Mezzanine Financing includes an instrument called Mezzanine Debt that has an equity instrument embedded within it. Mezzanine essentially relates to an intermediate floor connecting two main floors of a building. This instrument has an option to be converted into equity after a certain set of mandates have been met. Mezzanine Debt is an unsecured form of debt leading to higher risk. However, the equity convertibility option makes it attractive for the lender. On the other hand, borrowers find it attractive due to the tax deduction allowed for the interest payments of mezzanine debts.
It is important to note here that Mezzanine Debt is neither pure equity instrument nor pure debt instrument. It gains a priority over the common equity stock as well as the preferred equity but comes below the company’s creditors. Hence, Mezzanine Financing/Debt acts as a connecting link between the company’s total debt and total equity.
Mezzanine Debt is usually used for the expansion of the company that has gained significant growth. It gains importance during acquisitions and buyouts because it can balance the interests of the old as well as the new owners of the company. It also enables the lenders to take some time to gauge the company’s perforce before becoming a full-time equity owner of the company, however, that is quite rare to observe. On average, 20%+ returns are gained out of Mezzanine Debts by the lenders making Mezzanine Financing even more attractive.