What Exactly Is Mezzanine Debt?

When a hybrid debt offering is subordinated to another debt issue from the same issuer, mezzanine debt occurs. Embedded equity instruments accompany mezzanine debt, sometimes referred to as warrants, which raise the value of the subordinated debt and provide greater flexibility when dealing with bondholders. Mezzanine debt is often related to acquisitions and buyouts, and it can be used to prioritize new owners above existing owners in the event of bankruptcy.

Understanding Mezzanine Debt

Mezzanine debt is one of the most risky types since it spans the gap between debt and equity financing. It is superior to pure equity but inferior to pure debt. However, it also provides some of the most significant returns compared to other types of debt, with rates often ranging between 12% and 20% per year.

Mezzanine Debt Types

Numerous sorts of equity can be coupled with debt. Stock call options, rights, and warrants are instances of embedded options. Mezzanine debt acts more like a stock than a debt since the embedded options make the debt-to-stock conversion more appealing.

In leveraged buyouts, mezzanine debt structures are the most popular. For example, a private equity firm may wish to borrow $100 million to purchase a company, but the lender only wants to put up 80% of the value, proposing a loan of $80 million. The private equity group does not want to put up $20 million of its own money and instead seeks a $15 million mezzanine investor.

The company only needs to invest $5 million to meet the $100 million price tag. Because the investor employed mezzanine financing, they can convert it to stock if certain conditions are met. This kind of financing maximizes the buyer’s potential return while lowering the capital required for the transaction.

The US Generally Accepted Accounting Principles (GAAP) determine how the loan element affects the embedded option when classifying a hybrid security on the balance sheet. If exercising the embedded option is influenced by the debt structure, then the two components of the hybrid—the debt and the embedded equity option—must be classified in the balance sheet’s liability and shareholders’ equity sections.

Mezzanine Debt Example

Mergers and acquisitions (M&A) are the most common uses for mezzanine loans. For example, in 2016, Olympus Partners, a Connecticut-based private equity firm, received debt financing from Antares Capital to acquire AmSpec Holding Corp. This company provides testing, inspection, and certification services to petroleum traders and refineries.

The financing totaled $215 million, including a revolving credit facility, a term loan, and a delayed draw term loan. Antares Financing contributed the entire financing as a mezzanine loan, allowing it to exercise equity options.

Conclusion

• When a hybrid debt issue is subordinated to another debt issue from the same issuer, it is called mezzanine debt.
• Mezzanine debt crosses the debt-equity financing divide and is one of the most risky types of finance, being subordinate to pure debt yet senior to pure equity.
• Mezzanine debt acts more like a stock than a debt since the embedded options make the debt-to-stock conversion more appealing.
• Compared to other debt categories, mezzanine financing provides some of the best yields, frequently yielding rates between 12% and 20% per year.