What Is Mezzanine Debt?
Let me explain mezzanine debt directly: it's what happens when a hybrid debt issue gets subordinated to another debt from the same issuer. You'll see embedded equity instruments attached, like warrants, which boost the appeal of this subordinated debt and give more flexibility in dealing with bondholders.
This type of debt often comes up in acquisitions and buyouts, where it can prioritize new owners over existing ones in the event of liquidation.
Understanding Mezzanine Debt
You need to know that mezzanine debt fills the space between straight debt and equity financing, and it's one of the riskiest debt forms out there. It's junior to pure debt but senior to pure equity, yet in practice, it acts more like stock because those embedded options make converting to equity highly appealing.
Expect some of the highest returns compared to other debts—rates often hit 12% to 20% per year, and in high-leverage cases, they can reach 40%.
Types of Mezzanine Debt
The equity components in mezzanine debt can vary widely. Think stock call options, rights, or warrants as common embedded options. Remember, these make the debt behave more like stock, especially since conversion becomes so attractive.
Example of Mezzanine Debt
You'll see mezzanine debt most in leveraged buyouts. Suppose a private equity firm wants to buy a company for $100 million but the lender only covers $80 million. The firm doesn't want to front the full $20 million, so it brings in a mezzanine investor for $15 million, leaving just $5 million from its own pocket.
This setup leverages returns while cutting capital needs, and the investor gets conversion rights to equity if conditions are met.
Under U.S. GAAP, classify the hybrid based on how the embedded option ties to the debt—split it into liability and equity on the balance sheet if there's influence.
A real case: In 2016, Olympus Partners used $215 million from Antares Capital, including mezzanine debt with equity options, to acquire AmSpec Holding Corp.
Frequently Asked Questions
What is equity financing? It's raising capital by selling company shares, giving investors ownership stakes.
What is a hybrid security? These blend stock and bond traits, like convertible bonds or preferred stocks, with middling risks and returns—easy to convert but often with lower rates.
What is a warrant in finance? It's a security granting the right, not obligation, to buy at a set price by a deadline, often bundled with bonds or given as incentives.
The Bottom Line
To wrap this up, mezzanine debt arises from subordinating one hybrid debt to another from the same issuer, commonly in mergers and acquisitions. It bridges debt and equity, shares stock-like features, and delivers returns up to 20% or 40% in some cases, making it a strong choice over other debts for investors seeking higher yields.
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