How does Mezzanine Financing Work in Construction Financing

How Does Mezzanine Financing work?

Mezzanine Financing is an offering made to investors by private companies to purchase debt-notes in those companies with the option to later convert the notes to an equity stake.

For example, a private construction company may need to finance the purchase of some equipment costing $5,000,000 in order to have the capacity to take on more work as they grow. However, the construction company does not have the resources on hand to pay for their purchase, so they go to the mezzanine debt market in order to obtain enough money to make the purchase, which in turn will boost their output ability moving forward.

For the sake of this example, let's say that 10 different private investors were willing to pay $500,000 each to help the construction company complete its purchase. Each investor is offered a debt security by the company owner that pays 6% interest annually for 12 years and then returns the principal at the end of those 12 years, or the investor can convert the note to a 3% equity stake in the company within five years.

This would stop the interest payments that the creditor (i.e. the investor) is owed by the construction company, but that investor would have a say in company operations and would also be able to draw trail revenue from the company operations moving forward. The trail would likely be far less than the 6% annually he or she was getting on the debt holding, but the income stream would perpetuate unless if the company providing it went out of business.

Mezzanine Financing Rates

Generally speaking, mezzanine debt rates are usually higher than most other market rates for debt offerings, because the investors are investing in private companies. Since private companies aren't overseen by a governing body like the SEC, that means that there is far less transparency in this marketplace.

As a result, mezzanine debt commands a higher interest rate than senior debt, because the holders of mezzanine debt aren't always entitled to clear information about their investments. Senior debt holders, like banks, usually require highly audited financial statements before they are willing to loan, but once those statements are verified larger institutions are usually willing to make loans at relatively cheap rates.

Furthermore, if the company holding the debt were to default, mezzanine financed debt collections are paid out following the collections of senior debt-holders. This means that larger institutions, like the banks, who have given the company loans will get first dibs on collections when a company declares bankruptcy, thus making their investment higher priority and more insulated/insured.

Mezzanine Finance Providers

There are a number of available mezzanine financing providers to choose from. For the smallest of companies, the simplest place to start is with friends and family. However, for large institutions, groups like Peninsula Funds, Blackrock, American Capital and others may be more realistic for providing large amounts of investment capital.

What Does All This Mean?

The most important thing to take from this article is this: your options are many. The best construction loan may or may not be a mezzanine-based debt offering. Depending on the company, it may be easier to get a loan from a bank, P2P lending site like LendingTree (assuming it is an S-corp), or other locations without having to pay such a high interest rate.

Furthermore, it is always worthwhile to consider all of the options available when choosing where one can obtain a loan, as many options do not require the risk of giving away company equity stake, as mezzanine financing does, when it comes to getting a loan. Some loan offerings just require a proposition of collateral and interest in exchange for a decently cheap market rate.