Mezzanine debt is junior term financing with a fixed maturity and a contractual coupon that sits between senior debt and common equity. It is usually unsecured or second lien and often includes payment in kind features and warrants. Think of it as flexible leverage priced for being second in line. For sponsors, the payoff is incremental capital without handing over control; for lenders, the reward is yield and optionality for taking subordination risk.
Why sponsors choose mezzanine and what each party gets
Sponsors use mezzanine to bridge valuation gaps, fund acquisitions and growth, and finance distributions when senior leverage ceilings bind. They accept a higher coupon in return for speed and flexibility at the holding company. Senior lenders tolerate mezzanine beneath them to cap their own exposure while protecting collateral. Mezzanine investors accept subordination in exchange for yield, warrants, and negotiated influence over refinancing and exits.
Boundaries, variants, and what mezzanine is not
Mezzanine is subordinated term debt with a negotiated intercreditor framework beneath senior creditors. It is often issued at a holding company, which creates structural subordination because cash must be upstreamed before mezz is paid. It is not a unitranche loan that shares the same lien on a pari passu basis, not preferred equity that lacks a debt claim, and not a broadly traded high yield bond.
Common forms include unsecured subordinated notes, second-lien loans, holding company PIK only loans, exchangeables or convertibles at holdco, and structured equity with debt-like covenants. Market language often lumps these under junior capital or sub debt. Holdco PIK has its own dialect and documentation nuance, and you can find deeper terms under holdco PIK notes.
Incentives and trade-offs that set the price
Sponsors buy incremental leverage and flexibility while preserving control and minimizing dilution versus a straight preferred instrument. Mezzanine investors price for loss severity and refinancing risk, trading day-to-day governance for economics and optionality. Warrants often appear where growth is modest or leverage is stretched. The trade-off is more documentation and slower execution than a unitranche, but lighter governance than preferred equity.
Legal frameworks that drive seniority and recoveries
In the United States, Delaware holding companies issuing New York law governed notes or entering New York credit agreements are the standard. Structural subordination comes from lending at holdco, so upstream distributions must fit within the senior facility’s restricted payment controls. Contractual subordination is set in intercreditor agreements or subordination agreements among the mezz lender, the senior agent, and the issuer, and those are generally respected in Chapter 11.
In the United Kingdom and Europe, English law loan notes or facilities are common, often through Luxembourg holding companies for upstreaming and tax efficiency. Intercreditor agreements follow LMA norms on priority, standstill, and waterfall. Security is commonly limited to share pledges over top entities rather than all asset liens. U.K. schemes, Part 26A plans, and EU pre-insolvency tools can bind junior creditors when thresholds are met.
Funding flows, collateral, and maturity design
Mezzanine is funded at close or via delayed draws tied to acquisitions or capex. Revolving needs sit with seniors to preserve borrowing base discipline. Unsecured mezz relies on subordination and turnover provisions, while second lien mezz shares collateral on a junior basis. Holdco PIK typically takes share pledges, not operating asset liens.
Cash pay coupons are often paired with PIK to manage cash usage and reduce stress during integration or growth phases. Amortization is minimal. Maturity typically sits six to twelve months beyond senior debt to allow a refinancing runway and reduce cliff risk.
Waterfalls are predictable. Operating company cash pays senior secured first. Upstreaming is allowed only within senior baskets. At mezz, cash interest pays current if permitted and PIK interest accrues. Enforcement proceeds follow the intercreditor waterfall: senior debt and costs first, then mezz, then equity.
Who controls what and how transfers work
Mezz consent is required for changes to ranking, maturity, interest, collateral, and enforcement. Seniors lead on operating company covenants and releases, subject to sacred rights. Transfer restrictions flow through sponsor consents, white lists, and disqualified lender lists. Liquidity is lower than broadly syndicated loans because placements are private and buyer lists are narrow.
Core documentation and closing deliverables
The documentation map is consistent across markets and is usually anchored by mezz lender counsel’s precedent. Core agreements typically include a credit agreement or note purchase agreement, an intercreditor or subordination agreement, security documents for share pledges and any second lien filings, warrant or co-invest agreements, and a fee letter that captures OID, ticking fees, exit fees, and prepayment premia.
Closing deliverables usually include lien searches, solvency certificates, perfection steps, board approvals, and enforceability and subordination opinions. These items protect seniority and are critical in any future workout.
Economics, fees, and equity kickers
First lien direct lending to middle market borrowers priced around 11 to 12 percent all in as base rates rose in 2023 and 2024. Mezzanine sits above that, with European coupons clearing in the mid teens in the first half of 2024. Funds underwrite low to mid teens net IRRs.
- Cash interest: Often 4 to 8 percent depending on cash generation and leverage cushion.
- PIK interest: Often 3 to 8 percent to bridge the coupon without cash burn. Toggles are commonly tied to leverage or liquidity tests.
- OID and fees: One to three percent for OID and upfront, with one to two percent exit fees in some markets.
- Call protection: Make whole or a declining premium, for example 103 to 102 to 101. Many mezz loans target an IRR make whole on early repayment to protect hold period returns. See a primer on call protection and OID for mechanics.
- Equity kickers: Warrants on 1 to 5 percent fully diluted, sometimes penny warrants tied to a hurdle IRR. Anti dilution matters if M&A and earnouts are likely.
A simple illustration helps. A 75 million dollar unsecured mezz tranche at 6 percent cash plus 6 percent PIK with 2 percent OID produces 4.5 million dollars of current cash interest per year. PIK accretes principal to roughly 84 million dollars by year three. A year three refinancing at par plus a 2 percent call yields a mid teens realized IRR before any warrant value.
Covenants and practical reporting that actually help
Financial tests are often incurrence style and aligned with senior baskets. Some structures add a springing maintenance test at holdco or a minimum interest coverage when cash pay is meaningful. Negative covenants mirror senior constructs but with tighter baskets to curb leakage and priming risk. Reporting typically runs monthly or quarterly with budgets, KPIs, and annual audited financials. Amendments tied to ratio resets often carry fees.
Accounting treatment for issuers and lenders
For issuers, mezz with fixed maturity and mandatory interest is recorded as debt. OID amortizes under GAAP ASC 835-30 using the effective interest method and PIK accrues to principal. Embedded features may fall under ASC 815 and separate warrants can trigger ASC 470-20 allocation. Under IFRS, IAS 32 and IFRS 9 split liability and equity components and use effective interest for amortized cost.
For lenders, funds mark positions at fair value under ASC 946 or IFRS 9 using fair value through profit or loss. Models reflect credit spreads, performance, and optionality. Heavy PIK accruals require valuation support to avoid overstated NAV in limited partner reporting.
Tax items that move the after tax cost
In the United States, IRC section 163(j) caps interest deductions at 30 percent of adjusted taxable income. PIK and OID accrue whether or not paid. AHYDO rules under section 163(e)(5) can defer or deny deductions if yield or maturity thresholds are crossed. Structures avoid AHYDO through coupon design, maturities, and paydowns. Cross border lenders rely on the portfolio interest exemption, FATCA compliance, and W 8 forms. Related party lending raises transfer pricing and state addback considerations.
In the U.K. and EU, U.K. withholding is generally 20 percent with exemptions. The 2023 Qualifying Private Placement regime waives withholding on eligible private placements. Corporate interest restriction and hybrid mismatch rules limit deductions. Luxembourg typically imposes no withholding on arm’s length interest but treaty and beneficial ownership tests still apply.
Regulatory and compliance checklist
U.S. private credit advisers operate under the Advisers Act. Amendments to Form PF increased event reporting, and the SEC’s recent exam priorities emphasize valuation, fees and expenses, conflicts, and preferential terms. In the EU and U.K., AIFMD II adds rules for loan origination funds on concentration, retention, leverage, conflicts, and borrower exposures.
Transactions require KYC and AML checks on borrowers and sponsors. The U.S. Corporate Transparency Act beneficial ownership reporting took effect in 2024 and may touch borrower entities. Marketing must align with the U.S. advertising rule and AIFMD passporting or national private placement regimes. Active selling can trigger U.S. broker dealer or MiFID II requirements.
Risks that matter most in underwriting
Refinancing windows can slip when base rates are high or credit tightens. Call protection guards against early takeouts, not extensions. Intercreditor gaps, permissive baskets, or short standstills can erode recoveries. Voting thresholds and lien release mechanics can enable uptiers or drop downs that move mezz out of the money. Structural subordination means holdco debt depends on upstream capacity, so tight restricted payment controls can starve coupons even when EBITDA is fine. Subordinated recoveries are lower on average than senior unsecured levels, with warrants helping only in going concerns.
Typical use cases with a clear fit
- LBO gap financing: Completes purchase price when senior leverage caps out. Model cash interest under downside cases and align intercreditor terms early.
- Minority or dividend recap: Delivers cash to owners with modest dilution via warrants, helpful when unitranche capacity or restricted payment flexibility falls short.
- Add-on acquisitions: Delayed draw mezz funds bolt ons without reopening senior docs or triggering MFN.
- Founder growth capital: Funds expansion without board control shifts, but pricing reflects information gaps and limited sponsor support.
- Holdco PIK bridge: Buys time for M&A when senior syndication is uncertain. Step ups and tight call premia encourage term out.
Pricing and documentation in today’s environment
With base rates elevated, first lien all in yields in the low double digits push mezzanine into the mid teens all in for leveraged borrowers. Equity kickers appear when growth is uncertain or leverage is stretched. In higher growth, sponsor led exits, a straight coupon with call protection often clears. Documents remain borrower friendly but are typically tighter than a unitranche on restricted payments and additional debt. Portability is resisted, and if included it comes with leverage caps, diligence triggers, and a fee.
Alternatives and how to choose among them
- Unitranche: Faster and cheaper with simpler governance, but tighter operational controls and MFN pressure. Mezz wins when senior quantum tops out or when sponsors want flexibility at holdco.
- Second lien: Better collateral and lower coupon, but heavier intercreditor friction. It fits asset rich credits while unsecured mezz suits asset light models with clean structural subordination.
- Preferred or structured equity: Avoids fixed interest and deduction limits but dilutes more and sits below debt. It is useful when cash interest is impractical.
- Seller notes or earnouts: Cheap and flexible, but small and light on covenants, so not scalable for platform builds.
Execution timeline that avoids surprises
Weeks 0 to 1: Mandate and term sheet. Dual track with unitranche if needed and outline key intercreditor terms early. Weeks 2 to 3: First drafts for mezz credit or NPA, intercreditor, and warrants. Map covenants to senior docs. Confirm tax structuring on 163(j), AHYDO, and withholding. Start lien and corporate diligence and solvency work. Weeks 4 to 5: Negotiate, form a club if relevant, complete perfection steps, approvals, and intercreditor execution order. Clear regulatory consents and KYC and AML checks. Week 6 plus: Close and fund, then complete filings, collateral confirmations, fee finalization, reporting setup, and any board observer logistics.
Common pitfalls and simple guardrails
- Senior consent gaps: If the senior agent will not support subordination and enforcement mechanics, stop. Do not fund on conditional intercreditors.
- After tax cost drift: If 163(j) and AHYDO push the after tax cost above alternatives under downside EBITDA, pick another tool.
- Dividend capacity: If upstreaming looks tight, increase PIK, add step downs before cash pay, or resize the tranche.
- Maturity laddering: Mezz should mature beyond the senior and revolver stack. If not, price for the risk or pass.
- Leakage and priming: Tighten negative pledge, debt baskets, and restricted payment definitions to block structurally senior leakage and future priming liens.
- Warrant valuation: If equity visibility is low and information rights are thin, underwrite warrants at zero.
Governance terms that actually work
Information rights should include monthly flash KPIs, quarterly financials with budget to actual variance, and immediate breach notices. Observer rights at the board improve early warning without control liabilities. Define materiality with clear monetary thresholds. MFN on subsequent junior capital preserves economics. Track upstream distributions, intercompany loans, and extraordinary items with dedicated reporting.
Enforcement reality in subordinated positions
Model recoveries assuming zero warrant value in liquidation. Subordinated instruments often recover through negotiated restructurings rather than courtroom results. Timing, sponsor reputation, and alignment across the stack matter more than legal maneuvers. A practical guide to intercreditor dynamics can help set expectations early and reduce litigation risk later.
What to push and what to concede in negotiations
- Push hard on: Standstills no longer than 180 days, sacred rights around lien priority and payment blockages, anti priming protections that cover uptiers and drop downs, and restricted payment capacity that allows cash pay after deleveraging.
- Concede selectively: No separate maintenance covenant if senior already has one and cash pay is modest, narrow portability for a pre vetted buyer set with leverage and EBITDA floors, and small baskets for subordinated acquisition debt behind mezz.
A quick fit test you can run in a day
Choose mezzanine when senior lenders cap capacity, the business has durable margins and cash conversion, and a three to five year exit is plausible. Avoid it when cash conversion is uneven, senior restricted payment controls are tight, or tax and regulatory frictions like 163(j), AHYDO, or non exempt withholding make the effective cost uncompetitive. Highly complex cross border structures with hard to align intercreditors are poor candidates on short timelines.
Fresh angle: a two line underwriting rule of thumb
If free cash flow conversion is less than 70 percent through the cycle or maintenance capex above six percent of revenue, assume full PIK for two years and price any cash pay as upside. If customer concentration over 25 percent or churn risk is elevated, underwrite warrants at zero and target a higher cash coupon to compensate.
Conclusion
Mezzanine debt fills the gap between what senior lenders will provide and what equity owners will accept. When structured with clear intercreditor terms, disciplined covenants, and realistic refinancing timelines, it delivers flexible funding to sponsors and attractive risk adjusted returns to lenders. The key is to solve for enforceable seniority, sustainable cash flows, and clean paths to takeout before documents get signed.