What is Mezzanine Financing?

Mezzanine financing offers companies in need of capital a means of attracting investors through a combination of both equity and debt.

If the company receiving capital defaults on their loan, the lender has the right to convert their contribution from debt to equity interest in the borrowing company.

Mezzanine financing can help companies raise large amounts of capital at a moment's notice, but the costs of doing so are higher than other alternatives. In addition to offering investors potential equity as an incentive, companies raising capital through mezzanine financing also tend to offer higher annual returns than usual. 

These costs can put immense strain on a company that fails to allocate raised capital appropriately and succeed at improving its bottom line. Thus, mezzanine financing is not always a good idea for companies that need quick access to capital.

How investors can profit from a mezzanine arrangement

In addition to receiving interest payments often in excess of 12% on their initial contribution, investors may be able to recoup their investment and enjoy profits in multiple ways when they engage in a mezzanine arrangement.

For example, investors can opt to receive interest payments as a single "payment in kind" instead of collecting individual interest payments periodically. This makes it so the company in question does not need to pay back interest each year. Instead, the company must return the initial investment, plus all the interest payments over the agreement period, all as a lump sum.

Another option available to mezzanine investors is a participation payout. This grants investors a percentage of the company's net sales or profits. An arrangement fee must also be paid to investors when the lending transaction is closed, making this form of financing even more profitable when it proves to be successful.

Mezzanine financing is a hybrid of debt and equity financing, beginning as a debt that lenders can convert to equity in the borrowing company at a later date. In mezzanine financing, lenders often exercise the option to convert debt to equity when a loan is not repaid in a timely manner or in full.