Mezzanine finance: what it is and when it is used

Mezzanine finance is borrowing that ranks below a senior loan but above the owners’ equity, so it is repaid after the senior lender and before shareholders. The word comes from the architectural term for a middle floor, and the finance sits in the middle of the funding structure in the same way.

Because it ranks lower, the lender carries more risk if the business struggles. That is why it is priced differently from senior debt and why it is used for specific purposes rather than everyday working capital. It is also a specialist product: the people who offer it tend to look at larger and more complex deals.

Mezzanine debt ranks behind senior debt and ahead of equity when a company’s assets are used to pay what it owes. GOV.UK explains that when a company is liquidated its assets are used to pay off its debts, and any money left goes to shareholders.

The order is set by the security each lender holds and by insolvency law, and the details sit in the loan documents. Capzy does not give legal advice, so a solicitor should read how the layers rank in your deal before you sign.

Mezzanine finance is usually a loan documented separately from the senior facility, with its own repayment terms, and often a second charge or a different type of security. Companies House describes a charge as the security a company gives for a loan, and a charge created by a company must be registered within 21 days or it may be difficult to recover the debt if the company becomes insolvent.

The features that set it apart from a senior loan tend to include:

• Subordination: the lender agrees its claim ranks behind the senior lender, often set out in an agreement between the two lenders.
• Flexible repayment: interest may be paid in cash, added to the balance until the end, or split between the two. Capital is often repaid in one go at the end of the term.
• Extra reward: some mezzanine lenders take a small share in the business as well as interest, for example through an option to buy shares. Ask whether a deal includes this.
• Covenants: conditions about performance, further borrowing or changes in ownership, which the business must keep to.

The senior lender will usually have a say in whether junior debt is allowed at all. If you are comparing the two layers, our guide on secured and unsecured borrowing explains the basic difference in how lenders take security.

Businesses use mezzanine finance when senior debt and their own money do not cover the full cost of a project and they would rather not sell more of the company. It tends to fill the gap between the two.

• Property development: it can top up senior development lending on a larger scheme. See our guide to development finance for the senior layer.
• Acquisitions: it can help a buyer fund the price of another company, covered in our guide to acquisition finance.
• Management buyouts: it can fill the gap between senior debt and the managers’ own funds in a management buyout.
• Growth: an established company may use it to fund expansion once senior borrowing is fully used.

The government’s National Housing Bank, for example, lists senior and mezzanine lending among the products it offers to housebuilders in England, which shows how the two layers can sit together on one scheme.

Mezzanine finance is not right when cash flow is thin, the business cannot comfortably service another layer of debt or a simpler product would do the job. Junior debt adds a repayment on top of the senior one, and it is the layer lenders are most likely to price for risk.

• The business is early stage or has no steady trading record to support repayments.
• The amount is small enough for a conventional loan, asset finance or invoice finance.
• There is no clear way to repay at the end, such as a sale, a refinance or strong cash generation.
• The senior lender’s terms prohibit further borrowing.

A useful test is cover. Our guide to interest cover ratio shows how lenders judge whether profit is enough to pay the interest on all the debt together.

The main risks are the cost, the extra pressure on cash flow and the rights the lender holds if things go wrong. A business takes on a second lender who has its own conditions, and in a downturn two lenders can be harder to deal with than one.

Directors may also be asked for a personal guarantee. If a company cannot pay its debts, speak to a licensed insolvency practitioner and take advice early. Our overview of company insolvency sets out the options.

Mezzanine finance to a limited company is generally outside the FCA’s consumer credit perimeter. The FCA says business lending above £25,000 would generally fall outside that perimeter, and that a loan to a limited company would not be within it.

That does not mean there are no protections: the loan agreement is a contract and it should be read closely. Terms are negotiated, so the lender’s documents carry more weight than any standard rules.

Alternatives include a larger senior facility, asset or invoice finance, a bridging loan for a short gap and, for growing companies, equity or venture debt. Which suits you depends on what the money is for and how it will be repaid.

Capzy is a credit broker, not a lender, and is paid by the lender. Mezzanine finance is specialist and is often arranged through corporate finance advisers, so it may not be something we can help with directly. Where a lender offers junior or second-charge debt for a property deal, we can introduce you, subject to status and that lender’s criteria.

You can check your funding options with a soft search that does not affect your credit score. A full application to a lender may involve a hard search, and any offer is subject to status and lender criteria. Speak to an accountant or solicitor about the structure before you commit.