What it means
Picture a company's funding as a stack. Senior bank debt sits at the bottom with first claim on the assets, ordinary shares sit at the top carrying the most risk, and mezzanine occupies the middle floor, which is where the name comes from.
Because mezzanine lenders rank behind the bank, they take more risk and charge accordingly. Typical all-in returns sit well into double digits, made up of cash interest paid quarterly, payment-in-kind interest that accrues onto the loan balance instead of being paid, and often warrants giving the lender the right to buy a slice of equity later.
The appeal to a business owner is dilution. Selling more shares to fund an acquisition might hand over 20% of the company permanently, whereas mezzanine might cost 14% a year plus a warrant over 3%, leaving the founders with far more of the upside if things go well.
Mezzanine is common in management buyouts, acquisitions and expansion projects where cash flow is predictable but there are not enough tangible assets for the bank to secure against. Lenders care much more about reliable earnings than about property or machinery, which suits service and software businesses.
The nuance to keep in view is that payment-in-kind interest is genuinely expensive even though it feels free. Nothing leaves the bank account, so the loan looks affordable month to month, but the balance compounds quietly and the repayment due at the end is much larger than the amount originally borrowed.
In practice
Real-world examples.
Example
A family-owned engineering firm buys a competitor for $12,000,000. The bank lends $6,000,000 against property and machinery, the family contributes $3,000,000, and a mezzanine fund provides the remaining $3,000,000 at 13% so the family avoids bringing in an outside shareholder.
Example
A hotel group wants to refurbish eight sites but has already borrowed to its senior covenant limit. Mezzanine funding covers the refurbishment because the lender is willing to look at forecast room revenue rather than asking for more property security.
Example
A software business with recurring subscriptions and almost no physical assets raises $8,000,000 of mezzanine to fund international expansion. The lender takes warrants over 4% of the equity, betting that growth will make those warrants worth more than the interest itself.
Think of it
“Mezzanine financing is a hybrid-debt that can become equity, sitting between regular loans and ownership.
Formula
Calculation
Annual mezzanine cost = (cash interest rate x outstanding balance) + (payment-in-kind rate x outstanding balance)
Closing balance = opening balance + payment-in-kind interest accrued
A management team buys its business for $20,000,000. The bank provides $10,000,000 of senior debt and the team plus a sponsor put in $6,000,000 of equity, leaving a gap of $4,000,000. Rounding the facility up, a mezzanine lender provides $5,000,000 at 10% cash interest plus 4% payment-in-kind, with warrants over 3% of the equity.
Year one: cash interest = $5,000,000 x 10% = $500,000, paid out of operating cash flow. Payment-in-kind interest = $5,000,000 x 4% = $200,000, which is added to the loan, taking the balance to $5,200,000.
Year two: cash interest = $5,200,000 x 10% = $520,000 and payment-in-kind interest = $5,200,000 x 4% = $208,000, giving a closing balance of $5,408,000. Two years in, the company has paid out $1,020,000 in cash and still owes $408,000 more than it borrowed, before the warrants are even considered.Case study
Seen in the real world.
This illustrative case is entirely fictional. Thornbury Instruments, an invented maker of laboratory equipment, needed $5,000,000 to buy out a retiring founder. Its bank would lend only $3,000,000 against the balance sheet, and the remaining shareholders were unwilling to sell a further 15% of the company to a private equity buyer to raise the rest.
They took $2,000,000 of mezzanine at 9% cash plus 5% payment-in-kind with warrants over 2.5% of the shares. Cash interest of $180,000 a year was comfortably covered by operating profit, and the finance director modelled the accruing balance carefully so the board knew the redemption figure would grow year by year rather than staying flat.
Four years later the fictional company refinanced the mezzanine with ordinary bank debt once its earnings had grown enough to support it, settling the accrued balance and buying back the warrants. The shareholders had paid a high rate for four years but retained 97.5% of a business that was worth considerably more than when they started.
Watch out
Common mistakes.
- Reading only the cash interest rate and ignoring payment-in-kind interest and warrants, which together often double the true cost of the money.
- Forecasting cash flow without the eventual bullet repayment, then discovering the business has to refinance or sell at exactly the wrong moment.
- Assuming mezzanine is simply expensive debt, when the warrants make it a genuine claim on future equity value.
Questions
People also ask.
Is mezzanine financing debt or equity?
Legally it is usually debt, but the conversion rights or warrants attached to it give it much of the risk and reward profile of equity.
Who typically provides mezzanine funding?
Specialist debt funds, private credit arms of asset managers and some private equity houses, rather than high street banks.
When does mezzanine make more sense than simply issuing shares?
When owners expect the business to be worth substantially more in a few years, since paying interest for a period costs less than permanently giving away a share of that growth.
From the founder's library
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