What is mezzanine financing and how can you use it in private equity?

2 Types of mezzanine financing

Mezzanine financing comes in various forms, depending on the terms and conditions of the agreement. Subordinated debt, for instance, is a loan that has a higher interest rate than senior debt and may come with warrants or options attached. Preferred equity is a form of equity with a fixed dividend and preference over common equity in case of liquidation, and may have convertible or redeemable features. PIK notes are a type of subordinated debt that allows the borrower to pay interest in kind, deferring the cash outflow and increasing the debt balance.

3 How to use mezzanine financing in private equity

Mezzanine financing can be used in different stages of the private equity deal cycle, such as acquisition, growth, and exit. During acquisition, mezzanine financing can bridge the gap between the purchase price and the senior debt available, while providing flexibility and speed in closing the deal. For growth, it can help fund acquisitions, capital expenditures, or working capital needs. And for exit, mezzanine financing can help achieve a higher exit value and a faster exit process, as well as avoid refinancing or renegotiating senior debt. Thus, mezzanine financing offers private equity firms a number of advantages throughout the deal cycle.

4 Risks and challenges of mezzanine financing

Mezzanine financing can present certain risks and challenges for both private equity firms and target companies. Cost is one of the main issues, as mezzanine financing is more expensive than senior debt, potentially increasing the overall debt burden and interest payments of the company. Additionally, mezzanine lenders may have certain rights or provisions, such as board representation or veto power, which can lead to a loss of control or influence over the company. Furthermore, misalignment of interests or expectations may arise between the private equity firm, the mezzanine lender, and the target company. For instance, they may have different objectives or strategies in regards to exiting the deal.

5 Best practices for mezzanine financing

To successfully use mezzanine financing in private equity, it is important to follow some best practices. Choosing the right partner is key, as mezzanine financing is a long-term and complex relationship. Establish clear and transparent communication and trust with the partner, and align the goals and incentives of all parties involved. Negotiating the terms is also crucial, as mezzanine financing is a flexible and customizable instrument. Consider the interest rate, maturity, repayment schedule, security, covenants, warrants, and conversion or redemption options. Additionally, monitoring the performance of the deal and company is essential to identify any issues or opportunities that may arise and adjust terms or strategies accordingly.

6 Here’s what else to consider

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