How do Mezz funds make $$$?

They, as the buyout funds, will probably raise a certain amount of money (equity) from institutional investors and provide (invest) that money to PE funds who want to leverage even further their equity returns (above what they would get in a senior debt only deal). So the mezz fund is nothing more than a lender to these guys. For this service, the mezz fund receives an annual interest of ~10%-15% (obviously can vary), which is much higher than what senior lenders get, due to increased risk, and at the end the principal back. For sake of simplicity, im assuming the annual interest is cash-pay, not PIK, and the mezz tranche doesnt include warrants. If my understanding is correct, 10-15% return is pretty low compared to PE funds - in other words IS THAT IT? OR do mezz funds themselves lever their funds, to increase those mediocre returns??

(By leveraging their funds I mean as an example: $1bn mezz fund, say its levered 4x, that allows the fund to lend $4bn, instead of $1bn.)

and now the million $ question: If they do lever their funds, where are they getting this leverage (debt) from, and at what rate? - presumably the interest they pay on this leverage must be lower than what they are charging the company, right? And how can someone lend money to a mezz fund, when the fund itself doesnt own anything that can serve as a collateral for the lender? And why would a lender want to lend money to a mezz fund and not lend it directly to the company, who they can charge a higher interest than what they would get from a mezz fund?

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Comments (19)

Best Response
Dec 27, 2010 - 8:37pm

Many middle market funds lever their mezzanine funds and can capture returns in the low 20s. This can be done through the SBIC program, or SBA, which allows lenders to small businesses (5-10mm in EBITDA) to borrow as low as L+300bps and invest the proceeds. Mezz returns have been much higher than you think over the past year. In 2009, even some senior deals were priced at as high as 20% for companies with up to $30mm in EBITDA.

Mezz fund GPs are compensated like private equity GPs, but usually make a bit less, from my personal experience.

Dec 28, 2010 - 10:33am
BankingRUs9:
Many middle market funds lever their mezzanine funds and can capture returns in the low 20s. This can be done through the SBIC program, or SBA, which allows lenders to small businesses (5-10mm in EBITDA) to borrow as low as L+300bps and invest the proceeds. Mezz returns have been much higher than you think over the past year. In 2009, even some senior deals were priced at as high as 20% for companies with up to $30mm in EBITDA.

Mezz fund GPs are compensated like private equity GPs, but usually make a bit less, from my personal experience.

Arbitrage baby!!

Regards

"The trouble with our liberal friends is not that they're ignorant, it's just that they know so much that isn't so." - Ronald Reagan
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Dec 27, 2010 - 8:37pm

Many middle market funds lever their mezzanine funds and can capture returns in the low 20s. This can be done through the SBIC program, or SBA, which allows lenders to small businesses (5-10mm in EBITDA) to borrow as low as L+300bps and invest the proceeds. Mezz returns have been much higher than you think over the past year. In 2009, even some senior deals were priced at as high as 20% for companies with up to $30mm in EBITDA.

Mezz fund GPs are compensated like private equity GPs, but usually make a bit less, from my personal experience.

Dec 27, 2010 - 9:12pm

Good question. Mezz is an interesting beastas I've seen conflicting tranche position across deals, and I've only worked with Mezz secondarily. However I'll see if I can provide a little clarity.

PE firms will identify and initiate on a potential investment. They have the highest risk exposure but also first crack at a favorable term sheet. When the PE fund or consortium doesn't have have enough capital to get a deal done a Mezzanine debt is typically the first that gets called on. So really you shouldn't think of Mezz as any different than other debt. Mezz is not intended to stay on the balance sheet long term (or shouldn't at least) as it's very expensive ie the dreaded PIK note. So typically the originator will want to take out Mezz as soon as possible. Typical life span for Mezz is as short as a week to a year.

Mezz funds can definitely lever up. I'd assume Mezz could put up their tranches as collateral. Which would make sense as to why PIK notes are so punishing in the event of default or covenant violation. And the reason why Mezz funds make investments instead of their lenders is the same reason why fund of funds invest in HF/PE, because they don't have the expertise, can't/won't take on the risk exposure, etc. It gets REALLY complicated especially when covenants/warrants come into play so it's tough to get a definitive answer about some of this stuff and sometimes you just have to work with it face to face before some of this make sense.

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Dec 28, 2010 - 10:39am
Stringer Bell:
...Typical life span for Mezz is as short as a week to a year...

Good points, but I don't think this is typically true. The debt mentioned above in the quote is more of a bridge loan than a mezz loan. Mezz loans need to stay outstanding in order to make a return because they are similar to traditional PE funds in the sense they have an investment period and want to put that money to work as fast as possible and for as long as possible. From my experience, mezz debt usually has a prepayment built into the term sheet in an effort to discourage early payment of the note.

Regards

"The trouble with our liberal friends is not that they're ignorant, it's just that they know so much that isn't so." - Ronald Reagan
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Dec 27, 2010 - 9:18pm

Not really your exact question but...Mezz sort of trades off the chance of a home-run for a higher chance of a pretty good outcome. i.e. less asymmetric but more certain. If things go poorly and the mezz is fairly thin, there is zero downside protection. However, if the investment sort of muddles through and delivers a low or negative (but not a donut) return to the equity, the mezz still get their 15-25%. Doing larger mezz deals seems like a tough business given the main customer of mezz funds is buyout shops. Relationships matter but you are ultimately selling a commodity product to a very sharp customer that doesn't necessarily need your product.

Dec 27, 2010 - 9:58pm

Mezz funds almost always demand a small equity stake in our deals. Lets them partake in the upside.

Also -- to the comment above, in the middle market deals that I do, the sub-debt lasts the life of the investment, not just a "week to a year." Yes, it is extremely expensive, so we don't want to overload the company with mezz, but sometimes it is the only way to get that last turn of leverage you need to buy a company. Also, a lot of the debt that we put on the companies have pre-payment penalties (maybe 3% in year 1, 2% in year 2, 1% in year 3). If you end up flipping assets quickly, this can also take a small chunk out of your proceeds.

CompBanker

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Dec 28, 2010 - 10:47am
CompBanker:
Mezz funds almost always demand a small equity stake in our deals. Lets them partake in the upside.

Also -- to the comment above, in the middle market deals that I do, the sub-debt lasts the life of the investment, not just a "week to a year." Yes, it is extremely expensive, so we don't want to overload the company with mezz, but sometimes it is the only way to get that last turn of leverage you need to buy a company. Also, a lot of the debt that we put on the companies have pre-payment penalties (maybe 3% in year 1, 2% in year 2, 1% in year 3). If you end up flipping assets quickly, this can also take a small chunk out of your proceeds.

Some shops (typically smaller) will even have a 5%,4%,3%,2%,1% prepayment penalty set up for years 1-5, respectively.

As Comp alluded too, banks will only provide so much debt for a company. As markets got tight during the recession and lending standards rose/tightened then the mezz space became very opportunistic as PEGs don't want to put in any more equity than they have to and banks stopped handing out loans to companies that were massively levered (maybe they focused more on asset based lending as opposed to cash flow lending and their advance rates weren't as high anymore) so mezz picked up the slack and in some cases where getting modeled returns of 20%+ depending on where the warrant positions shook out.

Regards

"The trouble with our liberal friends is not that they're ignorant, it's just that they know so much that isn't so." - Ronald Reagan
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Dec 28, 2010 - 4:22pm

I'm fully aware that mezz funds boost their returns through equity warrants. However, there are some mezz and even senior lenders who make impressive returns not through equity warrants but through leveraging their own funds. Say their fund is $100mn and they lever it 10x to $1bn. They then lend that $1bn to whoever needs it (buyout shops, etc) for say 15%. But the fund pays say 8% on the $900mn of leverage. So in Y1 you get paid (on the total $1bn you lend), $150mn interest. Out of that you pay $72mn to your lenders (8% for $900mn) and the fund gets the rest: 150mn-72mn=78mn in Y1 , a 78% return on one year. In 5 years, I calculated the fund IRR to be around 42% which is better than what most PE shops return. Obviously the cost of capital figures I gave are pure estimates to illustrate my point. So if some mezz funds make money this way, where, how, for how much and from whom they get this extra leverage to achieve those returns. BankingRus gave a good answer (for small companies), but I'm interested in what the big mezz players out there use as their source of leverage.

Dec 28, 2010 - 4:59pm
wamartinu:
I'm fully aware that mezz funds boost their returns through equity warrants. However, there are some mezz and even senior lenders who make impressive returns not through equity warrants but through leveraging their own funds. Say their fund is $100mn and they lever it 10x to $1bn. They then lend that $1bn to whoever needs it (buyout shops, etc) for say 15%. But the fund pays say 8% on the $900mn of leverage. So in Y1 you get paid (on the total $1bn you lend), $150mn interest. Out of that you pay $72mn to your lenders (8% for $900mn) and the fund gets the rest: 150mn-72mn=78mn in Y1 , a 78% return on one year. In 5 years, I calculated the fund IRR to be around 42% which is better than what most PE shops return. Obviously the cost of capital figures I gave are pure estimates to illustrate my point. So if some mezz funds make money this way, where, how, for how much and from whom they get this extra leverage to achieve those returns. BankingRus gave a good answer (for small companies), but I'm interested in what the big mezz players out there use as their source of leverage.

I must be missing something here. I'm not aware of large shops doing that (not saying they don't, I just don't know of any) and you're the one saying big mezz shops lever their funds and then basically conduct arbitrage by lending it out at a higher rate...no one else is saying that..but you're asking us how it's done?

Do you have a link to a firm that does this? Outside of small shops that are SBICs, I wasn't aware that this occurred. That's not to say it doesn't, but like was mentioned before, why would a bank lend to an asset less firm that has no guarantee (outside of a potential personal guarantee by the owner or LPs) that it can even put the money to work much less generate a return? The large mezz funds that I know of are dedicated funds that don't use leverage...at least to my knowledge.

Also, warrants are used in ways other than to just "boost returns". They are a nice way to hedge for a larger upside while investing money as a debt security (typically second lien, but sometimes first lien in small companies) but they also allow a mezz shop to stay invested in a company even if they are refinanced out and participate in any future upside, while lowering their risk level (assuming they were paid out).

Regards

"The trouble with our liberal friends is not that they're ignorant, it's just that they know so much that isn't so." - Ronald Reagan
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Dec 28, 2010 - 5:09pm
wamartinu:
I'm fully aware that mezz funds boost their returns through equity warrants. However, there are some mezz and even senior lenders who make impressive returns not through equity warrants but through leveraging their own funds. Say their fund is $100mn and they lever it 10x to $1bn. They then lend that $1bn to whoever needs it (buyout shops, etc) for say 15%. But the fund pays say 8% on the $900mn of leverage. So in Y1 you get paid (on the total $1bn you lend), $150mn interest. Out of that you pay $72mn to your lenders (8% for $900mn) and the fund gets the rest: 150mn-72mn=78mn in Y1 , a 78% return on one year. In 5 years, I calculated the fund IRR to be around 42% which is better than what most PE shops return. Obviously the cost of capital figures I gave are pure estimates to illustrate my point. So if some mezz funds make money this way, where, how, for how much and from whom they get this extra leverage to achieve those returns. BankingRus gave a good answer (for small companies), but I'm interested in what the big mezz players out there use as their source of leverage.

No way are they getting up to 10x leverage. 3-5x max would be my guess. Prob less these days.
Dec 28, 2010 - 6:26pm
wamartinu:
I'm fully aware that mezz funds boost their returns through equity warrants. However, there are some mezz and even senior lenders who make impressive returns not through equity warrants but through leveraging their own funds. Say their fund is $100mn and they lever it 10x to $1bn. They then lend that $1bn to whoever needs it (buyout shops, etc) for say 15%. But the fund pays say 8% on the $900mn of leverage. So in Y1 you get paid (on the total $1bn you lend), $150mn interest. Out of that you pay $72mn to your lenders (8% for $900mn) and the fund gets the rest: 150mn-72mn=78mn in Y1 , a 78% return on one year. In 5 years, I calculated the fund IRR to be around 42% which is better than what most PE shops return. Obviously the cost of capital figures I gave are pure estimates to illustrate my point. So if some mezz funds make money this way, where, how, for how much and from whom they get this extra leverage to achieve those returns. BankingRus gave a good answer (for small companies), but I'm interested in what the big mezz players out there use as their source of leverage.

1) Pre-2008, most banks provided warehouse lines to funds. I typically heard of these being at the 50-60% leverage level (so way lower than what you mentioned in your example).
2) Of course there are assets that are collateral for the bank--the assets are the mezz loans made by the funds. The warehouse lender is senior to the equity, so gets the first dollars coming in--the idea is that the diversification of having the whole fund as collateral provides additional credit support.

Dec 28, 2010 - 6:16pm

I don't think you can lever it up that much. Otherwise what's the point of going to institutional investors in the first place, when you can just go to a bank and get your $3B right there and then invest it at a higher rate. Unless you want to rake in the management fees or whatnot, or unless the bank won't lever you up unless they see institutional investors investing in you; but even in this case, I'm not sure why the latter will matter when the banks (supposedly) lever you up 3-4x times that (never mind 10x).

However, I'd like to applaud the OP for the thread. Definitely one of those classical value (or knowledge)-add discussions the WSO is famous for.

Dec 28, 2010 - 6:45pm

the 10x leverage was just an example to make my point. I know that GS Mezz Partners uses leverage (how much I dont know) and what sparked my interest was an article about this middle-market fund in Europe called Haymarket Financial, and here's the exact quote:

"HayFin will tap the wholesale capital markets to gear up its equity and make loans, rather than taking commercial or retail deposits.The senior sources said the amount it lent would be a multiple of the $750 million in equity, but said the lending would be done "very cautiously, to good credits" over the next 12 months"

So what do they mean by "tapping the wholesale capital markets".Who exactly provides this gearing they are talking about?

Dec 29, 2010 - 10:02am

Mezz is a different value proposition from PE. You earn less than as a PE LP (generally) with a less risky profile (generally). That's part of why many (most?) pure mezz funds are affiliated with either a bank or a sponsor. KKR has a track record as a sponsor so they can easily raise capital from investors with a lower risk profile who WANT to earn good returns with some upside but with less risk than as an equity investor.

I can't say I've ever seen mezz funds lever more than 1:1, though I'm sure it happens. Our fund that invests in mezz and special opportunities (mostly distressed) is levered 1 turn, though the cost of leverage is much lower than what is cited here.

There have been many great comebacks throughout history. Jesus was dead but then came back as an all-powerful God-Zombie.
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Dec 29, 2010 - 10:49am

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