Mezzanine debt is a type of liability financing often used by businesses to fund specific projects and, occasionally, as a source of operational

capital. Mezzanine debt is also frequently used in real estate acquisitions and construction development transactions. Mezzanine debt commonly refers to subordinate obligations of a company that are repaid only after all other debt financing of the company.

1. Function
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Mezzanine lenders typically have no claim or security interest on the physical assets of the borrower. Many types of other debt financing are directly collateralized by the borrower. For example, a mortgage might attach to a building and land owned by a corporation. Another common loan may attach to the account receivable of a corporation. If these loans were to default, the lender would have a claim to the building, land or accounts receivable of the corporation. Mezzanine debt typically does not involve such a claim.

Uses
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Mezzanine debt is typically used by companies to fund riskier projects or to fund unanticipated operational costs. Because mezzanine debt is unsecured, lenders typically charge a higher interest rate than on more senior debt instruments. For some companies, particularly, riskier firms, the difference in interest rate can be significant. As a result, many companies will seek other, less expensive, forms of debt financing before acquiring mezzanine debt.

Features
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While most forms of mezzanine debt involve no attachment of security interests to the physical assets of a corporation, some forms of mezzanine debt will attach a security interest to the stock of a corporation. In the case of a borrower default, the lender will therefore be entitled to receive ownership interests in the entire corporation, including all physical assets and liabilities. This type of mezzanine debt financing is used extensively in real estate transactions.

Real Estate Financing

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When used in real estate financing, mezzanine debt is typically used after initial mortgage borrowings and any construction financing debt. Lenders often prefer to collateralize mezzanine debt with the stock of a corporation since it simplifies the recovery process in the case of default. While obtaining title to mortgaged property in a bankruptcy case can be time consuming and expensive, claiming the physical stock of a corporation is relative more facile and often does not affect other contractual agreements.

Private Equity
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Mezzanine debt is used extensively in private equity leveraged buyouts. Typically, private equity firms, when acquiring a company, use an initial amount of firm and investor capital and, potentially, a layer of less expensive senior debt. The remaining financing often comes in the form of mezzanine debt. Since mezzanine debt is significantly more expensive, private equity firms often try to unload their investments as quickly as possible to avoid building up substantial interest charges.