Business organizations are often on a buying spree, having mergers, acquisitions, and diversification into new business lines being the trend. It is a fact that businesses need money to run, operate, and perform their functions.
Mezzanine debt is a popular financing option often tapped by several private equity firms, asset reconstruction companies, and other corporates to get money for their business needs.
What Is a Mezzanine Debt in A Simple Language?
Have you ever subscribed to the debentures of a company? You buy the bonds at a fixed face-value and get paid interest, calculated based on a pre-determined coupon rate.
A mezzanine debt works in the same way; however, it differs in terms of the status (subordination) and the additional options (mezzanine warrants) that it has compared to the other debt issues.
It is a sub-ordinated debt. If the borrowing company goes for liquidation or bankruptcy, the investors of mezzanine debt will get paid after the unsubordinated debt, such as other corporate loans and debentures, are re-paid.
We can understand this using the following example:
Alex is a salaried professional and is looking to develop some sources of passive income by investing in debt instruments. His financial advisor advises him to invest in the Mezzanine Debt, as it offers a comparatively higher interest rate, leading to a higher interest income.
His financial advisor also told Alex that mezzanine debt is a sub-ordinated debt and carries a higher risk of losing the principal amount. He further gave him the following presentation:
O’range Services Inc. is an asset reconstruction company and has gathered finance to buyout a sick business unit for $200 million in the following manner.
|Source of Capital||Amount raised|
|Equity financing (issuing additional equity stocks)||$50 million|
|Issue of Debentures @ 5% per annum||$85 million|
|Issue of Mezzanine Debt @ 11% per annum||$45million|
|Capital infused by Promoters||$20 million|
Now, in case the organization O’range Services Inc. is liquidated in a bankruptcy court, then the order of re-payments will be:
|Order of Charge||Borrowers||Amount to be repaid|
|First charge||Debenture Holders||$85 million|
|Second Charge||Mezzanine Debt Holders||$45 million|
|Third Charge||Equity Stockholders (including the infusion made by the promoters)||$70 million|
One can observe from the table above that the mezzanine debt holders will get repaid:
- After the debenture holders
- Before the equity stockholders
Because of this feature of sub-ordination, we often consider mezzanine debt the riskiest form of debt. Mezzanine debt is a hybrid investment and has equity instruments embedded in it. Let us gain a thorough understanding of the same.
What Is Embedded in A Mezzanine Debt or What Are Mezzanine Warrants?
A mezzanine debt is junior and is inferior to all the other forms of debt. But what separates it from the others and makes it attractive are the embedded equity instruments, commonly known as mezzanine warrants.
Besides the contracted rate, at which the mezzanine debt investors get periodical interest, they also enjoy the facility of participating in the equity.
It means that upon the occurrence of certain events (such as the sale of equity, issue of I.P.O, etc.) the promoters or institutional owners will allot or transfer a certain percentage of shares to these mezzanine debt investors.
Investing into the instruments of mezzanine debt is risky, especially when it has been entitled to the status of a “junior” or “subordinate”. Hence, mezzanine warrants make it rewarding for mezzanine investors to extend such risky loans.
What Is the Working of a Mezzanine Debt?
A mezzanine debt fund helps the business owners to get money, which otherwise would be shelled out from the pocket of the equity investors.
Let us understand the practical working of a mezzanine debt using an example.
Mr. Michael is a progressive individual and the will to start something of this own. For this purpose, he even accumulated capital from his full-time regular employment.
Since childhood, he has nursed a dream to open a coffee shop in the Greater Toronto Area and has even found a potential target.
He will buy out a small coffee shop that:
- Earns $50,000 of operating income every year
- Is available at the selling price of $850,000
Since Michael has an accumulated fund of $300,000, he is hunting to find investors and market leaders who can fund him.
He has found a senior leader who will extend a loan of $400,000 at 7.5% per annum. For the balance amount of $150,000, he has convinced a mezzanine debt investor to provide for the funds.
In the absence of a mezzanine debt investor, Michael would have required to fund this amount of $150,000 from his pocket.