How Mezzanine Debt Works
Mezzanine debt occupies a specific position in the capital structure hierarchy. Senior secured lenders have first claim on the borrower's assets, mezzanine lenders are next, and equity holders are last. This ordering determines who gets paid first if the borrower cannot meet all its obligations.
Because of its subordinated position, mezzanine debt carries higher interest rates than senior debt to compensate for the additional risk. Mezzanine instruments may also include equity conversion features (such as warrants) that give the lender upside participation if the borrower performs well. Common structures include subordinated notes, second-lien loans, and preferred equity with debt-like characteristics.
Mezzanine Debt in Portfolio Acquisitions
Some debt portfolio buyers use mezzanine financing as part of their capital structure. A buyer might fund a portfolio acquisition with a combination of senior bank debt, mezzanine financing, and equity. The senior lender and mezzanine lender will enter into an intercreditor agreement that governs their respective rights and priorities.
The mezzanine lender's return depends on the portfolio's recovery performance. If collections exceed expectations, the mezzanine lender receives its contracted interest plus any equity kicker. If collections disappoint, the mezzanine lender bears losses after the senior lender is repaid but before equity investors.
Distressed Mezzanine on the Secondary Market
When a borrower encounters financial difficulty, the mezzanine position often trades at a significant discount to par value because of the increased risk of loss. Specialized investors in the Canadian secondary market acquire distressed mezzanine positions when they believe the discount exceeds the actual risk of loss, or when they plan to use the position strategically in a restructuring. The pricing of distressed mezzanine debt depends on the borrower's overall financial health, the terms of the intercreditor agreement, and the likelihood and timing of recovery.
Frequently Asked Questions
What is mezzanine debt?
Mezzanine debt is subordinated debt that sits between senior secured debt and equity in a company's capital structure. It carries higher interest rates than senior debt because it is repaid after senior obligations in the event of default. Mezzanine instruments may include equity conversion features such as warrants.
How does mezzanine debt relate to debt portfolio acquisitions?
Some portfolio buyers use mezzanine financing as part of their capital structure to fund acquisitions. The mezzanine lender's return depends on the portfolio's recovery performance. If collections exceed expectations, the lender earns its contracted interest plus any equity participation. If collections disappoint, the mezzanine lender absorbs losses before equity investors.
Can distressed mezzanine debt be bought and sold?
Yes. When a borrower encounters financial difficulty, mezzanine positions often trade at a significant discount on the secondary market. Specialized investors acquire these positions when they believe the discount exceeds the actual risk of loss, or when they plan to use the position strategically in a restructuring.
Related Insights
Distressed Mezzanine Debt: Hold or Sell?
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Intercreditor Agreements and Mezzanine Debt Sales
How intercreditor agreements affect mezzanine debt transactions.