Chartered Alternative Investment Analyst Association (CAIA) Practice Exam

Compared to senior debt, mezzanine debt will most likely include which of the following?

1. A lower expected return

2. A shorter time horizon

3. Warrants tied to the debt

4. More restrictive covenants

The correct answer is: Warrants tied to the debt

Mezzanine debt is positioned in the capital structure between senior debt and equity, which typically allows it to carry a higher risk and, consequently, a higher potential return. One defining feature of mezzanine financing is that it often includes equity-like instruments, such as warrants. These warrants provide the lender with an option to purchase equity in the company at a predetermined price, thereby offering a potential upside in addition to the interest payments that they receive on the debt. This characteristic of incorporating warrants is designed to compensate lenders for the higher risk associated with mezzanine financing compared to senior debt. Senior debt generally offers less risk, lower returns, and is secured by the company's assets, whereas mezzanine debt is often unsecured and comes with higher uncertainty about recoveries in the event of a default. Overall, the presence of warrants in mezzanine debt arrangements reflects its unique position in the capital structure, where lenders seek to enhance their return potential while also taking on greater risk.