Mezzanine finance: fill the gap between senior debt and equity

Mezzanine finance sits between senior debt and equity. It can provide capital where a bank will not lend the full amount and shareholders do not want to fund the entire gap, but the lender normally charges more because it ranks behind senior lenders and can also receive rights that convert part of the debt into equity.

Mezzanine combines debt characteristics with equity-style upside

The British Business Bank describes mezzanine finance as a hybrid of debt and equity. The company borrows money and pays interest, but some structures allow the lender to convert debt into equity or receive other equity-linked rights if repayment fails.

This makes the product useful where a company needs more funding than senior lenders will provide but wants to limit immediate equity dilution.

Senior lenders normally rank ahead of mezzanine lenders

Mezzanine debt is typically subordinated to senior bank debt. If the business fails, senior secured creditors are generally paid before mezzanine lenders, while ordinary shareholders sit behind debt holders.

That weaker recovery position is one reason mezzanine pricing is higher. The borrower should read intercreditor and subordination terms carefully because they can affect what the company is allowed to pay and when.

The product can fund acquisitions, growth and larger projects

British Business Bank guidance highlights transactions such as acquisitions, property deals and scale-up projects where senior debt and shareholder funding leave a financing gap.

For a £5 million acquisition funded with £3 million senior debt and £1 million shareholder equity, mezzanine can potentially fill the remaining £1 million. The transaction still needs enough future cash flow to service all layers.

Expect pricing materially above ordinary senior debt

The lender bears more risk and can therefore charge a higher interest rate than a conventional secured bank. Fees and equity-linked participation can add further cost.

Compare mezzanine with selling more equity. The debt can preserve ownership if repaid successfully, but a high cash coupon can reduce flexibility during the very growth period the financing is supposed to support.

Equity conversion can dilute shareholders if things go wrong

Mezzanine can look less dilutive than equity at the start because shareholders keep their current ownership. That benefit changes if the company cannot repay and the lender exercises conversion or warrant rights.

Model the cap table under both successful repayment and conversion scenarios. Founders should know the maximum potential dilution before approving the deal.

Use mezzanine only where the business can support a layered capital structure

Management needs a realistic forecast showing senior interest, mezzanine interest, principal repayment and required working capital. The company should still have headroom under a downside scenario.

Use professional legal and finance advice because the documents are more complex than a normal business loan. The product works best when the financed project creates enough cash or value to support the higher-risk layer.

Worked example: a business buying a competitor for £10 million receives £6 million of senior bank debt and contributes £2 million of shareholder funds. A £2 million mezzanine layer closes the gap. If senior interest is 7 percent and mezzanine cash cost is materially higher, the combined debt service must still fit the acquired company's expected cash generation after integration costs.

Intercreditor terms deserve special attention. The senior lender can restrict payments to the mezzanine lender after a default or covenant breach, while the mezzanine lender can have rights that activate later. Management needs one debt schedule showing how these layers interact rather than treating each facility as a separate negotiation.

Mezzanine can also complicate a future refinance because a new senior lender will review the subordinated debt and conversion rights. Plan the capital structure as a whole. A funding gap solved today should not make the next financing impossible unless the project creates enough value to justify the complexity.

Check whether interest is paid entirely in cash or partly rolled up. Payment-in-kind interest can preserve current cash but increases the amount owed at maturity. Management should show both the current bank outflow and the growing future liability so the board does not confuse lower monthly cash cost with lower economic cost.

Review consent rights before making distributions or taking more debt. A mezzanine lender can have restrictions that sit between senior-bank covenants and shareholder rights. Treasury should add those conditions to the same compliance calendar used for bank covenants.

Before completion, calculate a combined leverage schedule showing senior debt, mezzanine principal, accrued interest and any equity-linked instruments. Lenders and future investors will look at the whole stack. A company can appear conservatively geared if it reports only bank debt while a large subordinated facility sits outside the headline number.