In the world of investments, mezzanine loans are a useful tool for both lenders and borrowers. There are many reasons why a buyer may want to obtain mezzanine financing for a transaction, as well as many reasons why an investor would be willing to fund a mezzanine loan.
When a buyer is assembling a large financial transaction, they must secure financing. Senior debt refers to the primary source of financing, such as a commercial real estate mortgage. Additional tiers of financing are required in such a deal, including subordinated debt and mezzanine debt or equity. All of these sources of financing, plus the cash that the buyer will invest as equity, are combined to complete the transaction. Then it is up to the buyer to ensure that payments are made on time and in full to all the lenders, including the mezzanine investor.
Mezzanine loans are the final tier of financing in such a deal, and they can be structured as a hybrid of debt and equity. That is, the mezzanine investor will receive a high interest rate on the loan, as well as a share of equity in the deal. This helps to offset the risk of mezzanine financing, as the investor will be last to recoup losses in the event that the buyer defaults.
Why would a mezzanine investor want to take such a risk? One reason is the aforementioned high interest rate. Investors can demand significantly higher interest rates than on senior or subordinated debt, often upwards of 20%. This is a potentially great reward for having accepted such risk. Mezzanine loans also have a shorter repayment period than a commercial mortgage, so this high return on investment is collected relatively quickly too, which is another advantage enjoyed by mezzanine investors.
The buyer also benefits from mezzanine financing, and not only because it can be necessary to ensure a complex transaction moves forward. The buyer makes an investment in the deal by putting up their own cash as equity. With mezzanine financing, the buyer does not have to invest as much. This can allow the buyer to engage in multiple transactions and mitigate their own financial risk so that they are not counting on the performance of a single investment. The buyer may also use mezzanine financing to maximize their return on equity.
Mezzanine loans can be used as a smart investment option for both borrowers and lenders when structuring complex transactions. Not only can they be a necessary source of financing for buyers, they have the potential to generate significant returns for investors.