MFEG Mezzanine Finance

Mezzanine finance, or ‘second mortgage finance’, is a financial bridge between debt and equity financing. It is a high-risk form of debt that sits between pure equity and pure debt. Due to its position between the two, it's a hybrid form of raising funds that can often lead to a healthy return to investors of up to 20% a year in most cases.

Flexibility in Financing

By injecting mezzanine capital into a project, developers can lower the loan-to-value ratio on senior debt, making it less risky for senior lenders. This can lead to lower interest rates, reduced pre-sale requirements, and improved access to senior financing. 

Mezzanine financing can enhance the financial structure of a development project, making it a more attractive proposition for senior lenders and potentially reducing overall borrowing costs.

Ownership and Financial Efficiency

Unlike equity financing, mezzanine loans do not require giving up ownership stakes. Additionally, the interest paid on mezzanine debt is tax-deductible, reducing the company's taxable income and potentially lowering its overall tax liability. 

This combination of control retention and tax advantages can significantly enhance the business's financial position, enabling it to access vital capital for growth and operations while optimising its tax efficiency.

Enhancing Business Growth and Stability

Instead of relinquishing equity, developers secure mezzanine loans, which act as a source of capital. These loans offer flexible terms, higher interest rates, and sometimes an equity kicker, allowing developers to access funds for various projects simultaneously while retaining full ownership and control of their ventures. It's a strategy that helps developers scale their business without the need for equity partners.

There are three key supports that mezzanine finance offers businesses contemplating project investment.

1. Risk Mitigation: Mezzanine financing reduces the risk for senior lenders by providing additional capital, which can lead to more favourable terms and lower interest rates on senior debt. This mitigates the financial risk associated with the project, making it more attractive to lenders and investors.
2. Property Purchase: Mezzanine financing can be used to cover part of the property purchase price. This is particularly beneficial when developers want to acquire a property but need more equity for a down payment. Mezzanine loans bridge this gap, facilitating property acquisition.
3. Cash Flow Management: Mezzanine financing provides developers with an infusion of capital that can be used for various project needs, including construction costs, permits, and other expenses. This ensures smooth cash flow management throughout the development process, reducing the risk of delays or cost overruns.

Here is an example of mezzanine finance. The Bank of Floyd provides Happy Homes with $20 million in loan financing. This was instead of a $10 million credit line.

Happy Homes now has more capital to speed up the finishing of a housing development by being able to hire more workers and purchase more supplies.

The Bank of Floyd will collect 10% a year in interest payments and will be able to convert any debt remaining into an equity stake if Happy Homes ever defaults on their loan.

The Bank of Floyd, as part of the conditions, was also able to prevent Happy Homes from borrowing additional funds to apply some financial ratio standards.

There are risks and rewards for both borrowers and lenders.

Rewards for Borrowers: It provides access to substantial capital without immediate equity dilution, enabling growth and project expansion. Additionally, the interest on mezzanine debt is tax-deductible, reducing overall financing costs.

Risks for Borrowers: Mezzanine debt financing involves higher interest rates and potential equity conversion, impacting profitability. Default risks can lead to asset loss or equity dilution.

Rewards for Lenders: Mezzanine lenders enjoy higher interest rates, potential equity upside, and a position ahead of equity investors in case of default.

Risks for Lenders: The subordinate position increases risk, as they are repaid after senior debt. Borrower defaults can result in losses.

Factors influencing risk profiles include:

• the borrower's creditworthiness, 
• project viability, and 
• economic conditions.

Mezzanine financing combines elements of debt and equity, offering capital with interest and potential equity conversion. It avoids immediate equity dilution, making it appealing to borrowers. 

In contrast, equity financing involves selling ownership shares in the business to investors, diluting existing ownership. 

While mezzanine financing offers a middle ground between pure debt and equity, equity financing results in direct ownership changes and shared control.