What is mezzanine finance?

Mezzanine provides subordinated capital between what the senior lender will advance and the equity the sponsor is willing to contribute. It is contractually junior to senior debt, so in a wind-up the senior lender's claims are met first. Interest can be paid in cash monthly or quarterly like a normal loan, or accrue as payment-in-kind (PIK) interest that is added to the balance when cash is tight, which increases the principal outstanding.

To compensate for the extra risk, the lender often takes an equity kicker: warrants, conversion rights or a share of profits. Terms commonly run two to seven years and are matched to a defined exit, such as refinancing with cheaper senior debt, an asset sale, an equity recapitalisation or a sponsor buyout. Without a credible, timed exit plan, mezzanine is hard to obtain.

Mezzanine is delivered through a few common instruments. A subordinated loan is contractual debt with a fixed interest rate that sits below the senior facility, often secured by a second-ranking charge. A convertible note starts as a loan and converts into equity at a set price or on an event such as the next equity round. Preferred equity ranks above ordinary shares for dividends and in a liquidation but below all debt. Warrants give the lender an option to buy equity at a strike price.

Security varies by deal: a second-ranking mortgage or charge over property, a fixed charge over specific assets such as units in a development entity, share pledges or negative pledges. An intercreditor agreement with the senior lender sets the payment waterfall, standstill periods and step-in rights, and limits when the mezzanine lender can enforce.

Typical uses are buyouts and acquisitions where the senior lender funds most of the purchase price, property development top-ups once the senior loan-to-value ratio limit is reached, recapitalisations where owners want to extract value without full dilution, growth capital for businesses with predictable cashflow but little spare collateral, and short-term bridging of an equity shortfall until a refinance or sale.

Providers include specialist mezzanine funds, private credit managers, private equity funds offering convertible notes or preferred equity, boutique lenders and family offices. High net worth investors sometimes participate in smaller property deals. Smaller businesses can access mezzanine through boutique funds and family offices, although terms tend to be tighter and costs higher than for large sponsors.

Pricing has several layers: cash interest, any PIK interest, arrangement and exit fees, the value of the equity kicker, and legal and due diligence costs. The loan is often a bullet, interest only with principal due at maturity, and covenants are usually lighter than on senior debt. Lenders assess the whole capital stack, the combined loan-to-value ratio, debt service cover, the sponsor's track record and the exit scenarios.

Interest and borrowing costs are generally deductible where they are genuine financial expenses. Convertible notes and preferred equity can raise debt versus equity characterisation questions that affect deductibility and investor tax outcomes, some security arrangements attract state duties, and conversion features may need special accounting treatment. Check the structure with your accountant, tax adviser and lawyer before signing.