Navigating the complex landscape of business financing requires careful consideration of the many financing options that you have at your disposal as a business owner. Among these options, two prominent forms of financing stand out: mezzanine debt vs direct lending.
While both mezzanine debt and direct lending serve as a way to fund operational needs, new acquisitions, or growth initiatives, it is essential to understand the nuances and distinctions of each one.
This will help you make an informed decision that aligns with your company’s strategic objectives and financial capabilities in a way that drives business growth long-term. In this article, we will explain all the main differences when comparing mezzanine debt vs direct lending.
Continue reading to learn more:
Mezzanine Debt vs Direct Lending: 10 Key Differences
1. Structure
One of the key differences when comparing mezzanine debt vs direct lending is the structure of each type of financing.
| Direct Lending | Mezzanine Debt |
| Direct lending typically refers to business loans provided directly to the borrower (the company). Direct lending can be senior debt, meaning it has priority over other debts in case of a default, or subordinated, depending on the type of financing product used.
Direct lending can be secured against the company’s assets, providing a lien on assets as collateral, but it can also come as unsecured funding. It may include financial covenants that require the business to meet certain performance criteria, although these are more common in mezzanine debt solutions. |
Mezzanine debt stands in between debt and equity, occupying the middle layer between secured senior debt and equity in a company’s capital structure. Because it’s subordinated to direct loans and other types of senior debts, it’s paid after these other debts in the event of insolvency.
When comparing direct lending vs mezzanine debt, a key difference is that mezzanine loans are typically unsecured, or only have a junior lien on assets as collateral. However, mezzanine debt may come with equity stipulations, where the lender assumes equity of the business under certain circumstances. |
2. Risk profile
| Direct Lending | Mezzanine Debt |
| Another key difference when comparing direct lending vs mezzanine debt is risk profile. If secured, direct lending carries the risk of losing business assets in default scenarios. Unsecured financing often comes with personal guarantees, which make the borrower personally responsible for the business’s unpaid debts. | On another hand, mezzanine debt has a higher risk profile overall. This type of debt often comes with covenants and warrants that transfer ownership from the business owner to the lender under certain criteria. In some cases, businesses can “pop” these covenants accidentally or unknowingly, causing them to suddenly own less of their business. |
3. Interest rates
| Direct Lending | Mezzanine Debt |
| Interest rate is another key difference when comparing mezzanine debt vs direct lending, and it is often directly tied to the risk that each type of financing carries. Direct lending at the senior position is associated with lower risk because it’s often secured by the borrower’s assets.
Subordinated direct lending often comes with higher interest rates than senior debt because of the risk profile. |
Mezzanine lending, on another hand, is associated with higher risk – not only because it’s subordinated to senior debts, but also because it’s not secured by the borrower’s assets. As a result, mezzanine lenders typically compensate for the risk with much higher interest rates.
They can range from mid to high double-digit annual percentages, factoring in the base rate plus a substantial risk premium. They may also include payment-in-kind (PIK) interest, which increases the total interest burden. Interest rates are lower on mezzanine debt than subordinated debt, but keep in mind that equity stipulations can raise the total cost of capital much higher. |
4. Collateral requirements
| Direct Lending | Mezzanine Debt |
| Speaking of the differences between mezzanine debts vs direct lending, it’s also important to mention the collateral requirements for each type of financing. When it comes to direct loans, collateral is often required – which can include real estate, inventory, or equipment.
In the event of defaulting or insolvency, the lender can seize the collateral. |
As we mentioned earlier, mezzanine lending typically doesn’t require collateral. In the cases where collateral is involved, this type of debt may be secured with a second lien or a junior claim on the assets, aka senior debt holders will have priority over claiming it in the case of insolvency.
To mitigate the higher risk of being unsecured, mezzanine financing carries higher interest rates and often includes equity-like components such as warrants. |
5. Flexibility in repayment
The flexibility of repayment terms is another key difference between mezzanine debt vs direct lending, and it reflects the distinctive structures of each type of financing.
| Direct Lending | Mezzanine Debt |
| Direct loans are usually associated with more structured repayment schedules, consisting of regular monthly installments that may include both principal and interest. The schedules are designed to align with the borrower’s cash flow capabilities but are not as flexible overall. | When comparing mezzanine debt vs direct lending, mezzanine debt is definitely more flexible between the two forms of financing. They typically include initial periods where only interest is paid, and the principal repayment is deferred to the end of the loan term.
Other factors that influence the flexibility of mezzanine lending include covenants with equity stipulations – which can be used strategically to manage repayment costs, customizable terms – designed to fit specific deal structures and projections, as well as the Payment-In-Kind (PIK) Interest. Covenants are a common challenge for companies nationwide. They may seem attractive because they create more flexibility and feature lower interest rates, but the loss of ownership can mitigate these benefits. |
6. Purpose of funds
When comparing mezzanine debt vs direct lending, it is also imperative to mention the purpose of the funds.
| Direct Lending | Mezzanine Debt |
Direct lending can be used for almost any business purpose, including:
Direct lending requires businesses to meet robust financial qualifications to access higher funding amounts. Revenue-based solutions take the focus off a business’s credit score, but they must still generate revenue in correlation to the amount they’re seeking to reach an approval. |
Mezzanine lending, on the other hand, is commonly used for:
Mezzanine debt is attractive to businesses looking to make significant investments in growth while lacking traditional financing requirements, like credit score or revenue levels. The equity stipulations and other unique factors allow lenders to offer higher dollar amounts to businesses with lesser financials. Still, the loss of equity can be expensive. |
7. Tax implications
Tax implications are another key difference when comparing mezzanine debt vs direct lending.
| Direct Lending | Mezzanine Debt |
| Interest expenses on direct loans are generally tax-deductible for the borrower, which can reduce the overall cost of financing. This deduction applies as long as the funds are used for business purposes.
For lenders, the interest income received from direct lending is taxable as ordinary income. This structure makes direct lending an attractive option for borrowers looking to leverage tax benefits to lower their effective borrowing costs. |
Mezzanine debt offers similar tax deductibility on interest payments, which helps reduce the effective cost of borrowing. However, the presence of equity features like warrants or conversion options can complicate the tax situation.
If these options are exercised, it may lead to capital gains taxes for the lenders on any profits made from equity. For borrowers, while the interest remains deductible, any payments related to equity features are not tax-deductible. |
8. Loan sizes
Loan sizes also vary between mezzanine debt vs direct lending – here’s how:
| Direct Lending | Mezzanine Debt |
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9. Maturity
| Direct Lending | Mezzanine Debt |
| Another key difference between mezzanine debt and direct lending is that direct lending typically features shorter maturity terms, ranging from 3 to 7 years. These loans are often amortizing, meaning regular payments of both principal and interest are made until full repayment at the loan’s maturity.
Subordinated debt comes with even shorter repayment terms, rarely extending past 2 years, with an average of 12 months. |
Mezzanine debt usually offers longer maturity terms, from 5 to 10 years, reflecting its higher risk and growth-focused financing purpose. It often includes structures such as interest-only payments with a balloon payment at the end or Payment-In-Kind (PIK) options, which defer cash payments until maturity. |
10. Prepayment penalties
Last but not least, prepayment penalties are another important difference that should be mentioned when discussing mezzanine debt vs. direct lending.
| Direct Lending | Mezzanine Debt |
| Direct loans can include prepayment penalties, which discourage early repayment. These penalties compensate lenders for interest income lost due to early loan closure. The terms vary but aim to stabilize the expected returns for lenders over the loan’s planned duration. | Mezzanine debt may also have prepayment penalties, especially if it includes equity components like warrants. These penalties can be higher due to the riskier nature of the investment and the potential for higher returns.
The structure ensures that lenders gain a minimum return, even if the loan is repaid early. |
Explore Your Loan Options with National Business Capital
Minor changes to an interest rate often isn’t enough to warrant losing equity in your business. While mezzanine debt serves a purpose in the market, it’s important that companies understand the full picture of mezzanine financing before finalizing a contract.
It’s recommended that every business owner explore their debt financing options before sacrificing the equity they’ve worked so hard to create. National Business Capital, a Debt Advisory Group, can help you do so as quickly and conveniently as possible.
With $2+ billion financed since 2007 and an experienced team of Business Finance Advisors, we have everything you need to find the best financing options for your project.
Are you ready to get started? Apply here.
Frequently Asked Questions
What are the risks associated with mezzanine debt vs direct lending?
Mezzanine debt carries higher risks compared to direct lending due to its subordinated status and often unsecured nature. If a borrower defaults, mezzanine lenders are paid after all senior debts are settled, increasing their risk of loss.
Additionally, the inclusion of equity features introduces variability in returns, dependent on the company’s performance. These risks are offset by higher potential returns than those offered by secured, senior direct loans.
Which industries or types of companies are best suited for mezzanine debt?
Mezzanine debt is best suited for mature industries with stable cash flows, such as manufacturing, healthcare, and business services.
It’s ideal for companies undergoing growth, acquisitions, or leveraged buyouts that can sustain high-interest debt while pursuing expansion.
Which industries or types of companies are best suited for direct lending?
Direct lending is particularly well-suited for small to medium-sized enterprises (SMEs) across various industries, including manufacturing, retail, and services, that require stable, straightforward financing.
These companies benefit from direct loans for operational funding, asset purchases, or refinancing, leveraging their tangible assets for secured, lower-risk debt.
Is direct lending better for small businesses than mezzanine debt?
Direct lending is generally better for small businesses than mezzanine debt due to its lower risk and more straightforward structure. It offers secured, predictable financing suitable for basic operational needs and asset purchases, without the complex terms and higher costs associated with mezzanine debt.
What are the long-term implications of mezzanine debt?
Long-term implications of mezzanine debt include potential equity dilution if conversion options or warrants are exercised. While it can boost growth with flexible, substantial funding, it also increases financial leverage and repayment burdens, which could affect future financial stability.
What are the benefits of direct lending?
Direct lending offers small to medium-sized businesses accessible, straightforward financing with lower interest rates due to secured loans. The predictable repayment structure helps manage cash flow effectively.
It also bypasses traditional bank lending requirements, providing quicker funding solutions with less administrative burden, making it ideal for businesses needing timely capital injections for growth or operational stability.
Disclaimer: The information and insights in this article are provided for informational purposes only, and do not constitute financial, legal, tax, business or personal advice from National Business Capital and the author. Do not rely on this information as advice and please consult with your financial advisor, accountant and/or attorney before making any decisions. If you rely solely on this information it is at your own risk. The information is true and accurate to the best of our knowledge, but there may be errors, omissions, or mistakes.
Phil Fernandes
Phil Fernandes serves as Chief Operating Officer for National Business Capital. He boasts 15 years of experience in sales and 10+ years of management experience as National’s VP of Financing/Analytics. Phil is also an excellent writer who's completed the Applied Business Analytics executive program at MIT and regularly contributes articles to National Business Capital’s blog.
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