Mezzanine Loans: How Are They Secured

Mezzanine loans are a type of financing arranged for large property holders. These loans, which are around $2 million or more in size (although smaller funding can be arranged in some circumstances), are considered subordinate debt that is based on a primary mortgage loan.

A mezzanine loan can be secured in several ways, including preferred stock and participating notes. The company that seeks mezzanine loan financing can give up an equity share in their business in the form of preferred stock. They may also give up some of the revenue or cash flow in the project by issuing participating notes.

Preferred Stock

Giving a lender preferred stock to secure a mezzanine finance loan cedes some of the control over a project. It establishes an equity position for the lender in the event that the loan defaults.

The way this form of security works is that the borrower establishes a partnership that defines the role each party will play in the financed project. The terms, conditions and equity arrangement are set forth in the partnership or joint agreement. This is important as it sets the parameters of the lender’s equity participation in the corporation making the mezzanine loan. It limits that participation to the amount lent under the mezzanine loan.

The borrower cedes some of its ownership in the form of preferred stock. The borrower is however compensated for this loss through the capital it receives in order to finance their project. The lender protects its interest by being able to step in and assume control of the property should the borrower be unable to repay the loan.

Participating Notes

Instead of giving up ownership in the company as a way to secure a mezzanine loan, a borrower may issue a participating note. This form of equity/debt instrument pays a stated coupon rate, like a bond, to the lender in exchange for the loan. The principal amount is paid back over time, thus allowing the company to have access to the needed financing but maintaining corporate control over the project or property.

Either forms of security that a corporate borrower uses are acceptable to most lenders that provide mezzanine loan financing. The preference for preferred stock versus participating notes is a personal one of the borrower and is usually stated in the loan agreement. The type of security used is more a matter of control for the borrower and the need for the mezzanine financing.