Mezzanine financing rescues deals when traditional lending cannot bear the risk.
With conventional lenders both restricted by regulations and wary of riskier ventures, mezzanine financing is playing a stronger role in providing equity for commercial real estate developments. For example, a builder wanted new capital to finance a multimillion- dollar construction project. Due to the company's moderate economic performance, the bank was willing to finance only a portion. Venture capitalists were not interested.
Finally, the builder secured an investment from subordinated debt carrying 13 percent interest with partial conversion in equity later. The banker viewed this mezzanine financing as quasi-equity and then lent the balance of required funds.
Similarly, a Real Estate Investment Trust needed more funds to acquire large parcels of commercial real estate in a growing market. Both the lender and the venture capitalists were hesitant until the REIT persuaded an investor to lend through subordinated debt with no equity conversion requirement.
Both these companies solved their financial quandary through mezzanine financing, a noncommon debt and quasi-equity instrument that has become increasingly popular. In finance, Wikipedia defines mezzanine capital as “any subordinated debt or preferred equity instrument that represents a claim on a company's assets, which is senior only to that of the common shares. Mezzanine financings can be structured either as debt or preferred stock or a combination of both.”
In the layman's language, these loans are like second mortgages on homes. Mezzanine financing is used in commercial real estate deals to obtain more funding when the lender will not venture beyond a certain loan-to-value ratio.
The cost of mezzanine capital typically is higher than secured debt, while mainly being unsecured and subordinated to the primary debt. For instance, if a default occurs, the mezzanine financing is repaid after all senior obligations have been satisfied.
In the risk and reward hierarchy for a lender, the position can be described as the higher the risks, the higher the rewards are for the lender. Technically, mezzanine debt can take the form of any of the following financing instruments: junior debt; preferred equity; convertible debt; and participating debt.
Convertible debt can be converted into equity either on fulfillment or nonfulfillment of certain conditions attached to the debt instrument. Participating debt occurs where the mezzanine financier participates in the net returns above a certain level.
Mezzanine debt offers term capital to borrowers at an affordable price. The cost is more than primary debt but less than equity. This also adds up to the return on investment by appropriate leverage of equity.
From the lender's perspective, mezzanine financing provides a higher return than the principal debt and has a lower risk than direct equity. Also, mezzanine financing can be structured in different ways, giving flexibility to the parties involved. For larger acquisitions, a mezzanine package minimizes the cost of a private equity sale.
Supply and Demand
On the supply side, the market segment is difficult to quantify because of various complications and different forms and types of debt structuring that occur. However, the increasing appetite of the lenders and investors to seek higher ROI for higher risks is pushing more transactions to use mezzanine financing.
On the demand side, three important aggregators are taking place in the current U.S. commercial real estate and capital markets: a pickup in new construction activities; expanding transaction activity; and increased senior loan obligation.
Investors may participate in the high yields from mezzanine loans through investments that either make mezzanine loans or hold this type of loan through a portfolio of debt securities. REIT companies specializing in commercial property debt often make mezzanine loans.
Loan participation-focused, closed-end funds also may own mezzanine debt. Both REIT and closed-end fund shares trade on the stock exchanges and can be purchased through a stock brokerage account.
Mezzanine financing can offer favorable risk and reward
opportunities for investors. However, it is difficult to recommend it unless
the interests of the borrowers are aligned with those of the mezzanine provider
and the first mortgage lender. For a beginner, the best way to look for
additional investment through mezzanine financing is to consult their banker,
accountant, and attorney. Even if unfamiliar, these professionals can locate
the right sources of mezzanine financing to structure a deal that is suited to
the borrower’s specific needs.