Mezzanine financing

What is mezzanine financing?

Mezzanine finance is a hybrid of debt and equity financing which can be useful for large projects, management buyouts or growing businesses. It’s a fairly complex form of business loan. If you’re looking for the right funding option, we can help you find finance from over 120 providers across the whole market.

For businesses looking to raise money, there are two basic routes: debt, where you borrow money using a business loan; or equity, where you sell a share of your business in return for cash. Mezzanine finance can also be be a type of property development finance.

Mezzanine finance covers a range of complex funding scenarios (in fact, the word itself comes from the Latin for “middle”) and for certain situations it can make more sense than either debt or equity in their pure forms.

Why use mezzanine financing?

Mezzanine finance is normally used in situations where the perceived risk is high enough that the borrower can’t raise enough money through a traditional business loan. The alternative would usually be equity finance — but many companies don’t want to give up shares in their business.

Mezzanine finance allows such businesses to borrow a larger amount which, if things go to plan, will be paid for through profits gained.

Put simply, it allows a bigger investment aiming at a bigger return. Mezzanine finance is repaid as one lump sum in some situations, and in others the interest payments can be deferred. Mezzanine finance may also have tax-deductible interest.

All these factors make mezzanine finance a little bit different to a normal business loan.

How does mezzanine finance work?

Mezzanine finance is effectively a business loan where the debt becomes an equity share after a predetermined timeframe has passed. That means if the company can’t pay back the funding, the lender gets a share of equity instead. In this way, equity in the business is used as security.

In other contexts, mezzanine finance blends debt and equity by offering a share of profit as well as interest payments. In other words, the business borrows money, and in return the lender gets a share of the benefits.

Benefits of mezzanine finance

Mezzanine finance is often used as a kind of ‘top up’ in addition to the amount provided by the main lender. For example, if the main lender provides 65% of the amount you need for a project, mezzanine finance might provide a further 20% — leaving just 15% for the business to put in.

Or, mezzanine finance is a method of raising more capital with the same amount to put in yourself — it's often the facilitator for bigger projects that the business couldn't otherwise afford.

The result of such a setup is that the business can achieve the maximum return with the cash contribution they have available. Working capital levels are hugely important for any business, so mezzanine finance can be a welcome addition to the standard financing arrangements.

Mezzanine finance for property development

Property developers can use mezzanine development finance to bridge a gap between their deposit and the property development finance they receive from a lender to fund their project. Mezzanine finance provides the developer with a way to maximise their  return on investment with minimal upfront costs because it means they can pay a smaller deposit.

As well as reducing the deposit amount required, mezzanine finance can be used to fund a gap in a deposit or to enable the developer to reserve funds for future deals. The lender can usually cover up to 90% of project costs, leaving the developer to contribute 10%.

In terms of lending criteria for property mezzanine finance, developers will usually have to prove their experience, full and detailed planning consent must be granted and personal guarantees will be required. Valuation Reports & QS/ MS reports instructed by the senior lender may also be used by and addressed to the mezzanine finance lender.

How much does mezzanine finance cost?

Because mezzanine finance is secured by a second charge (it’s riskier to the lender) and has a higher Loan-to-Value, it’s more expensive than the senior loan. Interest rates will vary on a case-by-case basis and usually start at 12% per annum.

Arrangement fees usually begin at 1%. The interest rate will be determined by a variety of factors, including deposit input, market demand, location and amount of finance required.

Is taking out a mezzanine loan risky?

As with any type of business loan, there is a risk involved and the borrower is 100% liable for the debt. Regardless of whether the mezzanine loan is taken out in your personal name or through your company, you’ll be personally liable because you’ll be required to provide a personal guarantee. This means if you default on the loan and the property is repossessed, the sale price could be less than the loan amount and you’ll have to make up the difference.

Mezzanine finance for MBOs and LBOs

Mezzanine finance can also be used for management buyouts (MBOs) or leveraged buyouts (LBOs). These arrangements work in a similar way to standard mezzanine finance, but instead of a single asset, property or project it’s an entire business being financed.

LBOs and MBOs depend on specific circumstances of the business being bought so it’s tricky to generalise, but overall they’re a way to use the value of the business being bought as the security.

What are the alternatives to mezzanine finance?

As an alternative to mezzanine finance, you might be able to get the full amount you need from a single lender. When you use Funding Options to find business finance, we’ll match you with the best deals for your situation and short-term goals. Our Finance Experts are also on hand to guide you through the application process.

Mezzanine finance is clearly a complex product, but it has its uses. If you’re looking for mezzanine finance, or just researching the various ways to fund a project, we can help you find the funding that fits best from dozens of lenders across the whole market.