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Navigating the differences between mezzanine debt and subordinated debt is essential for business owners and financial decision-makers looking to build a smart, flexible capital structure. These financing options often play a key role for businesses that need capital to address cash-flow challenges or pursue growth opportunities.
This guide explains what mezzanine and subordinated debt are, how they differ, and how businesses can use them effectively.
What is mezzanine debt?
Mezzanine debt is a hybrid financing option that blends aspects of equity and debt, designed to fill the gap between the two in a company's capital stack. Often used in buyouts and acquisitions, mezzanine financing is typically unsecured and subordinated to senior debt, placing it below senior lenders but above equity holders in a liquidation.
Key Characteristics of Mezzanine Debt
| Caveat | Description |
|---|---|
| Subordinated position | Mezzanine debt holds a subordinate position to senior debt. In a liquidation, mezzanine lenders are repaid after senior creditors, but before equity holders. |
| Higher interest rates | Due to its subordinate position, mezzanine debt carries higher interest rates compared to senior debt. This compensates lenders for taking on additional risk. |
| Equity kickers | To make mezzanine financing more appealing, lenders often receive warrants or options to purchase equity in the borrowing company, providing potential upside similar to equity investment. |
| Flexible terms | Mezzanine debt structures are often more flexible than traditional senior loans, with variable repayment terms that can align with a borrower's cash flow capabilities. |
Real-World Scenario
A restaurant chain planning a major expansion may not be able to secure enough funding through traditional bank loans. In this case, mezzanine debt can fill the gap by providing additional capital without immediately diluting equity stakes.
>> Learn about Mezzanine Debt alternatives here.
What is Mezzanine Debt in an LBO?
In a leveraged buyout (LBO), mezzanine debt often includes equity kickers such as warrants or conversion options, giving lenders added upside if the company performs well. This structure allows buyers to reduce the amount of equity they need to invest while still maintaining ownership control.
What is the difference between convertible debt and Mezzanine Debt?
The main difference between convertible debt and mezzanine debt lies in how each form of financing can transition into equity and where it sits in the capital structure. Convertible debt starts as a loan that can be converted into equity - usually at a predetermined price or during a future funding round - making it common in early-stage or growth financing.
Mezzanine debt, by contrast, is typically used by more established businesses and sits between senior debt and equity, offering lenders higher returns through interest and potential equity warrants. In short, convertible debt emphasizes flexibility for investors in startups, while mezzanine debt provides leveraged growth capital for mature companies.
What is Subordinated Debt?
Subordinated debt, often called sub-debt, is financing that sits below senior debt when it comes to repayment priority. Businesses going through rapid growth or restructuring often use it to add flexible capital to their funding mix.
Characteristics of Subordinated Debt
| Caveat | Description |
|---|---|
| Lower ranking | Subordinated debt sits below senior debt in the capital stack. In a liquidation, it’s repaid after senior obligations but before equity. |
| Risk and reward | This type of debt is riskier for lenders due to its lower claim priority, which results in higher interest rates compared to senior debt. |
| Common forms | Subordinated debt can take the form of loans, bonds, or debentures, each serving different needs within the capital structure. |
| Attractive to banks | Banks may issue subordinated debt to strengthen their capital base. It also improves their ability to absorb losses, especially under regulatory requirements. |
Real-World Scenario
Consider an e-commerce company planning to boost its inventory ahead of a peak sales season. Subordinated debt can provide the necessary funds without disrupting existing credit arrangements with senior lenders, offering flexibility while accommodating cash flow fluctuations.
The Three Main Types of Debt Subordination
- Structural Subordination occurs when debt is issued by a subsidiary rather than the parent company, making repayment dependent on the subsidiary’s assets.
- Contractual Subordination is defined through an agreement where one creditor agrees to be paid after another in case of default.
- Collateral Subordination happens when one lender has a lower claim on specific assets used as collateral, giving priority to another lender with a higher security interest.
Comparing Mezzanine Debt and Subordinated Deb
Understanding the differences between mezzanine and subordinated debt helps businesses choose the financing option that best supports their goals. Both play important roles within the capital structure, but they vary significantly in risk, cost, and flexibility.
Risk and Cost
- Mezzanine Debt: Higher cost due to elevated risk, often includes equity participation as part of the deal.
- Subordinated Debt: Typically offers lower costs than mezzanine, but higher than senior debt, balancing risk with interest rates.
Payment Structures
- Mezzanine Debt: May include payment-in-kind (PIK) interest, where interest is not paid out in cash but added to the principal balance.
- Subordinated Debt: Generally involves regular interest payments that align with cash flow, reducing immediate liquidity pressure.
Strategic use cases
Mezzanine Debt:
Well-suited for rapid growth, acquisitions, or situations where owners want to limit equity dilution while accessing sizable capital.
Subordinated Debt:
Ideal for supplementing senior credit lines or adding flexibility without restructuring existing banking arrangements.
What is an example of a Subordinated Debenture?
An example of a subordinated debenture is a corporate bond issued by a company that ranks below other loans and debts in repayment priority. For instance, if a business issues subordinated debentures to raise capital, these bondholders are repaid only after senior creditors have been paid in full in the event of bankruptcy or liquidation.
Companies often use subordinated debentures to attract investors seeking higher returns in exchange for taking on greater risk.
Does Subordinated Debt count as tier 1 or tier 2?
Subordinated debt is considered Tier 2 capital under banking and financial regulations. Tier 2 capital represents supplementary capital that supports a bank’s stability but is less secure than Tier 1 capital, which consists mainly of common equity and retained earnings.
Since subordinated debt is repaid after senior obligations, it carries higher risk but still supports a bank’s capital adequacy. It acts as a buffer for losses beyond Tier 1 reserves.
The role of Mezzanine and Subordinated Debt in business growth
Both mezzanine and subordinated debt play pivotal roles in facilitating business growth and addressing cash flow challenges. Their flexible nature allows companies to tailor financing solutions to specific needs, whether it's bridging operational gaps or capitalizing on new opportunities.
Target Industries
Businesses within industries such as manufacturing and construction frequently utilize mezzanine and subordinated debt to fund capital-intensive projects. These sectors often face fluctuating demand and require financial agility, making subordinated financing an attractive option.
Addressing Cash Flow Challenges
Managing cash flow can put a lot of pressure on the business. Both mezzanine and subordinated debt can help maintain liquidity when it matters most. For example, a logistics company can use subordinated debt to upgrade its fleet without straining senior credit lines, keeping operations running smoothly during peak demand.
Final Thoughts
Deciding between mezzanine and subordinated debt starts with knowing what your business needs: how fast you want to grow, how much risk you can take on, and what your cash flow looks like. Each type of business financing serves a different purpose and can support growth in its own way.
When you understand how they work, you can choose the option that fits best, keep your operations running smoothly, and pursue new opportunities with clarity and confidence. Are you ready to get started? Apply here.
ABOUT THE AUTHOR
As COO, Phil oversees National Business Capital’s funding operations, tech infrastructure, and data intelligence. He breaks down the funding trends that matter most to decision-makers, with a special focus on leadership and CFOs who want to understand where capital is flowing and why it matters.
