A guide to mezzanine financing

Mezzanine finance is a type of hybrid financing, that most commonly combines features of debt (loans) and equity (investments). Although, mezzanine debt finance is also the term used to describe a secondary source of debt that ‘tops up’ the primary ‘senior’ loan. It typically sits in the middle of the senior debt and equity in the capital structure.

Mezzanine finance can be a fairly complex type of business loan, so in this guide, we focus on mezzanine debt financing, explaining what it is, what it’s commonly used for and the advantages and disadvantages of using it. This should help you understand if it’s the right type of debt finance for you.

What is mezzanine finance?

Mezzanine debt finance (also known as mezzanine debt) is a type of business loan that’s typically used when the perceived risk is substantial enough that the business is unable to secure a traditional business loan or requires a sum that a lender is unable or unwilling to provide in its entirety. Mezzanine loans are most commonly used for the expansion of established companies or scale-ups as opposed to start-ups or early-stage businesses.

As mentioned, there are generally two types of mezzanine financing – mezzanine debt, and debt to equity mezzanine financing. Debt-to-equity mezzanine loans are convertible loans that allow lenders to convert debt to an equity interest in the company in the case of default.

At OakNorth, we only provide senior debt finance, but we have a strong track record and years of experience working alongside leading mezzanine debt providers, making it easy for entrepreneurs to raise the full funds they need.

In debt mezzanine financing, a business secures a portion of their overall desired capital from a senior lender – this lender will typically give the borrower the majority of the cash they want, but not all of it. For example, if a borrower wanted to raise £5,000,000, they may get 70% of that through a senior debt finance lender, so £3,500,000. But to reach the £5,000,00 figure, the borrower can use a mezzanine debt lender, also known commonly as a secondary or junior lender. They will provide the remaining £1,500,000 debt to make up the full amount of capital.

It’s common for the ‘senior’ lender to lend the largest amount, but that isn’t always the case. In the transaction, the senior lender will always have the first charge on any assets or a debenture over the company and in the case of a default event, the senior lender will get repaid first, ahead of any Mezzanine lenders. Mezzanine or ‘junior’ lenders will typically have a second charge on any assets and therefore will not get repaid until the senior lender has taken back their share. This makes mezzanine loans riskier for lenders.

Say a business was looking for a loan of £2,000,000 to fund an acquisition, which once completed in six months’ time, would enable it to generate additional revenue and repay its lenders and generate a return on investment for investors.

Let’s assume a lender is willing to provide a business loan of £1,300,000 and a private equity firm is willing to invest £500,000 in the business. This leaves a funding gap of £200,000 – a gap which could be filled with mezzanine financing.

Any mezzanine lenders will rank behind the first senior lender and be subordinated. But, as this is riskier, although the size of the debt is smaller, the interest rates will be a lot higher, as the mezzanine lender adjust their rates based on the risk of them not getting repaid.

Mezzanine comes from the word ‘mezza’ which is Latin for middle. Mezzanine debt often falls right in the middle of the capital structure. If we think of the structure as a pyramid, the senior lender, often lending the most sits on the bottom, then the mezzanine lender or lenders will then come above with a smaller portion, then at the top sits the private equity investors with a smaller stake.  

• It can enable a business to secure a larger amount of capital as if a lender or investor is unable or unwilling to put in the full sum, the business may be able to secure the remaining portion from secondary or subordinated mezzanine lender/s.
• It requires a business to reduce its equity input and since common equity is not tax deductible it’s one of the most expensive forms of capital. By choosing to take on mezzanine finance or secondary lenders, businesses could reduce the after-tax cost of capital.
• Pure debt mezzanine finance enables a business to pursue larger projects that it otherwise wouldn’t be able to afford without having to dilute any ownership in the business.
• Mezzanine financing typically doesn’t require amortization during the term of the debt, so businesses can use the increased cash flow to repay their senior debt, invest in working capital or any other growth opportunities such as mergers, acquisitions or management buyouts.
• Mezzanine debt offers a lot of flexibility in shaping amortisation schedules and the rules of the borrowing itself, not least specifying special conditions for repayment.

• Similar to senior lenders, mezzanine lenders usually secure their debt against a business’ cash flow or equity in the business, and they will have a second charge on any properties after the senior lender. But as they’re higher up the risk curve, they’ll charge a higher interest rate to reflect this. This means a business will need to be confident in its growth and revenue before taking on secondary debt.
• Taking out a traditional business loan is typically considered a lengthy and arduous process. Doing this with multiple lenders or investors could make the process even longer and more complicated.
• Because mezzanine finance tends to be riskier for the lender involved and has a higher loan-to-value ratio (LTV), it tends to be pricier than the senior loan.

Property developers can use mezzanine development finance to bridge the gap between the debt finance they receive from a lender to fund their project, and the money they’ve put down as a deposit. Mezzanine finance enables the developer to pay a smaller down payment so they can spread their equity among a range of different developments or purchases.

Bridging loans and mezzanine loans are used for similar reasons, but they’re not technically the same. Mezzanine loans can be used for property development projects or if a business needs to stretch its cash flow in the shorter term to acquire a new business or invest in new areas. But mezzanine loans aren’t used to bridge short-term gaps like bridging loans are. They’re used for a wide number of reasons, partly because they can often offer businesses higher levels of flexibility in terms of debentures or covenants.

Mezzanine loans are always secondary, whereas bridging loans will be senior. Another difference between mezzanine finance and bridging loans is the security package. Bridging loans are often secured against a property as collateral and they’re commonly used in property development or property investment. Mezzanine loans are subordinated, meaning they come in as a secondary lender, so they typically rely on a business’ cash flow or equity in the business they’re borrowing to as their security, alongside their second charge on property, should the business default.

If your next growth stage requires debt financing, we can provide business loans from £250,000 up to tens of millions. So why not begin the process today, by filling out this short form and one of our lending experts will be in touch to talk you through your funding options.

We provide quick ‘yes’ or ‘no’ decisions and deliver funds in weeks rather than months. We’ve participated in numerous pure debt mezzanine financing transactions in the past as the senior lender, so will work with you to create bespoke loan facilities for up to several tens of millions of pounds.