Mezzanine and equity financing: benefits and drawbacks

There are two investment options when participating in Value Added projects (real estate construction and renovation):

• Mezzanine financing: the investor lends capital to the developer in exchange for a fixed interest for the use of the funds and, in some cases, gets a share of the profits from the project, known as an equity kicker.
• Equity financing: the investor provides the developer with equity capital, participates in the project and gets a share of the profits.

Each strategy has its own benefits and drawbacks investors should be aware of.

Yield

The investor providing mezzanine financing makes interest on the loan. In addition, the lender can claim an extra allowance from the net profits in the form of warrants or options. Mezzanine loans yield an average of 5-10% per annum.

The equity partner gets a share of the operating profits. This amount depends on a number of factors: the cost of capital, the scale of the developer’s investment, as well as the quality and the location of the project. The investor can expect an average yield of 10–20% per annum.

Risks

The assessment of risks associated with the two strategies is related to the project participant’s priority for receiving profits. The mezzanine investor is second after the bank to be paid, which reduces his/her risk of losing the investment. the amount of capital the developer provides is important for the investor, as it protects the mezzanine in the case of a negative scenario.

The equity partner does not enjoy the same level of protection. The equity partner is paid after the mezzanine investor and will be the first to incur losses if the project provides low returns. However, in an equity partnership, the returns are better, and this strategy will be more beneficial if the project is successful.

Flexibility

The less flexible mezzanine financing option is safer for the investor. In this arrangement, the investor receives flat-rate allowances over predetermined periods of time. the equity partner’s profits depend entirely on the project´s success, which can be to his/her disadvantage.

At the same time, mezzanine financing has greater flexibility in financing terms (payment regularity, debt redemption, interest rates and loan term) compared to a bank loan, and it is not always collateralised.

Control

The investor’s participation in the project is usually discussed during negotiations. As a rule, the equity partner, who is less protected from capital risks, has a greater influence on key decisions than the mezzanine investor. In turn, the mezzanine investor can have a voting representative on the board of directors.

George Kachmazov, managing partner at Tranio