In the industry known private investment funding is typically known as "mezzanine finance"?
Mezzanine finance is a cross between the two traditional ways of sponsoring a project:
Debt financing – money is borrowed from a lender and paid back over an agreed period of time in addition to interest. Examples of debt financing include mortgages, secured and business loans.
Equity financing – the borrower sells shares (equity) in their company in order to raise money.
How does mezzanine finance work?
This will depend on how the contract is set out. As a hybrid of debt and equity financing, mezzanine funding combines features of both.
For example, in some arrangements, investors are paid back through profits in addition to regular interest payments. If the original loan can’t be paid back in full, the value of the loan may transfer into an equity share – giving investors a stake in the business itself.
Why would businesses use mezzanine finance over debt or equity?
Mezzanine financing is an innovative way to raise funds based on anticipated future profits. In other words, it means businesses can raise the cash it needs now without immediately selling off ownership through shares. Instead, investment is received on the promise of potential earnings. With this in mind, mezzanine financing is often used to fund building projects where the profits won’t be realised until the properties are sold.
Another advantage is that businesses can set out their own terms and conditions of repayment and have greater control over the arrangement. This makes mezzanine funding an attractive option over traditional lenders (like banks) who have their own terms driven by their own needs and priorities (which may not suit the business).
What are the pros and cons of mezzanine finance?
Outlined below are just some of the benefits and drawbacks of mezzanine finance. Remember that all investments come with risk, and professional advice should be sought prior to making any financial commitments. (The following lists are not exhaustive)
Mezzanine funding pros:
Flexible repayment structures designed to suit business needs.
Businesses can retain control so long as profits are realised.
Investors receive interest payments which are often higher than traditional savings platforms (for example, ISAs).
An opportunity for lenders to invest in sectors they may not otherwise have access to.
Mezzanine funding cons:
No guarantee that expected profits will be realised leaving investors with potentially illiquid shares.
Businesses could lose control if investors cannot be paid back and funds are converted into an equity share.
Conditions to invest may be restrictive and investors may need to commit a minimum sum.
Higher levels of interest can mean it’s an expensive way for businesses to fund projects.
Does mezzanine finance replace other types of funding?
No, mezzanine funding doesn’t replace traditional funding methods. It’s predominantly used to raise extra capital if businesses can’t otherwise get the financing they need.
It’s also an innovative way to increase the working budget of a project at short notice with the extra funding used to maximise potential returns. For example, to increase a building’s specification in order to create a more desirable and higher value property.
Mezzanine finance/Private investor funding – in summary
Mezzanine finance/Private investor funding is an innovative and flexible way for businesses to raise capital. It’s an especially effective method of financing one-off projects or raising additional funds. It’s a method that also enables businesses to retain control over their assets.
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