Mezzanine Debt and Preferred Equity Program

Mezzanine debt and preferred equity fill a similar role in a capital structure but have important differences. A mezzanine debt and preferred equity program where either one or both forms of capital is employed can radically enhance a company’s access to capital and change the course of a company’s future. Mezzanine debt is a hybrid of subordinated debt and equity like options. Mezzanine debt has many of the traditional elements of a loan such as a term, interest rate, covenants and control provisions. It also has elements of preferred equity due to the warrant which gives the lender additional return upside, ahead of the common shareholders. Both forms of capital can be sourced directly and can be used to fund acquisitions and rapid growth. Preferred equity comes ahead of the common shares and has a dividend which accrues over its life. The preferred shares are either redeemable, similar to the principal on a loan being repaid, or convertible into the common shares. Mezzanine debt goes on the balance sheet as a loan whereas preferred equity is listed as equity. The big difference is the way that each investor realizes their return. The mezzanine debt lender targets an annual return of approximately 16% and makes about 12% of that return through collecting interest. The remaining 4% of their return comes through a warrant which is tied to the future value of the company. The lender usually takes a small warrant percentage, generally in the 2% to 5% range. When the warrant gets paid out, at the end of the deal, the lender gets enough return to give them this extra 4% return on an annual basis. Thus, the mezzanine lender receives 75% of their return through interest payments over the life of the loan. This contrasts with the return composition for the preferred equity investor. They target higher returns, generally 18% to 22%, and receive all of their return on the back end when their shares are cashed out. They generally do not get dividend payments during the life of the deal. This means that they are very focused on the long term value growth of the companies they invest in. Preferred shareholders receive much larger ownership percentages in the company than mezzanine lenders do, usually in the 20% to 30% range. They require this level of ownership because they have to make sure that they will reach their targeted return over the life of the deal, when their shares are cashed out. So the mezzanine lender gets paid over time whereas the preferred investor gets paid on the back end. All things being equal, companies are better off opting for the mezzanine debt. It is less dilutive and less expensive.