Mezzanine financing sits between senior debt and equity in the capital stack. For mid market businesses seeking growth capital, it can provide flexible funding without the immediate dilution associated with issuing new shares. It is often used to support acquisitions, management buyouts, refinancing or significant expansion projects.
Yet mezzanine finance is not a one size fits all solution. The legal structures can be complex. The rights attached to mezzanine instruments vary widely, as do the risks for borrowers and investors. Directors must understand how these arrangements interact with existing debt, shareholder agreements and corporate governance.
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What is mezzanine financing?
Position in the capital structure
Mezzanine finance typically ranks behind senior secured debt but ahead of ordinary equity. It is often unsecured or secured on a second ranking basis. Because mezzanine lenders take more risk than senior lenders, they expect a higher return. This return may be delivered through interest, fees, equity participation or a combination of these.
For growing companies, mezzanine can bridge the funding gap where senior lenders are unwilling to extend further credit and shareholders are reluctant to dilute their holdings. It can also be used to improve the overall leverage profile of a transaction.
Common use cases in the mid market
Mid market businesses turn to mezzanine finance in a range of scenarios, including:
- Funding acquisitions where senior debt alone is insufficient
- Supporting management buyouts or buy ins
- Providing growth capital for expansion into new markets
- Refinancing existing debt on more flexible terms
In each case, the legal structure must be tailored to the commercial context and the company’s wider funding arrangements.
Legal structures used in mezzanine financing
Subordinated loan notes
One of the most common mezzanine structures is the subordinated loan note. The lender advances funds under a loan agreement that is contractually subordinated to senior debt. Subordination is usually documented in an intercreditor agreement between senior lenders, mezzanine lenders and the borrower.
Key features include:
- Higher interest rates than senior debt
- Payment in kind interest, where interest accrues and is paid on redemption
- Longer maturity dates to align with growth plans
- Covenants that sit alongside senior facility covenants
Subordination arrangements must be carefully drafted. The rights of mezzanine lenders on enforcement, information access and standstill periods can materially affect the company’s flexibility in distressed scenarios.
Convertible instruments
Mezzanine finance may also be structured as convertible loan notes. These give the lender the right, and sometimes the obligation, to convert debt into equity on specified events. Conversion may occur on a future fundraising, sale of the company or at maturity.
Convertible structures blur the line between debt and equity. They can be attractive where there is upside potential and where valuation is difficult to fix at the outset. However, they raise additional legal and governance issues, including:
- The impact on existing shareholders and dilution
- The mechanics of conversion and valuation adjustments
- Shareholder approvals and pre emption rights
- Alignment with existing option schemes and incentive arrangements
Clear drafting of conversion triggers and pricing mechanics is essential to avoid disputes later.
Preference shares and equity kickers
In some cases, mezzanine investors receive preference shares or equity warrants alongside debt. These instruments provide enhanced economic rights, such as preferred returns on exit, while preserving the priority of senior lenders.
Preference shares may carry rights to dividends, redemption or priority on liquidation. Warrants offer the right to subscribe for shares at a future date, often at a pre agreed price. Both structures can align investor incentives with growth, but they add layers of complexity to the capital structure.
Intercreditor arrangements and lender priorities
Managing competing creditor interests
Where mezzanine finance sits alongside senior debt, intercreditor arrangements are central. These agreements govern the relationship between creditors, including:
- Priority of payments and security enforcement
- Standstill periods for mezzanine lenders
- Restrictions on amendments to senior facilities
- Information sharing and consultation rights
From the borrower’s perspective, these arrangements can constrain flexibility. For example, the company may be limited in its ability to amend senior terms without mezzanine consent. Directors should understand these constraints before entering into mezzanine arrangements.
Security and guarantees
Mezzanine lenders may seek security or guarantees, albeit on a subordinated basis. This can include charges over shares, assets or intra group receivables. The interaction between security packages must be carefully structured to avoid conflicts and unintended breaches of existing finance documents.
Guarantees given by group companies can also raise corporate benefit and financial assistance considerations. Each guarantor must have the capacity and authority to enter into the guarantee, and directors must consider whether doing so is in the best interests of that company.
Corporate governance and shareholder considerations
Impact on control and decision making
While mezzanine finance is often described as non dilutive, the governance rights attached to mezzanine instruments can be significant. Lenders may seek:
- Board observation rights
- Information rights beyond those of senior lenders
- Consent rights over major corporate actions
- Step in rights in certain circumstances
These rights can influence strategic decisions. Founders and boards should consider how much influence they are willing to grant in exchange for the capital.
Consents and amendments to existing arrangements
Entering into mezzanine finance may require consents under existing shareholder agreements, articles of association or senior finance documents. For example, negative pledge clauses may restrict the granting of security. Debt incurrence covenants may limit additional borrowing.
Early review of existing documentation avoids last minute obstacles. It also reduces the risk of inadvertently breaching covenants, which could trigger defaults under senior facilities.
Regulatory and compliance issues
Financial assistance and corporate benefit
In transactions involving acquisitions or buyouts, mezzanine finance may be linked to the purchase of shares. This can raise financial assistance issues under UK company law, particularly for public companies or companies connected to public groups. While the private company financial assistance prohibition has been relaxed, careful structuring is still required in group scenarios.
Corporate benefit is another key consideration. Directors of each group company involved must be satisfied that entering into finance documents is in that company’s interests. This is especially relevant where guarantees or security are provided by operating subsidiaries.
Director duties and risk management
Directors must act in good faith to promote the success of the company. Taking on mezzanine finance increases leverage and financial risk. Boards should consider:
- The company’s ability to service mezzanine debt alongside senior debt
- The downside scenarios if growth projections are not met
- The impact on solvency and long term sustainability
Where a company is under financial pressure, directors’ duties shift towards the interests of creditors. Entering into high cost mezzanine finance in such circumstances may attract scrutiny.
Key legal risks in mezzanine financing
Complexity and documentation risk
Mezzanine transactions involve multiple layers of documentation, including loan agreements, intercreditor agreements, security documents and equity instruments. Complexity increases the risk of inconsistencies and unintended consequences.
Poorly aligned documents can create uncertainty over enforcement rights, payment priorities and remedies. Comprehensive legal review and coordinated drafting across all finance documents are vital.
Refinancing and exit challenges
Mezzanine finance often has longer maturities and higher returns than senior debt. Refinancing mezzanine facilities can be challenging, particularly if market conditions change. The legal terms of redemption, prepayment penalties and consent requirements can materially affect exit options.
Companies should consider exit strategies at the outset. Understanding how mezzanine investors will be taken out, whether through refinancing, sale or conversion, helps avoid being locked into expensive capital.
How Blackstone Solicitors supports mid market growth
At Blackstone Solicitors, we advise mid market businesses across England and Wales on structuring mezzanine finance and navigating the legal complexities of growth capital. Our approach is commercially focused. We work closely with management teams, lenders and other advisers to align legal structures with strategic objectives.
Our services include:
- Structuring mezzanine instruments and intercreditor arrangements
- Reviewing and negotiating finance documentation
- Advising on corporate governance and shareholder impacts
- Managing regulatory and director duty considerations
- Supporting refinancings and exits
Early legal input can help shape a mezzanine structure that supports growth without storing up problems for the future.
Conclusion
Mezzanine financing can be a valuable tool for mid market businesses seeking to accelerate growth. It offers flexibility and can preserve shareholder value where equity issuance is unattractive. Yet the legal structures are intricate, and the consequences of poor structuring can be far reaching.
Companies considering mezzanine finance should take a holistic view of their capital structure, governance and risk profile. With careful planning and robust legal advice, mezzanine financing can support ambitious growth strategies while maintaining control and compliance.
We have a proven track record of helping clients deal with the legal implications of corporate law. We will guide you diligently and ensure all checks are carried out swiftly and efficiently and we firmly believe that with the right solicitors by your side, the entire process will seem more manageable and far less daunting. You can read more about the range of corporate services we offer by clicking here: https://blackstonesolicitorsltd.co.uk/corporate-legal-services/
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Disclaimer: This article provides general information only and does not constitute legal advice on any individual circumstances.
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