Question

what is the difference between mezzanine debt and senior debt? Why use mezzanine debt to buy a shopping centre? Why use senior debt to buy a shopping centre?

Answer 1

Senior debt, just as the name suggests, is a debt which has senority over other debt and unsecured debt. Senority is the terms of repayment i.e. if the company goes into liquidation, the senior debt provider shall have first preference in repayment. One example of senior debt is secured loan from bank. Such senior debt is usually collateralised by assets of the company. Mezzanine debt drastically differs from senior debt. Unlike senior debt, it does not have first preference in repayment in the event of liquidation, it is not usually secured and has a very high amount of risk as compared to senior debt. Mezzanine debt follows the simple rule of finance - high risk, high returns. Therefore mezzanine debt noticed to have huge returns to compensate the lenders for the huge risk they undertake. It is also to be noted that mezzanine debt is a hybrid instrument i.e it comes along with warrants which gives the lenders an option to convert their loan to equity. It has characteristics of both debt and equity (more of equity though). Mezzanine debt lenders are repaid when the company starts having positive cash flows. Senior debt has a lien on assets so they are more concerned with assets as against the cash flows of the company.

If purchasing a shopping mall involves an investment of say $500 million and the borrower wishes to borrow debt without having the possibility of debt being converted into equity by lenders, he shall go for semior debt borrowing. In that way there is no possibility of dilution of equity interest. But also, in that way, he shall have to repay the debt within the stipulated time limit or else his assets shall be auctioned to repay the debt. That is what might want the borrower to go for mezzanine debt borrowing instead. Since the repayment is supposed to be out of the cash flows of the company, the lenders shall have no choice but to wait till the time the shopping mall has started making positive cash flows. Therefore, going for each of these types of borrowings have their own motivation and demotivation.