Andras Crow-Hreidar 
Investing in corporate finance can be a complex endeavor, especially with so many different financing structures and instruments available to choose from. Two relatively similar options—preferred equity and mezzanine debt—often confuse investors when deciding which option is better for their specific needs. To make sure you make the right decision, you must understand some of the key differences between these two types of capital financing and how they’re typically structured. In this blog post, we’ll break down preferred equity vs. mezzanine debt, looking at why one might be preferable over another in certain situations.
Preferred Equity vs. Mezzanine Debt: What Are They?
Preferred Equity Offers You Specific Rights and Privileges:
Preferred equity, also known as preferred stock or preference shares, is a type of company ownership with specific rights and privileges that differ from those of common equity. Preferred equity holders have a higher priority over common equity holders when it comes to receiving dividends or in the event of liquidation or bankruptcy.
Preferred equity typically pays a fixed dividend, which is set at the time the shares are issued and does not carry voting rights or the ability to influence management decisions. However, preferred equity holders may have the right to convert their ownership into common equity under certain conditions, such as if the company achieves a certain level of profitability or if a predetermined date is reached.
Preferred equity is often used as a financing tool for companies that want to raise capital without diluting existing ownership. It can be issued to investors, venture capitalists, or private equity firms and is typically structured as a fixed-income security with a predetermined dividend rate and maturity date.
Mezzanine Debt Sits in Between Senior Debt and Equity:
Mezzanine debt is a type of financing that sits between senior debt (such as bank loans) and equity in a company’s capital structure. It is typically used to fund expansion, acquisitions, or other growth opportunities.
Mezzanine debt is structured as a hybrid instrument, combining debt and equity features. It is considered to be riskier than senior debt but less risky than equity, and as such, it typically carries a higher interest rate than senior debt.
Mezzanine debt is typically unsecured, meaning that it is not backed by collateral, but instead relies on the cash flow of the company to repay the debt. Mezzanine debt may also include equity features such as warrants or options, giving the lender the right to convert the debt into equity if certain conditions are met.
Because mezzanine debt sits in between senior debt and equity in the capital structure, it is often used to bridge the gap between a company’s debt capacity and its equity value. Mezzanine debt providers are usually specialized lenders or private equity firms that have experience in structuring and underwriting these types of investments.
Preferred Equity vs. Mezzanine Debt: What Are the Main Differences?
When comparing preferred equity vs. mezzanine debt, there are several things to understand. Here are the main differences between them:
Ownership:
Having a stake in the appreciation of a company’s value, preferred equity holders can benefit from dividends and their ownership. On the other hand, mezzanine debt is a form of loan financing that carries interest payments but no rights as an owner.
Repayment:
Mezzanine debt has a fixed reimbursement schedule, whereas preferred equity does not. Preference shares also often require cumulative payments, i.e., they must be paid in advance of common stock dividends; nevertheless, the payment of such dividends remains at the discretion of corporate executors.
Risk:
With preferred equity, there is a greater risk than that of mezzanine debt because repayment for the former is not guaranteed. Furthermore, in cases of bankruptcy, creditors are prioritized over those with equity considering their higher ranking. Mezzanine debt holders have precedence over shareholders but still, come after other senior-ranking debts should liquidation be necessary.
Interest rates:
Mezzanine debt is associated with a greater level of risk than preferred equity, which often results in higher interest rates. However, while the rate may be lower on preferred equity investments, investors have the advantage of reaping dividends and potential capital appreciation simultaneously.
Control:
Preference equity may grant voting rights and sway management decisions, while mezzanine debt holders typically lack any form of authority.
To Sum Up:
When comparing preferred equity vs. mezzanine debt, it is essential to note that the former represents an ownership stake in a business without having a predetermined repayment date. Consequently, there are heightened risks associated with this type of investment and may include voting rights or control over decisions; however, interest rates tend to be lower than those of mezzanine debt. On the other hand, mezzanine debt is categorized as financing rather than ownership. This means that investors do not take part in decision-making processes but can expect higher returns from pre-dictated payment schedules – although these come at greater risk for lenders.
