Mezzanine debt gets its name because it blurs the lines between what constitutes debt and equity. It is the highest-risk form of debt, but it offers some of the highest returns -- a typical rate is in the range of 12% to 20% per year.

A mezzanine lender is generally brought into a buyout to displace some of the capital that would usually be invested by an equity investor.

Mezzanine debt takes up some of the financing that an equity investor would otherwise chip in.

Suppose a private equity firm wants to buy a \$100 million company. A senior lender may only want to lend as high as 75% of the value of the firm, or \$75 million. The private equity sponsor doesn't want to put up the missing \$25 million on its own, so it finds a mezzanine investor to invest \$10 million.

With \$85 million in combined debt financing, the sponsor now only needs to contribute \$15 million of its own money toward the buyout. This leverages the buyer's potential return while minimizing the amount of capital it has to dedicate to the transaction.

An example of how mezzanine debt works and why it exists
Let's say you want to buy a small pizzeria in your hometown. The pizza shop earns \$200,000 per year in operating income, and the owners will sell it to you for \$1 million. You don't have \$1 million laying around to invest, so you find a senior lender who will finance \$600,000 of the purchase price at a rate of 8% per year.

The capital structure looks like this:

• The senior lender contributes \$600,000 of debt financing at a cost of 8% per year.
• You, the equity investor, contribute \$400,000 in equity.

With this in mind, we can calculate the return on your investment. We know the business produces \$200,000 in operating income per year. We need to subtract the \$48,000 in interest payable to the senior lender, thus arriving at pretax profits of \$152,000. We'll assume that the profits are taxed at 35%, so the after-tax profit is \$98,800.

Thus, your return on your \$400,000 equity investment is \$98,800 annually, or 24.7% per year -- not bad!

Example A: Financing the pizzeria with senior debt and equity

Operating income

\$200,000

Interest expense

-\$48,000

Pretax income

\$152,000

After-tax income

\$98,800

Annual return on your \$400,000 investment

24.7%

But what if you could reduce your equity investment? What if another lender could come in behind the senior lender and add more leverage? Suppose you could find mezzanine lender who will provide \$200,000 of financing at a rate of 15% per year.

The new capital structure would look like this:

• The senior lender contributes \$600,000 of debt financing at 8% per year.
• The mezzanine lender contributes \$200,000 of debt financing at 15% per year.
• You, the equity investor, contribute only \$200,000 in equity.

Starting from the same \$200,000 in operating income, we need to subtract the \$48,000 in interest for the senior loan, and \$30,000 in interest for the mezzanine loan. Thus, our pretax profits fall to \$122,000. Take out Uncle Sam's 35% cut, and you, the equity holder, will earn only \$79,300 each year.

By including a mezzanine debt investor in the deal, your after-tax profits fell from \$98,800 to \$79,300. However, your required investment was halved -- you only need to invest \$200,000 of your own capital instead of \$400,000.

As a result, your total annual profits fall, but your return on equity rises from 24.7% per year to 39.7% per year.

Example B: Financing the pizzeria with senior debt, mezzanine debt, and equity

Operating income

\$200,000

Interest expense

-\$78,000

Pretax income

\$122,000

After-tax income

\$79,300

Annual return on your \$200,000 investment

39.7%

Why investors like mezzanine debt
Mezzanine debt has several advantages for the investor. Typically, a mezzanine debt investment will include a free "kicker," usually in the form of a small slice of ownership, or an option (warrants), which entitle the debt investor to buy equity in the company at a future date. If the borrower goes on to be a massive success, these kickers can pay out to the tune of several multiples more than the amount borrowed.

Mezzanine debt also generates a return that is more consistent with equity than debt. To use a real-world example, mezzanine debt investor Triangle Capital earns as much as 19% annually on its mezzanine investments, an incredible interest rate given that U.S. Treasury notes pay less than 2.3% per year.

Finally, mezzanine investors take significant risks just like equity investors, but they also get the benefit of having contractually mandated interest payments each month, quarter, or year. An equity investor is not guaranteed any dividends and equity investors are not entitled to receive a specific amount of money on a regular basis.

Image source: Getty Images.

Why borrowers like mezzanine debt
It seems illogical for a borrower to ever borrow at rates nearing 20% per year, but mezzanine debt provides a big advantage to the borrower, too.

First, you have to consider that the interest on debt is a tax-deductible expense. Thus, at a standard corporate tax rate of 35%, a pretax interest rate of 20% is really only 13% after taxes are taken into consideration.

In addition, mezzanine debt often has unique features that make servicing the debt more manageable. Mezzanine lenders will occasionally include features like so-called PIK toggles, which allow the borrower to "pay" its interest by rolling it into the loan balance. Thus, if the company can't make an interest payment as normally scheduled, it can defer some or all of the interest for a period of time. You won't find this feature on senior debt.

Finally, fast-growing firms often find that they won't need to pay sky-high interest rates for very long. If the company grows, its value should grow, too. Thus, it's likely that the company will be able to refinance the entirety of its senior and mezzanine debt into a single senior loan at a lower interest rate in the future.

And while you're unlikely to see this kind of debt in the public debt markets, it's important to know how it works. Mezzanine debt can be found in deals ranging from highly leveraged private equity buyouts to new real estate developments. In fact, I can almost guarantee that manufacturer of your mattress was, at some point, financed by mezzanine lenders. (Private equity loves a good night's sleep, too.)