Mezzanine Financing For Real Estate

Sometimes, the loan is structured to allow the lender to transfer the debt into an equity interest in a business if your company can't repay its debt. This mechanism enables the lender to potentially recover its losses in the case of default, and a share of the business itself effectively becomes the collateral the loan is secured against. In other cases, if it is more advantageous, you can also use mezzanine finance as a hybrid of debt and equity. Here, you will raise debt via a lender and, in return, offer the lender equity in the business, giving the lender a share of your profits. 

Corporate debt is usually structured in terms of what must be repaid first if the company can't repay finance, on what is essentially a sliding scale of priority and risk. Senior debt (generally offered by banks and other large lending institutions) usually has to be repaid first in the event of default. As a result, this type of lending represents the least risk for lenders, even if the loan is substantial. Equity provided by venture capital firms or equity investors is prioritised last if a company can't repay its debt and therefore represents the most risk to lenders. However, potentially higher returns usually offset this. Mezzanine finance sits in the middle of these on the scale of priority. It is repaid after senior debt but before equity if a company defaults on its debt. Alternatively, lenders can structure the deal to include equity in your business to lower risk and increase their returns, alongside what you will pay in interest. 

Because there is more risk to lenders, mezzanine financing is more expensive than senior debt. However, it is sometimes the only financing tool available to fill the gap between the capital you borrowed via senior debt and what you need to make a project, acquisition, development or investment happen. Most senior debt lenders won't offer the total amount you need to finance the project, and you may not have the capital available to fund the difference. Alternatively, you may not want to use all your business' liquidity to bridge the gap between what you've borrowed and the capital you need. In this context, mezzanine financing is a useful way of accessing the money you need to get a project off the ground. Cost is always a consideration, but the difference between long-term returns on investment or the project not going ahead at all, mezzanine financing is usually a very cost-effective financing method. 

You can use mezzanine financing in different ways. Typical use cases are to generate capital for an acquisition or a buyout, or you can also use it to expand a business through different types of high-value investments. Lenders are open to different scenarios, providing a suitable use case exists. The lender's return on investment (either via equity or in terms of what they will generate in interest) supports financing. 

Mezzanine finance is a type of corporate debt, but it's not the same as most business loans. Corporate loans are usually relatively straightforward in how they are structured, the company doesn't need to borrow a significant amount, and there is comparatively little risk to lenders for various reasons. Mezzanine finance is used for large loans and in cases where financing carries enough risk that mainstream corporate lenders can't finance the deal. 

Depending on how your deal is structured, mezzanine financing can also mean that business owners don't have to dilute their shareholding by bringing on more shareholders or investors, as is usually the case when a company raises capital by offering equity in the business.  

Mezzanine real estate finance is a type of business loan used by large companies and property developers. There are several advantages which include:

Raise significant finance without diluting equity

Many companies that need to raise debt don't want to bring in more shareholders or equity investors. Doing so dilutes a business owners' shareholdings and equity in the company, which is usually not beneficial in terms of future return, company strategy and wealth generation. When structured in a way that only allows lenders equity if the loan is not repaid, Mezzanine financing provides the opportunity to raise significant capital while maintaining the current shareholding set-up in your business.

Bridge gaps between existing debt and what your business needs to borrow

Mezzanine financing is often used in combination with other types of loan. Banks and other large lenders offer senior debt, but it may not cover the amount you need to finance your project or investment. Mezzanine finance provides a way to bridge the gap between the total amount you need to borrow and what other lenders have already offered to finance. In some cases, you will have a significant business investment you will need to finance, and the missing amount is either too large for your business to cover alone or doing so would wipe out cash reserves and impact capital available for operations. You can use mezzanine finance to bridge the gap between what other lenders offer and what you need to borrow.   

Finance large investments

Buyouts, mergers, acquisitions and other types of business investment that generate significant return on investment, generate savings or grow a business exponentially are expensive. Few companies have enough capital to pay off these investments or projects in full using existing capital. Often, you will want to seize an opportunity or move quickly to create an outcome where Raising debt is a natural way to finance these projects. Mezzanine finance is a tool you can use to finance critical and high-value projects. 

Fiscal efficiency

Debt is often tax efficient for companies, and mezzanine finance is no exception. Usually, interest is deductible, which is beneficial for companies. Debt can be more fiscally advantageous than using existing capital from within the business to finance a large project. In many cases, it can be offset from profits. 

Flexibility

Mezzanine finance – with explanations about 'hybrid debt' and how it's structured – can come across as a very complex way to raise debt. Structuring and arranging this type of finance is sometimes complicated and absolutely requires specialist advice, negotiating and set-up (particularly for business – property development or mezzanine real estate finance can be more straightforward). However, it is a flexible type of finance. You can use mezzanine finance in many ways – to fund acquisitions, for business investments, buy out other business owners, in property developments, etc. Within each of these categories, there are many different ways to use the debt, depending on what you need to achieve.  

Mezzanine finance for management buyouts and leveraged buyouts 

If you want to fund a business buyout or acquisition, mezzanine finance will usually be an option, provided the company's financials and your plan supports this. You can use mezzanine finance to raise the capital to fund the acquisition.

In management buyouts, you can use mezzanine finance to purchase a company from its owners, buying the business from a current management team. 

Leveraged buyouts are similar to management buyouts but are used when a company acquires another business (as opposed to just buying out current owners). Leveraged buyout deals that involve mezzanine financing can be of higher value than management buyouts because the company you are acquiring is likely to be larger. In some cases, the deal will also be more complex and with more components. Usually, your lender will want to use some (or all) of the assets of the business you are buying and the business acquiring the company as security for mezzanine financing. Here, you can leverage your business's financial success and assets and/or the business your company is acquiring to support your access to mezzanine finance. 

Drawbacks of mezzanine financing

As with any loan, you will need to consider mezzanine finance carefully. This type of finance can come with drawbacks and potential pitfalls, and it's essential to understand these before you take out a loan. 

Structuring is critical

Mezzanine financing can be structured in many different ways. How a deal is set up for a property developer will be very different from a management buyout or acquisition. If you are a company, there are also many different options in terms of lenders being able to transfer the loan to equity in your business. Sometimes, this will only happen if you default on the loan. In other cases, it might be a prerequisite of the deal. Understanding what lenders will require of you in return for the loan and the real-world implications for your business is critical in this type of finance in both a best and worst-case scenario. Mezzanine finance is complex to set up, and you must make sure you understand the repercussions, effects and potential drawbacks of this type of finance. 

Risk

There is an inherent risk with any kind of lending if you can't pay back a loan or your investment, development, or acquisition doesn't bring the return on investment planned. It's important to note that mezzanine finance is not 'riskier' than other types of finance or that you shouldn't borrow – used responsibly and with expert advice, it is a fantastic tool for raising debt. The best way to mitigate risk is to ensure you understand the deal and how it will be arranged, also considering the senior debt lenders.