What Is the Difference Between Mezzanine Debt & Subordinated Debt?

A corporation borrows money to fund current operations or expand the business. The use of debt allows a company to earn a higher return on equity or shareholder capital. Mezzanine debt is a form of subordinated debt. Mezzanine generally refers to debt that can be converted to equity if the borrower defaults on the loan.

The different types of funding a corporation can access are based on the level of protection given to the provider of the money. Senior debt has first rights to a company's assets in the case of bankruptcy. Subordinated debt will be paid out of assets left after the senior debt lender has recovered its claims. Equity financing is share ownership, and in the event of bankruptcy, shareholders are last in line for any proceeds out of bankruptcy. A company can also have secured debt, which has specific assets pledged against the debt. In most cases, the senior debt lender has a say whether or not a company can borrow through the secured debt route.

Mezzanine debt is subordinated debt with some forms of equity enhancement attached. Regular subordinated debt just requires the borrowing company to pay interest and principal. With mezzanine debt, the lender has a piece of the action in the company's business. The equity kicker in a mezzanine loan can be in the form of attached stock warrants or bonus payments to the lender based on the valuation of the company. Warrants are used with publicly traded companies and other forms of equity participation will be attached to the mezzanine debt of closely held corporations.

The use of mezzanine debt provides benefits to both lenders and the borrowing company. The company taking out the debt gets to borrow at a lower rate than it would pay on straight subordinated debt. A mezzanine type loan may be the only way that a company can get a subordinated loan. The lender gets the benefit of participating in the better results forecast by the additional borrowing. If the borrower is successful in putting the newly borrowed mezzanine financing to work, the return to the lender will be much higher than just providing a subordinated loan.

Mezzanine debt can also be used to orchestrate the orderly transfer of ownership of a company headed for bankruptcy. In bankruptcy, the equity shareholders are typically wiped out and lose the ownership in the company. The equity position attached to the mezzanine debt then becomes the primary equity ownership in the company. This strategy allows a lender to become the owner of a troubled company using the bankruptcy courts.