A guide to mezzanine finance

The Latin root of mezzanine is medianus “of the middle”. This is a great starting point and prompt to describe this fascinating part of the capital stack.  This word is found in many industries within property, it is generally used to describe a secondary source of debt.  Mezzanine Finance can be found in the MIDDLE of senior loans and the common equity stake.

Let’s break this down further….

Senior lenders – Senior being the keyword here. Also, known as first charge lender, and can come from several different types of institutions, such as:

• Merchant banks
• High street lenders
• Funds
• Private offices
• Wealthy investors

If one of the above types of institutions take a first charge the mezzanine loan will be ‘subordinated’.  This means it will be paid back after the senior loan has been settled. The mezzanine is in a riskier position and would be entitled to receive a higher interest rate.

Let’s provide a working example….

  • You agree to buy a development site for £2M.
  • Construction costs are £2M.
  • The profit is to be circa £1M.
  • In a buoyant market, the developer would raise a maximum of £3.2M from a senior lender.
  • Leaving a requirement of £800,000 working capital or equity investment.
  • An experienced developer could split the £800,000 requirement roughly in half by using mezzanine lenders.
  • Remember the mezzanine loan will sit behind the senior lender.  Substantial negotiations regarding the required documentation will need to take place.

Positives of using Mezzanine

Our first mezzanine loan was arranged in 2011 and we have been involved in over 75 mezzanine deals. The single biggest attraction is how the mezzanine can boost a developer’s return on equity. Preserving equity and spreading it across several transactions spreads risk and can improve the returns to the developer.

Large projects suddenly become a possibility. Using the available equity in a more considered capital structure you can use it to help access deals previously unaccessible.

Mezzanine financing typically is used as a short-term loan. It is generally utilised in different ways to other loans. Amortisation or interest payments are not usually required during the term.  A bullet repayment is expected by the end of the term.

Our experience has presented that a mix of senior and mezzanine, compared to a stretched senior product provides a stronger return on equity to our clients. Test us hard on this as we constantly review the situation as the market brings new products to the market.

Warning signs to watch for….

You need to be confident in your numbers, growth, and profits. As the mezzanine is further up the risk curve, if you experience issues with your business plan this may start to erode your returns fast, therefore do your homework on who you are borrowing from.  Do they have a closed fund, whereby they must repay larger institutions by a certain date. This type of situation will put pressure on the developer and should be avoided at all costs.

A new fund will more likely be a riskier proposition compared to an established lender. A strong track record of lending will present that they understand property development is a risky business and that they have supported several lenders over several years.

It is on the face of it expensive. However, understand how it can work for you in your unique situation and it can propel your business forward.

As the mezzanine is ‘another mouth to feed’ there will be more time spent reporting to lenders. There will be more documentation at the onset as well.

Expensive legal costs – This needs to be considered with consideration for the size of the loan. The lender should be able to present deals they have completed similar to your deal and have established legal fees. This is a small detail but a warning sign we have seen with unestablished funders who use the client as the ‘guinea pig’ to establish their fund.

In Summary

Mezzanine is a fascinating product that comes with huge potential upside if utilised correctly. The directors of Hallcroft have been involved with mezzanine since 2011 and have not only presented lenders in the market to clients, but they have also taken mezzanine loans themselves to move their respective businesses forward. The experience of taking these loans gives a unique insight to our clients of all the pros and cons.
Choosing the right partner is paramount. Speak to a broker who has a long-established relationship with lenders to ensure you will be supported going into the transaction and throughout.
Right now, junior facilities have never been so cost-effective, relative to senior debt finance and can assist with lower land loan provision and meeting the required equity consideration.