Starting a mezz fund

We've funded a few sub notes through one or two of our investors before, but now the rest of our investor network is interested in participating so we're putting together our own little mezz fund. We've just started the process - drawing up an LP agreement currently - but I don't think any of us have gone through this before. Any tips or anything?

Comments (10)

 
May 15, 2014 - 10:26am

What's your current strategy and how does the mezz strategy fit? How actively will you need to source deals?

Caltius has done this pretty successfully (PE and mezz fund), but the two funds are very distinct from one another.

"For I am a sinner in the hands of an angry God. Bloody Mary full of vodka, blessed are you among cocktails. Pray for me now and at the hour of my death, which I hope is soon. Amen."
 
May 15, 2014 - 10:34am

duffmt6:

What's your current strategy and how does the mezz strategy fit? How actively will you need to source deals?

Caltius has done this pretty successfully (PE and mezz fund), but the two funds are very distinct from one another.

We've sourced I think all our sub debt for our portfolio from our investor network, particularly I think actually only one or maybe two investors. This would only be for our existing companies and perhaps new deals that we do, it wouldn't really be an entirely separate thing, it would just exist to support our portfolio and work as a vehicle for more than two investors to participate. So we wouldn't be sourcing deals just for the mezz fund.

FWIW we're not a closed fund, though the mezz fund would be.

It seems pretty straightforward, similar to setting up a closed PE fund, but I figured I'd just ask here to see if anyone had any input.

 
May 15, 2014 - 10:40am

Just a couple of thoughts:

1) Internally: Conflicts of interest between your mezz and private equity fund, particularly in a restructuring type event, could arise. Would the firm be comfortable using the private equity fund and mezz fund in the same deal? If the answer is yes, how would negotiations work from both a junior debt and equity perspective if shit hits the fan? Someone is going to have to take a loss... Are the teams going to be structured separately? If you have the opportunity to invest in the mezz and in the equity, but can only choose one, how do you choose fairly given that some LPs will be missing out on the opportunity?

2) Externally: What differentiates your mezz fund from other funds? There's been a ton of fundraising activity in the past couple of years and everyone and their mothers are entering the space. To another PE fund, how do you set yourself apart from other mezz funds that are trying to get some action? Pricing and leverage have been very aggressive as of late - what kind of hurdle rates / incentive structures are you proposing to your LPs?

 
May 15, 2014 - 11:20am

fearandloathinginca:

Just a couple of thoughts:

1) Internally: Conflicts of interest between your mezz and private equity fund, particularly in a restructuring type event, could arise. Would the firm be comfortable using the private equity fund and mezz fund in the same deal? If the answer is yes, how would negotiations work from both a junior debt and equity perspective if shit hits the fan? Someone is going to have to take a loss... Are the teams going to be structured separately? If you have the opportunity to invest in the mezz and in the equity, but can only choose one, how do you choose fairly given that some LPs will be missing out on the opportunity?

I suppose I didn't really get into the details of how our firm is structured because my OP was more about the procedural/legal side of setting up a fund vs. strategy but I appreciate the input, definitely. As a private equity fund, we're not a closed fund. We have a network of HNW/UHNW investors that we use to fund deals, and no institutionals. When we find a company we want to buy, we tap our network for the funds. This allows our investors to build their own portfolio while alleviating us from liquidity pressure. As a consequence, we have no limit on our holding period (our oldest company just turned 10).

To make money, my firm's partners invest their own equity in the deals as well as take monthly management fees out from the companies. In terms of the capital structure, it typically goes:

1. Bank debt
2. Sub debt
3. Preferred unit redemption of principle (level at which our investors put in money)
4. Priority return of preferred investment (typically 8-10% of preferred investment)
5. Common unit investment (typically management and incentive units as well as my firm's partners' units)
6. Remaining balance distributed to all unit holders on a pro-rata basis

So the mezz fund would be used to allocate sub debt to our existing portfolio companies as well as any new deals that we do that require it. Right now my firm has some funds in a sub note that would be transferred to the new mezz fund, so the partners will be invested at that level, above the preferred unit holders (our investors). I don't see this as causing a conflict of interest, though. The firm would get paid out on the sub debt investor above the preferred unit holders, but would potentially lose all of their common unit investment provided there aren't sufficient funds to redeem the original common unit investment.

2) Externally: What differentiates your mezz fund from other funds? There's been a ton of fundraising activity in the past couple of years and everyone and their mothers are entering the space. To another PE fund, how do you set yourself apart from other mezz funds that are trying to get some action? Pricing and leverage have been very aggressive as of late - what kind of hurdle rates / incentive structures are you proposing to your LPs?

This mezz fund would really only be for our portfolio. We wouldn't be interested in using it to invest externally.

 
May 15, 2014 - 11:32am

Got it - makes sense. I still think there would be conflicts of interest in the event of a liquidation or restructuring; that said, if the investors are 100% identical, then it wouldn't matter as much. If you start having different investors funding your equity than the ones in your mezz fund, then things get hairy because at the end of the day, you'll have to give preferential treatment to one party at the expense of another.

As RLC1 said, pricing becomes an issue as well. Pricing the mezz at a below market rate would give the equity investors (including the partners at your firm) a higher return, but that's not exactly kosher is it? I think this would be a tough situation to get around unless everything was pro rata at the investor level in all tranches of the capital structure, imho.

 
May 15, 2014 - 11:08am

So it's clear to me from this and another interesting post you made that you work for a fundless sponsor wherein I'm guessing the sponsors have a few bucks themselves but still need outside money for each deal.

My general comment here would be that if you intend to GP for the sub debt (instead of taking third party financing), then you should put all equity investors into the sub debt as well as the preferred equity pro rata. That way you're really just giving equity investors the attractive, tax-advantaged return stream inherent in the sub debt, as well as the equity stream, and eliminating any conflicts of interest. There is also the advantage that without third party mezz financing you really only have friendly debt (senior lenders are unlikely to take the keys on most lower MM businesses unless it's asset heavy and your team is incompetent, and the sub debt is just equity in disguise). I'm not sure how it makes sense to have a separate vehicle just for mezz for your own deals... i mean, who is going to price that? the GP? you guys are just going to optimize for fees! no bueno.

TLDR: Don't start a mezz fund.

 
May 15, 2014 - 11:25am

RLC1:

So it's clear to me from this and another interesting post you made that you work for a fundless sponsor wherein I'm guessing the sponsors have a few bucks themselves but still need outside money for each deal.

My general comment here would be that if you intend to GP for the sub debt (instead of taking third party financing), then you should put all equity investors into the sub debt as well as the preferred equity pro rata. That way you're really just giving equity investors the attractive, tax-advantaged return stream inherent in the sub debt, as well as the equity stream, and eliminating any conflicts of interest. There is also the advantage that without third party mezz financing you really only have friendly debt (senior lenders are unlikely to take the keys on most lower MM businesses unless it's asset heavy and your team is incompetent, and the sub debt is just equity in disguise). I'm not sure how it makes sense to have a separate vehicle just for mezz for your own deals... i mean, who is going to price that? the GP? you guys are just going to optimize for fees! no bueno.

TLDR: Don't start a mezz fund.

We would be providing this opportunity to all of our investors but we're not going to force them all to take it pro rata. There won't be any management fees; the only expenses would be related to organizing and running the fund (legal/tax/audit). The funds my firm has committed already as sub debt would be bought by the fund and we would receive a portion of the interest based on that percentage contribution. See my above post for more info.

 
May 15, 2014 - 11:33am

OK.... but how do you price the sub debt? What happens if a deal goes bad and the sub debt is the fulcrum security? You have the same GP negotiating with itself on behalf of two different securities that are potentially at odds with each other, with different LP make ups in each. It's a bad set up. The only way you can really make this work in a way that is sensible is if you are getting >51% third party mezz at market terms and then co-investing in the mezz on your own deals, not with your firm controlling the mezz.

Regarding your question on legal... don't write the docs yourself. You can get premium counsel to do formation on a mezz fund for probably $50k which would include an offshore vehicle in case you are doing international deals or have international investors.

 
May 15, 2014 - 11:54am

RLC1:

OK.... but how do you price the sub debt? What happens if a deal goes bad and the sub debt is the fulcrum security? You have the same GP negotiating with itself on behalf of two different securities that are potentially at odds with each other, with different LP make ups in each. It's a bad set up. The only way you can really make this work in a way that is sensible is if you are getting >51% third party mezz at market terms and then co-investing in the mezz on your own deals, not with your firm controlling the mezz.

Regarding your question on legal... don't write the docs yourself. You can get premium counsel to do formation on a mezz fund for probably $50k which would include an offshore vehicle in case you are doing international deals or have international investors.

I see what you're saying now. Thanks for the input, it's definitely valuable.

We weren't planning on writing legal docs by ourselves or anything. We're obviously going to run this all by our lawyers. I was more interested in the topic just for my learning than actually asking so I could do it myself haha. This experience is going to be pretty great to put on my resume.

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