Mezzanine is a subordinated loan: it has a maturity date, financial covenants and the right to default the company, and its interest is generally tax-deductible. Preferred equity is an ownership class with a priority return and usually no maturity default, so it costs more and gives the investor governance rights instead of covenants. The choice often turns on the senior lender. Mezzanine counts in total leverage and fixed charges; well-structured preferred equity does not. When the senior loan only works with less debt in the stack, the more expensive instrument can be the better one.
- Cheaper on paper
- Mezzanine debt
- Counts in total leverage
- Mezzanine, always; preferred only if it must be redeemed or paid in cash too early
- Remedy if unpaid
- Mezzanine: default and acceleration. Preferred: rate step-ups and governance rights
- Tax
- Mezzanine interest generally deductible; preferred returns generally not
- Pick preferred when
- The senior loan needs room under its leverage or coverage covenant
The two side by side
| Mezzanine debt | Preferred equity | |
|---|---|---|
| What it is | A loan, subordinated to the senior lender | A class of ownership ranking ahead of common equity |
| How it earns its return | Cash interest, PIK interest, often warrants | A preferred return, paid in cash or accrued, sometimes with a share of the upside |
| Maturity | A fixed date, after the senior loan | None, or a redemption date the investor can enforce |
| Security | Unsecured or a junior lien | None; it is equity |
| If the company underperforms | Covenant default, blockage of its payments, eventually acceleration after a standstill | Unpaid returns accrue; the investor may gain board seats or other rights |
| Controls on the owners | Financial covenants and negative covenants in a loan agreement | Consent rights over major decisions in the operating agreement or charter |
| Tax | Interest generally deductible, within federal limits on business interest | Returns generally paid from after-tax income |
| How the senior lender counts it | As debt, in total leverage and usually in fixed charges | As equity, if structured to stay behind the senior loan |
| Cost to the company | Lower | Higher |
Why preferred costs more
A preferred investor ranks behind every lender, including the mezzanine lender if there is one. It has no collateral and, in most structures, no date on which it can declare a default and demand its money. If the company fails, it is paid only after all debt. It prices that position accordingly: a higher preferred return than a mezzanine lender's interest rate, often with a participation in the company's value on a sale.
The tax gap widens the difference. Mezzanine interest is generally deductible as a business expense, subject to federal limits on how much business interest a company can deduct. Preferred returns paid by a corporation are distributions of after-tax profit. In an LLC taxed as a partnership, the preferred return is usually an allocation of income to the preferred member, which shifts taxable income among the owners rather than creating a deduction. The after-tax gap between the two depends on the entity and the owners, and is worth modelling with a tax adviser before choosing.
Owners comparing the two on headline rate alone tend to pick mezzanine. That is often right. It is not right when mezzanine makes the senior loan fail.
Why preferred can be what makes the senior loan work
Senior lenders set covenants on total leverage as well as their own, and test fixed charge coverage on every scheduled debt payment. Mezzanine sits inside both tests. Preferred equity that pays nothing in cash while the senior loan is outstanding, and cannot be redeemed until after it matures, sits inside neither. To the senior lender it looks like more equity under its loan.
An example in plain numbers. A company earns 1,000 a year. For an acquisition it needs 5,000 of capital beyond what the owners are putting in. A senior lender will lend 3,000, and its credit agreement caps total debt at three and a half times earnings. The remaining 2,000 has to come from somewhere.
| Senior plus mezzanine | Senior plus preferred equity | |
|---|---|---|
| Senior loan | 3,000 | 3,000 |
| Gap capital | 2,000 of mezzanine | 2,000 of preferred |
| Total debt for the covenant | 5,000 | 3,000 |
| Covenant limit on total debt | 3,500 | 3,500 |
| Result | Fails by 1,500 at closing | Passes, with 500 of room |
| Cash out each year for the gap capital | Mezzanine cash interest, counted in fixed charges | Nothing while the preferred return accrues |
The senior lender in this example has three choices with the mezzanine structure: lend less, raise its limit, or decline. The preferred structure gives it none of those problems. The company pays more for the gap capital, but it gets a senior loan it could not otherwise get, and it keeps cash in the business during the years when the loan is amortizing. That trade is common in acquisitions, recapitalizations and growth plans where earnings are expected to rise and the business will grow into its debt.
Preferred equity buys room under the senior lender's covenants. Whether the room is worth the price is the question to answer.
Redemption: the clause that decides whether preferred is really equity
Credit agreements do not take an investor's word that something is equity. Most define a class of equity that is treated as debt: equity the holder can require the company to redeem, or that must be paid in cash, before the senior loan matures. Preferred equity with a redemption date inside the senior loan's term, or with mandatory cash dividends, usually falls into that class and counts against the covenants just as mezzanine would.
So the preferred terms have to be written with the senior loan in mind:
- Any redemption right starts only after the senior loan's maturity, with some margin.
- Returns accrue while the senior loan is outstanding, or are paid in cash only when the credit agreement permits distributions and the company passes its covenants afterwards. Distributions under a loan covers what those tests usually look like.
- The investor's remedies for a missed redemption, such as a higher accruing rate, extra board seats or a right to force a sale, cannot interfere with the senior lender's collateral or its control of any workout.
The last point is where owners should look hardest. A preferred investor that is not repaid on its redemption date often gains the right to take control of the board or run a sale process. That right does not default the company, but it can end the owners' control of it. A mezzanine lender's rights, by contrast, are contractual and end when it is repaid; warrants aside, it does not own anything.
Covenant load and control rights
The two instruments constrain the owners in different ways.
- Mezzanine brings a second credit agreement: financial covenants set with a cushion below the senior lender's, reporting, limits on further debt and distributions, and events of default. It also brings an intercreditor agreement that decides how the two lenders act when something goes wrong. Its return may include warrants and PIK interest.
- Preferred equity brings no maintenance covenants but a list of decisions the owners cannot make without the investor's consent: selling the company, taking on debt above an agreed level, paying distributions to common owners, changing the business, issuing new equity, and sometimes approving the budget or hiring senior management. It usually brings a board seat.
Owners who dislike covenant tests sometimes prefer preferred equity for that reason. The trade is that a consent right is permanent for as long as the preferred is outstanding, and it applies in good years as well as bad, while a covenant only bites when the numbers slip.
How senior lenders view each
Senior lenders are used to mezzanine. They know the documents, they will negotiate an intercreditor agreement with an experienced mezzanine lender from familiar starting terms, and they will size their own loan with the mezzanine payments in the model. What they limit is the total: mezzanine that pushes total leverage past what the business can carry makes the whole stack fragile.
They usually welcome preferred equity, provided it is structured to stay behind them. They will read the preferred terms for redemption dates, cash dividend obligations and any investor right that could force a sale or change of control while the loan is outstanding. A change of control is normally an event of default, so a preferred investor's right to force a sale has to be consistent with the senior loan being repaid at that sale.
Which to choose
Mezzanine usually wins when the senior lender is comfortable with total leverage including it, earnings are stable enough to pay cash interest with room to spare, the owners want the lowest cost and the tax deduction, and there is a clear path to repaying it at maturity.
Preferred equity usually wins when the senior loan does not work with more debt in the stack, when cash needs to stay in the business for the first years, when the owners would rather give consent rights than accept a second set of covenants, or when there is no clear repayment date that a lender would accept.
Transparent's lender package models both structures on the same figures, including covenant tests for the senior lender in each year, so the choice is made on what each one does to the senior loan rather than on headline rate. Mezzanine vs preferred equity on cost and mezzanine debt for lower-middle-market companies go further on each.
Common questions
- Is preferred equity debt or equity?
- Legally it is equity. A senior lender will treat it as equity only if it cannot be redeemed, and does not have to be paid in cash, before the senior loan matures. Otherwise most credit agreements count it as debt.
- Can a preferred equity investor force a sale?
- Often, if the company does not redeem it by an agreed date. That right has to be written so it does not conflict with the senior loan, which is usually repaid on any sale.
- Is mezzanine interest tax-deductible?
- Generally yes, as business interest, subject to federal limits on how much a company can deduct each year. PIK interest raises its own timing questions. Get tax advice for the specific entity.
- Which is quicker to put in place?
- Usually mezzanine. Its documents are more standardized, and senior lenders know them. Preferred equity terms are more bespoke, because they sit in the company's charter or operating agreement and change the owners' rights.
- Can a company have both?
- Yes. Some structures use senior debt, a smaller mezzanine layer and preferred equity above it. Each layer adds its own agreement, and the senior lender will want all of them to fit around its loan.