April 02, 2025
5 mins read
When I first heard the term mezzanine financing, it made me think of a floor in a building that is between two main floors – the imagery seemed particularly appropriate because that is what it represents in finance - a middle between equity and debt.
At its core, mezzanine financing enables companies to raise funds without requiring the pledge of physical assets as collateral. You can picture it as a bridge: traditional loans on one side, equity ownership on the other, and mezzanine funding right in between.
It is particularly useful for businesses that are already generating revenue but may not have enough collateral to qualify for a conventional bank loan. By choosing this option, they avoid giving up full control of the company while still moving ahead with their plans. Since growing a business cannot always wait for the long process of getting a loan approved, mezzanine financing has become a realistic option for companies looking for a quick source of capital.
To begin, mezzanine financing is a type of financing that is comprised of both debt and equity. In short, mezzanine financing allows businesses to borrow money by providing the lender the right to convert their debt into equity if the borrower does not pay back the loan.
Since mezzanine financing is not a conventional loan with collateral backing the loan, it carries a high cost of capital because the risk is somewhat elevated.
One of the primary drivers that companies look to mezzanine financing for is that it provides access to cash without immediate repayment of the loan, since the lender has the option of converting into equity. This allows companies to leverage their cash to either fuel their company's growth or manage near-term liquidity.
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A real hybrid—it has parts of both debt and equity finance.
Unsecured, which means there is no need for real collateral. This is good for companies that don't have many assets.
Because lenders are taking on more risk, these loans generally have higher interest rates and cost more than regular bank loans.
Higher returns compared to normal debt instruments, which means better yields for lenders.
This type of interest structure lets you choose between fixed and variable rates, based on the terms of the agreement.
A company's balance sheet looks very simple when it comes to mezzanine financing. In terms of the capital structure, it comes after senior loans and before common stocks. In other words, this kind of debt is less important than senior debt when it comes to giving rights to the company's assets or stocks.
Unsecured junior debts, which are also called sub-debts, are given out as part of mezzanine financing. If the borrower doesn't pay back the loan, the person who holds the sub-debt can only put a claim on the company's assets or securities after the claims of the people who hold the main debt have been paid off.
The debt holder charges a higher interest rate because these are subordinated debts that are not secured. This is done to make the loan deal fair and just.
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So, let's say a medium-sized manufacturing business wants to grow and start marketing its products all over the country. What's wrong? You don't have any valuable things you can use as collateral for a bank loan.
They instead go to a venture capital firm to get junior financing. A ₹50 million loan with a 12% interest rate over eight years and a 5% share in the business are part of the deal.
The business can now get the money it needs to grow without having to put up land or equipment as collateral. The lender gets interest, and if the company can't pay back the loan, the lender can turn it into stock, which means they become a part-owner of the business. There is something at stake for everyone, and everyone stands to gain if the business grows.
Provides businesses access to cash without needing personal or business collateral, making it a convenient funding option.
Lenders often receive an equity stake, allowing them to benefit from the company’s future growth in exchange for financing.
Attractive for both businesses and lenders as it combines debt with potential ownership benefits.
Offers flexibility, as unpaid interest can sometimes be added to the loan principal, reducing immediate repayment pressure.
Helps borrowers maintain healthy cash flow by substituting equity instead of payments, supporting ongoing stability while enabling business expansion and growth opportunities.
The cost of mezzanine financing is high since interest rates are significantly higher than conventional loans due to lack of collateral or guarantees.
Borrowers must carefully evaluate repayment capacity, as the high cost can impact profitability and cash flow.
Lenders face last-in-line risk; if the company’s value declines, they may recover little or nothing on their investment.
To mitigate this risk, lenders often retain the option to convert debt into equity.
This conversion allows them to benefit from ownership and potential future growth, even if repayment becomes uncertain.
Mezzanine financing is usually offered by private equity firms, venture capital funds, dedicated mezzanine funds, or investment divisions of major banks. It is primarily extended to established businesses aiming to expand but lacking sufficient tangible assets to secure traditional loans or credit lines.
This financing acts as a hybrid between debt and equity, providing growth opportunities when conventional funding sources are limited. Companies often prefer mezzanine financing to bridge funding gaps and support their strategic expansion plans effectively.
Mezzanine financing is a valuable source of capital that assists both the borrower and lender in advancing their position in the competitive marketplace. While it can be very costly and carry higher interest rates, mezzanine capital can lead to expansion and value and when utilised appropriately.
As either the lender and/or borrower, you should always read and understand the investment agreement detailed terms of the mezzanine financing whether you are borrowing or lending.
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As mezzanine financing is unsecured, it carries higher risks, and investors require a higher rate of return than secured lenders. Typically, it pays an investor 12-20%, which is higher than the rate of return on ordinary debt.
The key factor that differentiates mezzanine financing from traditional loans is that in the former debt is offered against equity rather than collateral whereas under traditional loans it is offered against some or the other form of collateral.
Mezzanine financing usually comes at slightly higher interest rates as compared to traditional loans simply because these are unsecured debt offered to the borrower. However to make the financing agreement just and reasonable terms like higher interest rates or equity ownership to the lender are added, typically.
Ideal candidates for mezzanine financing are those companies that have a defensible market position along with a stable or growing market value.
Mezzanine financing helps business grow as it offers an opportunity to raise funds without offering collateral thus helping the business retain its ownership. Additionally, businesses can retain their liquidity by offering to repay the loan in the form of equity and this helps the business perform everyday activities easily through liquid capital
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