What is Mezzanine Debt?

Mezzanine debt is a hybrid debt issue that’s subordinate to pure debt, but has a higher priority than pure equity, representing the middle ground between debt and equity financing.

It has equity options attached that allow the conversion of debt into stock and is often used in acquisitions and buyouts to ensure that new owners have priority over existing owners should the company go bankrupt. It’s among the highest-risk types of debt but offers higher returns compared to most other types of debts. 

Mezzanine debt explained

Different types of investments in a company have different priorities. This is most evident in a bankruptcy. Debt has the highest priority and is settled first in the event of liquidation. Equity is settled last. This makes equity the riskiest form of investing in a company and debt the safest form. 

The returns also reflect the risk. Equities enjoy the highest returns, while debt has the lowest return. Mezzanine debt is the middle ground between the risk/reward nature of debt and equity.

Mezzanine debt is an instrument that acts like a debt instrument but can be converted to equity. This makes it a high-risk debt instrument. It’s riskier and has a lower priority than pure debt, although it offers higher returns. It also has a higher priority than equity.

Companies use mezzanine debt in scenarios such as:

Mezzanine debt is structured in such a manner that it can be converted to equity when the debtor wishes. It can be implemented using stock call options, rights, or warrants. When the equity value is higher than the yield of the debt, it’s better to convert mezzanine debt to equivalent equities. 

In the event of bankruptcy, it’s better to maintain it as debt, as it has a higher priority than equity in the event of liquidation. Due to the nature of mezzanine debt instruments, it behaves more like a stock than debt.

Example of mezzanine debt

ABC, a venture capital (VC) firm, is an existing investor in the company K. K needs more capital to fund its growth. ABC believes in the future of K but does not have the needed capital to fund the $10M K requires. ABC ropes in private equity firm XYZ to invest in K, but XYZ does not like the risk exposure of an equity investment in K. Also, K does not have sufficient collateral for a secured loan because it’s a new and growing company.

The middle ground is mezzanine debt. XYZ offers $10M as debt to K. It has provisions to convert the debt into equity using a stock call option. With a stock call option, XYZ can gain equity in K at a predetermined price before the option expires. If K grows fast, the value of equity will be worth more than the debt. In this case, XYZ earns higher returns by converting the debt to equity. If the company goes bankrupt instead of growing, XYZ can retain it as a debt and will have a higher priority than shareholders. As a result, XYZ has the potential for better rewards with lower risk.

Mezzanine debt is a hybrid debt instrument that offers flexibility to convert the debt to equity or maintain it as a debt, depending on the company’s financial situation. It’s a middle of the road option that has a higher priority than equity and a lower priority than pure debt, but it produces higher returns compared to pure debt.