Mezzanine financings can be completed through a variety of different structures based on the specific objectives of the transaction and the existing capital structure in place at the company. The basic forms used in most mezzanine financings are
subordinated notes and
preferred stock. Mezzanine lenders, typically specialist mezzanine
investment funds, look for a certain
rate of return which can come from
securities made up of any of the following or a combination thereof: • Cash interest: A periodic payment of cash based on a percentage of the outstanding balance of the mezzanine financing. The interest rate can be either fixed throughout the term of the loan or can fluctuate (i.e., float) along with a benchmark rate such as
SOFR or other
base rates;
LIBOR was widely used for this purpose until it was discontinued on 30 June 2023. • PIK interest:
Payable in kind interest is a periodic form of payment in which the interest payment is not paid in cash but rather by increasing the principal amount by the amount of the interest (e.g., a $100 million bond with an 8% PIK interest rate will have a balance of $108 million at the end of the period, but will not pay any cash interest). • Ownership: Along with the typical
interest payment associated with
debt, mezzanine capital will often include an
equity stake in the form of attached
warrants or a
conversion feature similar to that of a
convertible bond. The ownership component in mezzanine securities is almost always accompanied by either cash interest or PIK interest, and, in many cases, by both. Mezzanine lenders will also often charge an arrangement fee, payable upfront at the closing of the transaction. Arrangement fees contribute the least return, and their purposes are primarily to cover administrative costs or as an incentive to complete the transaction. The following are illustrative examples of mezzanine financings: • $100 million of
senior subordinated notes with warrants (10% cash interest, 3% PIK interest and warrants representing 4% of the fully diluted ownership of the company) • $50 million of
redeemable preferred stock with warrants (0% cash interest, 14% PIK interest and warrants representing 6% of the fully diluted ownership of the company) In structuring a mezzanine security, the company and lender work together to avoid burdening the borrower with the full interest cost of such a loan. Because mezzanine lenders will seek a return of 14% to 20%, this return must be achieved through means other than simple cash interest payments. As a result, by using equity ownership and PIK interest, the mezzanine lender effectively defers its compensation until the due date of the security or a change of control of the company. Mezzanine financings can be made at either the operating company level or at the level of a
holding company (also known as
structural subordination). In a holding company structure, as there are no operations and hence no cash flows, the structural subordination of the security and the reliance on cash
dividends from the operating company introduces additional risk and typically higher cost. ==Uses==