Subordinated Loans vs Mezzanine Loans

It is easy to confuse mezzanine loans with subordinated loans because mezzanine loans are also in a subordinated position. Any subordinated loan will not be paid off until primary loan obligations are met, in the case of bankruptcy. For example, when a family declares bankruptcy, home and auto loans typically are first in line to be paid off. Furniture stores, credit card companies and personal loans will be ordered by the court to determine which is paid off. Mezzanine loans are a particular type of subordinate loan with specific terms.

Partial Equity or Control

A mezzanine loan is given in exchange for some degree of equity, or joint venture status with the borrower. Because the mezzanine lender has a stake in the company's success, the lender will also maintain a degree of control over the financial decisions of that company. The degree to which a mezzanine lender will be involved in the operations of the company is determined by the loan contract. The borrower and lender determine the terms of the contract and explicitly express any voting rights or preferred stock benefits. 

High Interest Rates or Partial Profit Sharing

Mezzanine lenders are assuming a high degree of risk because they provide capital to businesses that are not established or looking to expand. In part, they consider the business plan they are presented with and decide to take the risk because they stand to benefit from the loan financially. Typically, mezzanine investors will arrange some type of profit split, or dividend payment. Straight interest rates may be arranged, but typically only for short-term loans. Mezzanine loans are very costly to the borrower.

Financial Restrictions

Mezzanine loans, unlike other types of subordinate loans, will usually come with certain financial restrictions on future actions of the borrower. This means the borrower may be prevented from getting more loans or refinancing existing loans they have. The lenders place these restrictions on the company to assure the financial health of that company does not change drastically, until they receive their payout. Without these restrictions, the mezzanine lender would have very little guarantee the borrower would not make irresponsible financial decisions and end up in bankruptcy. Bankruptcy is a worst case scenario for these lenders as they would not likely recover their investment.

Subordination

The one thing subordinated loans have in common with mezzanine loans, is that they both are in subordinate positions to other loans. This really only matters if there is a bankruptcy proceeding or liquidation of the borrower. Otherwise, being in a subordinate position has no effect on payments. However, because a lender is less likely to recover, the loan process will take longer to arrange and rates will be higher. It is not uncommon for a mezzanine or subordinate loan to take three months to go from the application stage to the actual provision of financing.