Mezzanine debt is a type of borrowing by a public company in which the lender has a particularly low claim on the company's assets in the event that it goes into liquidation before the debt is settled. In this situation, the lender's claim will be of a lower priority to all other creditors except for holders of common stock. As a result, this type of debt tends to carry higher costs for the lender than other types of borrowing.
The phrase mezzanine debt simply refers to the low priority of the lender's claim on assets and can cover two different ways in which the lending works. One is as a subordinated debt. This means that an existing lender lends more money to the borrower, with the specific agreement that this new debt is subordinate, meaning that it does not carry the same claim on assets.
The second main way of providing mezzanine debt is through preferred stock. This differs from common stock in that its holders have a greater claim on assets and priority in receiving any dividend payments. In the event of liquidation, holders of preferred stock will be entitled to receive the par value of their stock, assuming any money is left over for them. Only once all preferred stock holders receive this payment from the liquidation will common stock holders be entitled to get any of their money back.
In reality, most people who lend money in a form classed as mezzanine debt will often receive any money if the company goes into liquidation. This is because the debts that forced the liquidation will usually be so high that all assets will be eaten up by claims from other creditors who have a higher priority claim. Because of this higher risk, lenders of mezzanine debt usually demand a higher return. This would be through higher interest payments on subordinated debt, or higher dividend payments on preferred stock. There will often be an arrangement fee attached to mezzanine debt.
Because mezzanine debt has such distinctive characteristics, it is often provided by specialist lenders. Some of these offer mezzanine investment funds. These are inherently riskier but with a higher potential return than many other types of investment fund. In many cases a mezzanine debt will be set up so that all interest payments are held back until the capital of the loan is repaid. This can be useful for companies that resort to borrowing in such a way, particularly for those who are borrowing to ease cashflow problems.