Mezzanine financing is financing designed to fill the gap between senior equity and debt in a company. You can structure this as unsecured debt or preferred stock. It allows investors to convert to equity interest. Usually, mezzanine financing is used to fund growth prospects, including business acquisitions and expansion.

Reasons for Gaps

Gaps between senior debt and equity financing occur for a few reasons. One reason for this is that f01ixed assets, accounts receivables, and inventory are discounted at higher rates for fear of their value not being recognized. Another reason is that a large volume of intangible assets is recorded on your balance sheets. The last reason is to address the rise in regulatory pressure and defaults. Banks increase the limit of total debt a business can acquire.

There are several ways that mezzanine investors can see returns. Understanding these will help you decide if it is right for you. These return opportunities include:

Cash Interest

Investors will occasionally receive cash based on a portion of the existing mezzanine funding balance. The interest rate is either set or fluctuates during the loan period.

PIK Interest

Payment in Kind or PIK interest is another periodic payment method. The difference is that it isn’t paid in cash.

Instead, it’s added to the principal sum of the security. The total is paid after the loan period. An example would be a $40 million bond with a 10% PIK interest rate. At the end of the loan period, it amounts to $44 million, and there’s no cash interest payment.

Ownership

Like a convertible bond, mezzanine financing usually includes equity interest as a conversion feature or warrant. In most cases, PIK interest or cash interest will follow the ownership part of securities.

Participation Payout

Instead of equity, investors may receive a return on equity as a percentage of the company’s performance. It is measured by EBITDA, profit, or net sales.

Arrangement Fee

At the close of the transaction, mezzanine investors receive an arrangement fee. This is a requirement of the financial product.

Using Mezzanine Financing

Mezzanine financing offers benefits for everyone involved in the transaction. This includes the investors who can receive returns in several ways, as highlighted above. It’s important to note what returns are available to decide if this financial product is worth it. While it isn’t right for anyone, it’s beneficial in many ways, so considering it is a good idea for some investors.