The Hybrid: Debt Returns + Equity Upside
Mezzanine debt is subordinated, unsecured debt that sits between senior debt and equity in the capital structure. It combines debt-like cash interest payments with equity-like upside through warrants or profit participation.
Mezzanine fills the gap when companies need more leverage than banks will provide, but sponsors want to minimize equity. It's more expensive than senior debt (12-16% all-in) but cheaper than giving up equity ownership.
Like a mezzanine floor in a building - it's between the ground (senior debt) and penthouse (equity)
No collateral claims - ranks behind all secured debt and senior unsecured bonds
Targets 15-20% IRR through cash interest (8-12%) + PIK (2-5%) + warrant upside (3-8%)
Warrants for 5-20% of equity provide the upside that makes high returns possible
Mezzanine sits just above equity - last to get paid in default but first to participate in equity upside
| Component | Typical Range | Purpose |
|---|---|---|
| Cash Interest | 8-13% annually | Current income to lender, paid quarterly |
| PIK Interest | 2-5% annually | Accrues to principal, preserves borrower cash flow |
| Warrants | 5-20% of equity | Equity upside participation |
| Upfront Fees | 1-3% | Closing/commitment fees |
| Maturity | 5-8 years | 1-2 years beyond senior debt |
| Target IRR | 15-20% | All-in expected return |
Mezzanine combines three return components to achieve 15-20% target returns while preserving borrower flexibility.
8-12%
Paid quarterly in cash. Provides steady income stream to lender.
2-5%
Accrues to principal balance. Compounds over time, paid at maturity.
3-8%
Equity upside. Can be worth much more in successful deals!
Terms: 11% cash + 3% PIK + warrants for 10% of equity
Year 1 Cash Interest: $2.2M (paid quarterly)
Year 1 PIK: $0.6M (added to principal, now $20.6M)
Year 5 Balance: ~$23.2M with compounded PIK
If company worth $200M at exit: Warrants worth $20M (10% × $200M)
Total Return: $23.2M principal + $20M warrants = $43.2M on $20M invested = 21.6% IRR
$20M mezzanine at 11% cash + 3% PIK
Pay $2.2M cash interest. PIK $0.6M accrues. New balance: $20.6M
Pay $2.27M cash (11% × $20.6M). PIK $0.618M. Balance: $21.22M
Balance with compounded PIK: $23.2M. Must repay principal + PIK accretion.
Instead of paying $2.8M cash annually (14% all-in), borrowers only pay $2.2M (11%). The extra $0.6M stays in the business for growth, acquisitions, or weathering downturns. The trade-off? Principal grows over time and must be refinanced or paid at maturity.
| Feature | Senior Debt | Second Lien | Mezzanine | High Yield |
|---|---|---|---|---|
| Security | Secured 1st lien | Secured 2nd lien | Unsecured | Unsecured |
| Interest Rate | SOFR + 4-5% | SOFR + 7-9% | 11-14% (cash+PIK) | Fixed 6-10% |
| Equity Upside | None | None | Yes (warrants) | None |
| PIK Option | No | No | Yes | No |
| Covenants | Strict maintenance | Lighter | Lightest | Incurrence only |
| Target Return | 6-9% | 10-13% | 15-20% | 8-12% |
| Default Recovery | 70-90% | 20-40% | 10-30% | 30-50% |
Warrants are the "secret sauce" of mezzanine debt. They're options to buy equity at a predetermined price, allowing mezz lenders to participate in company growth like an equity investor.
Coverage: Typically 5-20% of fully diluted equity
Strike Price: At or below current enterprise value
Expiration: 7-10 years (long-dated)
Exercise: Usually at exit (acquisition or IPO)
Deal: Company worth $100M enterprise value today
Mezz provides: $20M
Warrants: Right to buy 10% of equity at $100M valuation ($10M strike price)
5 years later, company sold for $200M:
• Equity is worth $200M - $55M debt = $145M
• Mezz exercises warrants: pays $10M, gets 10% of equity = $14.5M
• Warrant profit: $14.5M - $10M = $4.5M
• That's a 45% return just from the warrants, on top of debt interest!
See how warrant value changes with company growth:
If company value 3x or 5x, warrants capture proportional gain. A home run deal can return 30-50% IRR.
If company struggles, you still have debt claim. Warrants worth zero but you can recover through debt.
Mezz lender's interests align with equity sponsors - both want maximum exit value.
Cash interest alone (11-14%) won't hit 15-20% target. Warrants provide the extra 3-8% needed.
If company value stays flat or declines, warrants may expire worthless:
• Entry EV: $100M, Exit EV: $80M → Equity worth less than initial value, warrants worthless
• This is why mezz lenders carefully underwrite growth potential and sponsor quality
• In these cases, mezz may only earn the 11-14% debt coupon, missing the 15-20% target
As the most junior debt, mezzanine is extremely vulnerable in defaults. Understanding the recovery waterfall is critical.
Adjust the recovery value to see how proceeds are distributed in default:
| Recovery | Senior ($55M) | Mezz ($20M) | HY ($20M) | Mezz Loss |
|---|---|---|---|---|
| $100M (80%) | $55M (100%) | $20M (100%) | $20M (100%) | $0 (0%) |
| $85M (68%) | $55M (100%) | $20M (100%) | $10M (50%) | $0 (0%) |
| $70M (56%) | $55M (100%) | $15M (75%) | $0 (0%) | $5M (25%) |
| $60M (48%) | $55M (100%) | $5M (25%) | $0 (0%) | $15M (75%) |
| $50M (40%) | $50M (91%) | $0 (0%) | $0 (0%) | $20M (100%) |
Critical Insight: Mezzanine only starts taking losses when recovery drops below (Senior Debt + Mezz). In this example, that's $75M (60% recovery).
Why mezz is risky:
• Below 80% recovery → Mezz gets nothing
• Even at 60% recovery → Mezz loses 75% of investment
• Historical average mezz recovery: 20-30% in defaults
This is why mezz needs:
• High cash interest (11-14%) to compensate for loss severity
• Warrant upside to achieve target returns
• Careful underwriting of downside scenarios
Subordination agreement typically requires 90-180 day standstill. Mezz can't take action while senior works out deal.
Senior lenders control bankruptcy process, asset sales, and restructuring negotiations. Mezz has observer rights only.
Can vote to block reorganization plan in bankruptcy. May trade debt for equity in restructuring to salvage value.
Recovery of 20-30 cents on the dollar. Often converted to equity in reorganized company. Warrants usually worthless.
Calculate total IRR including cash interest, PIK accretion, and warrant value to see if mezz hits its 15-20% target.
Annual cash interest provides current income. At 11% on $20M = $2.2M per year. This alone gives ~11% return if held to maturity.
PIK compounds annually. 3% PIK over 5 years grows principal to ~$23.2M. Adds ~3% to total return.
If company grows 80% ($100M → $180M), 10% warrants worth $18M vs $10M strike = $8M profit. This adds the final 3-6% to hit targets.
Successful mezz deals deliver 15-20% IRR. Home runs with 3-5x company growth can exceed 25-30% IRR.
Notice that cash + PIK alone typically yields 11-14%. To reach the 15-20% target, mezz lenders NEED the warrant upside. This is why:
• Mezz lenders focus on growth companies and quality sponsors
• They underwrite both downside (can I get my money back?) and upside (will warrants be valuable?)
• Deals with limited growth potential may not be attractive even at high cash rates
• The best mezz funds have strong relationships with PE sponsors who deliver exits at premium multiples