corporate expansion or an acquisition, for instance. Consultants may be hired to help a company sell mezzanine debt and lure the most ideal investors.

Investors who put up capital for mezzanine investing face the risk that a borrower will default, leaving lenders with little recourse because there may be no collateral backing the loan. One way to mitigate this risk is to increase the equity component in the hybrid financing. The increased equity portion of the transaction provides more of a safety net to investors. Another benefit for borrowers is the flexibility that can be applied to the mezzanine financing, while lenders can often earn generous profits based on fixed interest rates that are likely to exceed those in the traditional bond market coupled with steady income.

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