Mezzanine Debt: What It Is, How It Works, and Examples

Adam Hayes, Ph.D., CFA, is a financial writer with 15+ years Wall Street experience as a derivatives trader. Besides his extensive derivative trading expertise, Adam is an expert in economics and behavioral finance. Adam received his master's in economics from The New School for Social Research and his Ph.D. from the University of Wisconsin-Madison in sociology. He is a CFA charterholder as well as holding FINRA Series 7, 55 & 63 licenses. He currently researches and teaches economic sociology and the social studies of finance at the Hebrew University in Jerusalem.

Mezzanine debt occurs when a hybrid debt issue is subordinated to another debt issue from the same issuer. Mezzanine debt has embedded equity instruments attached, often known as warrants, which increase the attractiveness of the subordinated debt and allow greater flexibility when dealing with bondholders.

Mezzanine debt is frequently associated with acquisitions and buyouts, for which it may be used to rank new owners higher than existing owners in the stakeholder seniority list in case of company liquidation.

Investopedia / Jake Shi

Mezzanine debt bridges the gap between debt and equity financing and it's one of the highest-risk forms of debt. It's senior to pure equity but subordinate to pure debt but it also offers some of the highest returns when compared to other debt types. It often receives rates between 12% and 20% per year.

The types of equity included with the debt can be many. Some examples of embedded options include stock call options, rights, and warrants.

Mezzanine debt behaves more like a stock than debt in practice because the embedded options make the conversion of the debt into stock very attractive.

Mezzanine debt structures are most commonly found in leveraged buyouts. A private equity firm might seek to purchase a company for $100 million with debt but the lender only wants to put up 80% of the value and offers a loan of $80 million. The private equity firm doesn't want to put up $20 million of its own capital and instead looks for a mezzanine investor to finance $15 million.

The firm then only has to invest $5 million of its own dollars to meet the $100 million price tag. The investor used mezzanine debt so they'll be able to convert that debt to equity when certain requirements are met. Using this method of financing leverages the buyer's potential return while minimizing the amount of capital that it must put up for the transaction.

A hybrid security classification on the balance sheet under U.S. Generally Accepted Accounting Principles (GAAP) is dependent on how the embedded option is influenced by the debt portion. The two parts of the hybrid (the debt and the embedded equity option) must be classified in both the liability and stockholders' equity sections of the balance sheet if the act of exercising the embedded option is influenced by the structure of the debt in any way.

Mezzanine debt is most often used in mergers and acquisitions. Olympus Partners, a private equity firm based in Connecticut, received debt financing from Antares Capital in 2016 to acquire AmSpec Holding Corp, a company that provides testing, inspection, and certification services for petroleum traders and refiners.

The total amount of the financing was $215 million. This included a revolving credit facility, a term loan, and a delayed draw term loan. Antares Capital provided the total capital in the form of mezzanine debt, thus giving it equity options.

Equity financing is a means of raising capital through company shares. The shares are sold by the company to investors, granting them a percentage of ownership rights.

Hybrid securities share characteristics of stocks and bonds. They include preferred stocks, convertible bonds, and exchange-traded notes. Risks and returns hover somewhere in the middle between stocks and bonds. An investor can convert a convertible bond into a stock relatively easily but these bonds generally offer lower interest rates.

Warrants are securities that come with the right but not the obligation to purchase them. They're sometimes included with other bonds and shares or awarded to employees as an incentive. The price and a deadline to act are set at inception.

Mezzanine debt is the result of a hybrid debt issue being subordinated to another debt issue from the same issuer. It's often used in mergers and acquisitions. It provides a bridge between debt and equity financing and it shares several characteristics with stocks. Returns can range up to 20% annually, making this type of debt an attractive option for investors over other debt types.

CFI Education. "Mezzanine Financing."

Resurgent India Limited. "Mezzanine Funding—Meaning, Need and Types."

CFI Education. "Equity Financing."

The Vanguard Group. "What Are Hybrid Securities?"

CFAJournal. "What Is a Warrant in Finance?"