Mezzanine Capital: Features, Benefits and Examples

Businesses often require funding beyond what traditional bank loans or equity can offer. One such financing option, particularly useful for growing companies, is mezzanine capital. Though it sits between debt and equity on the capital structure, it offers unique flexibility for both investors and business owners. In this blog, we’ll explore what mezzanine capital is, how it works, its features, benefits, and real-world applications in the Indian context.

What Is Mezzanine Capital?

Mezzanine capital is a hybrid form of financing that combines elements of debt and equity. It typically comes into play when a business needs additional funding but doesn’t want to dilute too much equity or lacks sufficient collateral for a traditional loan.

This form of financing often involves unsecured loans with a higher interest rate than senior debt. In return for the higher risk, lenders may receive equity warrants or options to convert the loan into equity if it isn’t repaid on time. This arrangement makes it a middle ground between safer loans and riskier equity investments.

How Mezzanine Capital Works

Mezzanine capital usually enters the picture during business expansion, acquisitions, or management buyouts. Here’s how it generally works:

• A company raises mezzanine funding from specialised investors or financial institutions.

• The funding is structured as subordinated debt, which ranks below senior debt but above equity.

• The borrower agrees to pay a fixed interest (or coupon) along with potential equity upside through warrants or conversion rights.

• If the company defaults, mezzanine lenders have secondary claim after senior lenders but before shareholders.

This setup benefits companies that want to avoid giving up ownership while still securing capital for growth.

Features of Mezzanine Capital

Mezzanine capital has distinct features that differentiate it from other financing instruments:

• Subordinated Position: It ranks below senior debt in the repayment hierarchy.

• Higher Returns for Lenders: Due to increased risk, it typically offers interest rates between 12% and 20%, along with equity upside.

• Flexible Terms: It may include bullet payments (principal at maturity) or interest-only periods.

• Convertible Options: Lenders may convert debt into equity, especially if repayment becomes difficult.

• No Immediate Dilution: Unlike direct equity financing, it does not dilute ownership immediately.

• Customisation: Terms can be negotiated to suit both the investor’s return expectations and the business’s cash flow needs.

Benefits of Mezzanine Capital

Mezzanine capital can be advantageous for both growing companies and investors. Here are its primary benefits:

For Businesses:

• Growth Without Losing Control: Ideal for founders who want funds without giving away substantial ownership.

• Bridges Financing Gaps: Useful when a company needs more capital than a bank will lend but wants to avoid full equity dilution.

• Tax Benefits: Interest payments are usually tax-deductible, reducing the effective cost of borrowing.

• Enhanced Valuation: It allows businesses to reach a milestone (like expansion or acquisition) that can improve company valuation before the next funding round.

For Investors:

• Higher Yield: Offers better returns than traditional debt.

• Equity Upside: If the company performs well, equity conversion or warrants can deliver significant gains.

• Priority Over Equity: Investors have a better position than shareholders in case of liquidation.

How to Raise Mezzanine Capital in India

In India, raising mezzanine capital is possible through various channels, though it remains a niche form of financing. Here's how businesses typically raise it:

1. Approach Private Equity Firms: Some PE and venture capital firms offer mezzanine funding to companies in their growth phase.

2. NBFCs and Investment Banks: Non-banking financial companies and boutique investment banks offer structured mezzanine deals.

3. Corporate Venture Arms: Large corporations with strategic interests in startups may offer mezzanine capital.

4. Specialised Mezzanine Funds: Though still emerging in India, some funds focus on hybrid financing structures.

Before seeking mezzanine capital, a company should have a solid business plan, stable cash flows, and clear growth prospects to attract interest from potential lenders.

Examples of Mezzanine Capital

To understand how mezzanine capital works in practice, here are a few scenarios:

Example 1: Business Expansion

A mid-sized manufacturing firm in Gujarat seeks ₹10 crore to set up a new plant. Banks approve only ₹6 crore. To bridge the ₹4 crore gap without equity dilution, the firm raises mezzanine capital. The lender offers funding with 15% interest and warrants to purchase equity at a later stage.

Example 2: Management Buyout

A group of senior managers in a Bengaluru tech firm wants to buy out existing owners. They lack the full amount and use a mix of senior debt and mezzanine financing. The mezzanine lender receives a fixed return and equity options if the buyout succeeds.

Example 3: Real Estate Development

A real estate developer in Mumbai needs capital for project completion. With senior debt exhausted, they opt for mezzanine funding. The investor gets repayment priority over equity holders and potential profit-sharing upon project sale.

These examples highlight how mezzanine capital offers flexible solutions without immediate equity dilution.

Conclusion

Mezzanine capital is a powerful financing tool for businesses that are too large for traditional startup funding but not quite ready for full-scale public markets or equity dilution. Its hybrid nature provides the best of both worlds - debt for capital access and equity for investor returns.

While it comes at a higher cost than senior debt, the flexibility, minimal dilution, and growth potential it offers make it worth considering for strategic business milestones. As the Indian startup and SME ecosystem matures, mezzanine capital is likely to become a more mainstream option.