Mezzanine Loan

A Mezzanine Loan is a relatively large loan, typically unsecured (ie., not backed by a pledging of assets) or with a deeply subordinated security structure (e.g., third lien on the property but non-recourse vis-a-vis the borrower). Maturities usually exceed five years with the principal payable at the end of the loan term. In a standard offer, the loan carries a detachable warrant (finance) (the option to purchase a certain number of shares of stock or bonds at a given price for a certain period of time) or a similar mechanism to allow the lender to share in the future success of the business. Mezzanine loans can be used in financing a startup company or leveraged buy-outs, usually as part of a larger financing package.

Return and Interest

Mezzanine lenders, typically mezzanine funds, look for a certain minimum internal rate of return which can come from four sources: arrangement fee, cash interest, payment in kind and warrants. The arrangement fee, usually payable up-front, contributes the least return and is more aimed to cover administrative costs. Cash interest is the same as interest (finance), usually payable on the principal in equal periods until maturity. Payment in kind (PIK) is in addition to cash interest and accrues period after period, thus increasing the underlying principal (ie. compound interest). The PIK part is due on maturity of the principal. The achieved selling price of the shares acquired under the warrant are also part of the total return of the lender.

The idea behind the interest structure is to postpone burdening a borrower with the full interest cost of such a loan until the due date, effectively betting on substantially increasing cash flows (and equity value for the warrants) towards maturity. An extreme of such a financing instrument is the payment in kind PIK loan. The other extreme would be, technically speaking, the simple loan.

Interest on mezzanine loans is substantially higher than senior debt or debt of higher priority, thus making the compound interest a substantial part of the repayable principle. In addition, mezzanine loans typically carry some refinancing risk, meaning that the cash flow of the borrower in the repayment period will usually not suffice to repay all monies owed if the company does not perform excellently. By that definition, mezzanine lenders prefer borrowers with strong growth potential.

Real Estate Finance

In real estate finance, mezzanine loans are often used by developers to secure supplementary financing for development projects (typically in cases where the primary mortgage or construction loan equity requirements are larger than 10%). These sorts of mezzanine loans are often collateralized by the stock of the development company rather than the developed property itself (as would be the case with a traditional mortgage). This allows the lender to engage in a more rapid seizure of underlying collateral in the event of default and foreclosure. Standard mortgage foreclosure proceedings can take more than a year, whereas stock is a personal asset of the borrower and can be seized through a legal process taking as little as a few months.