Hidden Hazards of Mezzanine Debt: What You Need to Know

Financial Planning Dentist

Mezzanine debt refers to a type of financing that lies between traditional senior debt (such as bank loans) and equity in the capital structure of a company. It represents a form of subordinated debt that combines features of both debt and equity instruments. Mezzanine debt holders have a higher risk tolerance compared to senior debt holders but typically receive a higher potential return.

In the world of finance, mezzanine debt has gained popularity as an alternative investment option. It offers attractive returns to investors seeking higher yields than traditional fixed-income instruments. However, behind the allure of potential profits lie dangers and risks that demand careful consideration. In this blog post, we will shed light on the hidden hazards associated with buying mezzanine debt, allowing you to make informed decisions.

Subordinate Position:

Mezzanine debt typically holds a subordinate position in the capital structure of a company. This means that in the event of default or bankruptcy, mezzanine debt holders will be paid off after senior debt holders, leaving them exposed to greater risk. If the underlying company faces financial distress, the recovery prospects for mezzanine debt holders may be significantly diminished, leading to potential losses.

Complexity and Lack of Transparency:

Mezzanine debt investments can be complex and challenging to assess. Unlike publicly traded securities, mezzanine debt often lacks the transparency and oversight that comes with regulated markets. Investors may face difficulties in accurately evaluating the underlying assets, cash flows, and risks associated with these investments. Without proper due diligence, it becomes challenging to gauge the true value and sustainability of the investment.

Interest Rate and Payment Structure:

Mezzanine debt often carries a higher interest rate than traditional debt instruments, compensating investors for the additional risk they assume. However, the interest payments on mezzanine debt are often structured as “payment in kind” (PIK) or deferred payments. PIK interest accrues and is paid at a later date or upon maturity, leading to potential cash flow challenges for investors who rely on a regular income.

Market Dependency and Liquidity Risk:

Mezzanine debt is typically illiquid and lacks an active secondary market. Unlike publicly traded stocks or bonds, it can be difficult to find buyers or exit a mezzanine debt investment before maturity. This illiquidity exposes investors to significant liquidity risk, tying up their capital for extended periods. It can become problematic if the investor needs to access funds or respond to changing market conditions quickly.

Business Performance and Default Risk:

Investing in mezzanine debt inherently ties the investor’s fortunes to the performance and success of the underlying company. If the company’s financial health deteriorates or experiences operational challenges, the risk of default on the debt increases. Factors such as market conditions, industry disruptions, or poor management decisions can significantly impact the repayment ability of the company, thus jeopardizing the investment.

Lack of Collateral and Security:

Unlike senior debt holders, mezzanine debt investors often have limited or no access to collateral or security. In case of default, senior debt holders have a higher claim to the company’s assets, leaving mezzanine debt investors with diminished recovery prospects. This lack of collateral increases the risk exposure for mezzanine debt holders, as their recovery relies solely on the success and ability of the company to generate sufficient cash flows.

While mezzanine debt investments offer the potential for attractive returns, it is essential to understand the associated risks and hazards. Subordinate position, complexity, lack of transparency, interest payment structures, liquidity risk, business performance, and lack of collateral all contribute to the dangers involved in buying mezzanine debt. As an investor, thorough due diligence, risk assessment, and a well-diversified portfolio are crucial when considering this alternative investment option. It is advisable to consult with experienced financial professionals who can provide guidance tailored to your specific circumstances.


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Kevin Taylor

Better Money Habits: The first 8 “good” money habits (1/2)

Finding yourself in a healthy and happy financial life means practicing better money habits. And, putting you and your family in the best position possible. Raising your income, having income that not employment related, mitigating taxes and positioning your assets in a way to provide maximum benefit for your family are all a part of having “good” money habits. Following these eight very controllable tips will have a positive impact on your families outlook. Your net worth to the world is usually determined by what remains after your bad habits are subtracted from your good ones. ~ Benjamin Franklin By Kevin T. Taylor AIF® and Peter Locke CFP® Pay yourself first For many, money gets mentally earmarked as spending, investing, saving, and giving away.  For some, finding the right balance among these four categories is difficult but essential, and a budget can be a very useful tool to help you accomplish this. So, one of the best better money habits, is paying yourself first. This becomes the mantra for the most successful savers and is the fuel for a financial plan. Here is the two step “Pay yourself first” plan: First create a budget: The only way to start planning is to create a budget. Thinking about both the near-term and long-term financial goals and what a monthly spend looks like and what one you can aspire to have in retirement might look like. This will help generate a baseline for mapping out and putting other better money habits in place. But don’t make the mistake of using this formula, Income – Expenses = Savings. This is the source of most people’s failure to plan. Because it makes you and your future self come last, i.e. the end result of the equation. Create a budget with the future you in mind, that version of your future self is the most important part of the equation. That equation should look like Income – Required Savings = Expenses.  Then create a budget that is less than the expenses amount. Although difficult to implement, this is the priority that financially healthy people adopt. Automate your savings: Making savings a priority in your budget.  Consider determining a specific amount and making a deposit on a regular basis. Think about your 401k or other company contribution plan where funds are taken automatically from your paycheck and deposited in an investment vehicle or savings plan with every run of payroll. Your personal savings plan should be no different.  In order to do this, you need to know your required rate (read and listen to our required rate podcast for more information) so you know how much savings you need to put away at your required rate to reach your goals. Know your tax plan The entirety of the IRS tax plan is complicated, full of loopholes and derived from years of bolting on special interests onto the code. Hence, the process of doing taxes reflects this. But, the second of the better money habits addresses this. At its core there are four main sources of income: Employment, investments, inheritance and windfalls. Each of these sources may be taxed in different ways and at different levels. Have a plan and control what you can control.  Have two plans for how you want to be taxed: Tax plan today: You may not feel like you have a lot of control over how you’re taxed and at what rate. But if you take a step back, you will find you have far more control then you may be aware of. Lets build on the budget example.  If you know exactly what your monthly spend looks like, then you can have more control over the total that goes into pre-tax or after-tax savings options. Think about it this way, if you make $100,000 a year but your budget only requires $80,000, then by letting yourself accept all that income you’re likely surrendering somewhere between $5,000 – $9,000 to taxes of the remaining $20,000. This should be written down as a total loss of income that could have been prevented with the use of a budget and a tax plan. Tax plan tomorrow: Knowing how to mitigate taxes in your working years is great, but having a plan for after retirement may be more important. One of the most tragic events in retirement is being confronted with the risk of a short fall, well into retirement. Finding out that your shortfall was the result of poor tax planning and income management. Having a plan in place in your working years, for how you fund pre-tax, Roth, and post tax savings gives you options for controlling the amount you will pay in taxes in a given year in retirement. This helps elongate the timeline your cash will survive, and gives you flexibility for a changing taxation landscape. Additionally, having a diverse source of cash flow from investments is a better money habits you will develop. If placed in the proper accounts it helps confirm both the amount and source of income throughout retirement. Every dollar that is mitigated in tax planning in retirement, helps to elongate the plan, support measures for unforeseen risks, and adds to your legacy. Remember: Tax nuances exist in every area of wealth planning. There may also be opportunities to incorporate potential tax benefits into your plans but oftentimes there are also negative tax consequences associated with certain decisions. It’s important to step back now to have a vision for yourself, so you can plan accordingly. Additionally, when choosing the best investments for your circumstances, taxes should not be the only consideration.  It’s important to factor in the after-tax rate of return in determining tax-efficient investments. For these reasons, it’s crucial to consult with a qualified tax advisor to ensure your circumstances and needs are appropriately accounted for. Stop living on borrowed time All borrowed money needs to be divided into two camps, accretive and erosive. When you borrow money you are borrowing from that money’s future

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Peter Locke

The Rich Man’s Roth

Life Insurance…. Let me guess, was your first thought, “are you serious?” If so, don’t worry mine was too. How could life insurance be like anything like a Roth? When I was first presented with the idea that life insurance was more than purchasing protection about five years ago, being a CFP®, I immediately thought the same thing, this can’t be right. I mean outside of a few cases like when individuals have a high need for income protection being the primary breadwinner of the family, paying estate taxes, paying off debt and future obligations with a death benefit, or using it as a gifting strategy to avoid the estate tax exclusion (for the ultra-wealthy), I didn’t think there was more. I knew a lot of people needed it but I just thought most people would get term life insurance and call it good. It wasn’t until I spoke with a CPA and one of the leading tax attorneys in the country on multiple zoom calls, thanks Covid, where everything I thought about life insurance was flipped upside down. I think many people were and maybe still are in the same position as I once was years ago. I am here now to tell you that permanent life insurance might be one of the best-kept secrets that the ultra-wealthy have been using for decades to get tax-free income, leverage, income protection, and asset protection. Now there are a million ways to design life insurance but I want to share with you on a high level how some of the policies we design work and why it might be something that would complement the rest of your portfolio. As a financial planner, I want my clients to have a wide variety of different income streams, strategies, and ways to grow their wealth. Life insurance, I believe, was the piece I have been missing in our InSight-Full® Plan. My goal for every client is to help them reach their goals by maximizing how each dollar is used both now and in the future by simplifying each part of their financial lives. This means finding which accounts should be funded, when, how, and then how to withdraw from them when you need them. So why is life insurance so great? For the right person and situation, some types of permanent life insurance policies can provide individuals a mix of growth, protection, tax-free income, and additional leverage should they choose to use it. Let’s start with growth. Whether you’re using a universal life policy that’s tied to an index (think SP500) or ownership in an insurance company (think of a dividend payout) clients can accumulate wealth inside of a policy that’s providing them protection. As the money grows, the death benefit can also increase which means more of a payout to beneficiaries. In some types of insurance like whole life, cash accumulates (cash value) similar to that of a bank account. As that money accumulates, policy owners can withdraw that money and pay interest back to the insurance company. The beautiful part about this is the dividends paid by the insurance company for owning whole life insurance can be more than the interest being charged (leading to a positive arbitrage). Second, since most individuals use life insurance for asset protection and income protection for a certain amount of time (term insurance), permanent life insurance gives you this protection for life. Unlike term insurance, where once you reach the end of your term your coverage ends and there is no value remaining, permanent life insurance continues giving you the flexibility to use the cash value accumulated for almost anything you want. So whether you take out a loan and use that money to make other investments or you annuitize your cash value into an income stream, having permanent life insurance can provide you more value in my opinion than term insurance in the long run due to its cash value. Permanent life insurance can be used as a tax-free income generator as well. Every premium that is paid earns dividends and interest. As that money grows and compounds over time, you end up with a nest egg of cash value. This cash value can be annuitized into a tax-free income stream for life (all growth inside the policy is tax-free) with distribution rates as high as 6-7%. Outside of a Roth IRA and Municipal Bonds, tax-free income is hard to come by. Tax-free income that also pays out a death benefit to beneficiaries is a win-win for everyone. Lastly, some insurance companies allow life insurance to be used as collateral for a loan making permanent life insurance one of the most flexible and lucrative vehicles out there. So whether you’re looking for income and or asset protection, tax-free income in retirement, leverage, or coverage for estate taxes, permanent life insurance is a great place to look. Keep in mind, not all insurance policies are created equal and provide the same features so you need to make sure to do your due diligence, talk with a professional, to make the best decision for you and your family.

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