What is a Mezzanine Loan? Pros and Cons

Lidia Staron, author at OpenLoans
Lidia Staron   Head of Content
Personal Finance
I enjoy navigating people through important financial decisions.

Mezzanine loans are somewhere between debt and equity. You aren't technically selling your equity if you get a mezzanine loan, but it is a way to borrow against the equity in a business. This is ordinarily the capital that an angel investor or equity investor would buy. It's an expensive form of lending, as it can be a high risk for mezzanine lenders, but it can be a solution if you can't raise enough funds for expansion in your business.

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What is Mezzanine Loan?

Signing a loan.

Mezzanine funding is a way to get income from the equity on your business and provide you with funding to help you purchase a new business, building, or asset. It's a way to ensure that you don't have to raise vast sums of money through a bank, for instance. Mezzanine loans are a specialist type of funding, and they are ideal in certain situations.

A mezzanine-type loan may form a sort of bridge between what you can borrow from a bank and what you need to expand or buy out a business. There are often multiple repayment methods, and some may also give a small amount of equity to the lender as a part of the deal. This is a permanent arrangement rather than just security for the loan.

How It Works

Mezzanine loans provide a hybrid between debt in a business and equity. The arrangement means that the lender might receive equity in the company as part of the agreement or if the loan can't be repaid.

It's often only really an option for businesses that can prove the state of their financial wellness, and it needs to be an attractive proposition for potential lenders. Unfortunately, the lending costs tend to be relatively high, and getting a mezzanine loan isn't always easy.

Rate of Return of a Mezzanine Fund

There are often additional agreements regarding mezzanine-type loans. Lenders can recoup their money in a variety of different ways. A typical rate of return is around 12% to 20%, much higher than other bonds or loans. However, because the cash isn't as liquid as some other debts and is tied closely to the company, it's quite a high-risk loan in specific scenarios.

Eligibility

Discussing loan terms.To get "Mezz financing," it is pretty vital that a business can show a positive track record, including making a profit and having plans for the future. Mezzanine loans can be used for companies with a good level of operating cash flow. They're suitable for expansion in the majority of scenarios.

As with every loan, particularly in a business scenario, you will have to fill out a suitability form. This often means that people who lend you money will want to look at your accounts and discuss your plans for the money. This is all a part of the due diligence when you are looking to get a mezzanine loan. Lenders would not be responsible to simply hand out these loans, especially when they are so closely tied to many businesses' success.

Maturity and Redemption

The maturity period of this type of loan is often around five years. However, the RoR can be much higher, so many lenders prefer a shorter maturity for this type of loan. There may also be a mandatory clause for the redemption of the asset in question that is sold or in specific scenarios for the business.

The details regarding the maturity and redemption of a loan should be outlined when you go into the loan agreement. The contract of mezzanine loans can become quite complex.

Transferability

Approval for a loan.

A mezzanine is what is referred to as a "buy and hold" product. It isn't traded in the same way that some other financial products are, like bonds and stocks and shares in a company. People who manage these funds consider the fact that they are not transferable. Even though they can be very profitable for lenders and provide a good option for making a good return, they are not transferable.

Pros and Cons of Mezzanine Loans for Borrowers

There are benefits and disadvantages when it comes to getting a mezzanine loan. As a borrower, it can sometimes be one of the only options, and there are pros and cons to the method.

Advantages

  • One of the key advantages is that you can get capital you might not be able to from the bank ordinarily, allowing you to expand as a business.
  • Minimizing the amount that you have to dilute your business equity and what you own yourself.
  • Mezzanine loans may allow you to deduct interest payments on your tax returns.
  • There may be benefits to the balance sheet, showing lower debt levels, which may mean handling.

Disadvantages

  • They're a type of lending, and if things don't work out, you might have to find other ways to repay the loan or lose the equity.
  • Equity loss is usually written into the contract, so you might have to give a part of your business to the lender if things go wrong.
  • There may also be complex demands within the contract; it can quickly get confusing. You might also have to stick within specific ratios, for example.

Pros and Cons of Mezzanine Loans for Lenders

Receiving a loan. Lenders need to be very cautious with the funds they are managing. It's not a good idea to lend money in a high-risk manner, so the risks attached to mezzanine loans must be closely considered. But, of course, there are plenty of good things about this type of lending, or it simply would not exist.

Advantages

  • A high return on investment. The yearly income provided by a mezzanine loan can bring in quite a bit of money. A rate of return that is 15% to 20% is not uncommon.
  • There is often some security in the form of equity. For example, even if someone should default on a loan, there may be a clause written into the contract allowing a lender to claim some ownership on a mezzanine loan.

Disadvantages

  • Default risk. This is always a risk for a loan, as the loan may not get repaid.
  • The business may not have to pay the loan back quickly, called low seniority. Other types of funds might be prioritized, so you might have to wait until liens have been paid elsewhere before calling in debt.

Conclusion

Mezzanine loans are a clever system that allows both the lender and the borrower to experience benefits.

For business growth, this can be one of the most innovative ways to raise capital. If you are left struggling to get money from traditional routes and other forms of lending and investment, a mezzanine loan can free up extra money to grow as a business.

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