Mezzanine Debt
Mezzanine debt is the layer between senior debt and equity: a subordinated loan that ranks behind the banks, is repaid later, charges a high rate — much of it rolled up — and often carries warrants over the equity. It fills the gap when senior lenders will not lend enough and the sponsor will not add equity, at a price that reflects being second in line.
- Also known as
- Mezzanine financing, Mezz, Subordinated debt with warrants
- Used at
- leveraged buy-outs, growth financing of companies too levered for banks, and refinancings when senior capacity has fallen — less common since private credit funds began lending the whole stack as "unitranche"
- Binding
- a mezzanine facility agreement, an intercreditor agreement subordinating it to the senior debt, and a warrant instrument if there is equity participation
- Typical terms
- 10–15% total return, of which 4–6% cash interest and the rest rolled up (payment-in-kind) or in warrants; a bullet repayment after the senior debt, typically 6–8 years; covenants set 10–15% looser than the senior lenders'
- Typical size
- 1–2× EBITDA on top of 3–4× of senior debt; the last turn of leverage
- Parties
- the borrower, the mezzanine fund (specialist lenders, insurers), the senior lenders who dictate the subordination, and the sponsor whose equity ranks below
How mezzanine debt works in practice
A sponsor buying a company with €20m of EBITDA for €200m finds senior lenders will provide €80m at 4×. It wants to put in €90m of equity, not €120m. A mezzanine fund lends the €30m gap: 12% a year, 5% paid in cash and 7% rolled into the principal, repayable in seven years after the senior debt, with warrants over 4% of the equity. The senior lenders accept because the mezzanine is subordinated — it cannot be repaid or enforced ahead of them, and its cash interest stops if the senior covenants are breached. The sponsor accepts because €30m of mezzanine at 12% is cheaper than €30m of equity at the 20% it needs, provided the business performs.
The mezzanine lender's position is between: senior to the equity, so it is paid before the sponsor in a restructuring; junior to the banks, so it is paid after them, and in a bad case not at all. Its return therefore has two parts — the contractual interest, which it collects if the company survives, and the warrants, which pay if the company thrives. In a restructuring the mezzanine is often the "fulcrum" — the class whose claim the value runs out in, and which therefore ends up owning the company.
Unitranche loans from private credit funds — one facility at a blended rate replacing senior plus mezzanine — have taken much of the market since 2018, but the layer returns whenever banks retreat.
Example
The €30m mezzanine tranche above accrues: after seven years the rolled-up 7% has taken the principal to about €48m, on top of €1.5m of cash interest a year. The company is sold in year six for €320m. The senior debt of €55m remaining is repaid; the mezzanine receives its accrued €45m plus 4% of the equity through its warrants — 4% of (€320m − €100m of debt) = €8.8m — a total of about €54m on €30m lent, a 13.5% annual return. The sponsor's €90m of equity becomes €211m — 2.3×. Had the company been sold for €160m instead, the senior would have been repaid, the mezzanine would have received €45m of the remaining €105m, and the sponsor €60m on €90m — the mezzanine paid in full, the equity at a loss, which is the ranking working as written.
Common mistakes
- Treating rolled-up interest as free; it compounds and comes out of the exit. - Warrants granted without modelling their cost at the exit values the sponsor hopes for. - Intercreditor terms that let the mezzanine enforce while the senior debt is outstanding — no senior lender will sign. - Mezzanine sized to close the price gap rather than to what the cash flows can carry after the senior debt. - Forgetting the fulcrum: in a downturn the mezzanine lender is the one who ends up with the keys.