Nothing is as simple as it first seems – that applies to many pieces of the great jigsaw puzzle that makes up the financial world, and equity and debt are no exceptions.
They’re at opposite ends of the spectrum, and in between lies an entire world where ingenious financiers and lawyers have developed all sorts of techniques for making equity more debt-like, and debt more equity-like.
The technical term for much of this is not “magic,” but rather mezzanine investing.
Mezzanine falls squarely into that space between equity and debt, and has elements of both investment banking and private equity.
And it might just be better than either.
What is Mezzanine?
In a typical leveraged buyout, the private equity firm contributes its own equity (the cash it has on hand) and then raises debt from banks to cover the rest of the purchase price.
It’s just like buying a house: you front whatever cash you can for the down payment, and then take out a mortgage to cover the rest of the price.
With houses it’s fairly simple and (most) people only have one mortgage, but when you’re buying entire companies, often you need multiple different types of debt, with each one coming from a different investor.
Mezzanine is “in between” debt and equity in such a deal – mezzanine investors take on more risk than the normal debt providers, have a lower claim to the company’s assets, and expect a higher return.
“Mezzanine” itself is usually a more “junior” form of debt that can sometimes be converted to equity; sometimes PE firms themselves provide the debt and other times it comes from banks, but dedicated mezzanine funds provide the bulk of the loans.
I could go on about what mezzanine is and what it isn’t, but I recently had the chance to interview a Partner at a dedicated mezzanine fund – so you’ll get to hear all about it directly from the source:
Breaking Into Mezzanine – The Journey
Q: So, tell me about your journey. How did you end up in mezzanine?
A: I went to a good US school – not Ivy League, but still a good reputation – and then joined a US-based investment bank as an analyst in the M&A department.
I stayed on until I was promoted to associate, and as things were starting to slow down (in the last recession), I decided it might be a good time to do an MBA, so I went to Europe for that; I was in my mid-to-late twenties back then.
At the time my intentions were to get into PE; a lot of people go into mezz because they want to do PE and become a Principal there. If you do normal debt deals you feel very much like a lender, but mezzanine, with its fund structure, is much more like being an investor.
So there I was, looking at PE and researching it over the course of my MBA when I began to look more closely at mezzanine as another option. With mezz, you do largely the same work as PE, but you do deals with a much greater “frequency” as there’s considerably less portfolio management – at least when things are working as they should be.
It’s sort of like “PE-lite,” which was a great fit for me – as a former banker I didn’t have much operational experience and I didn’t want to be as involved operationally as you might be in PE. But it’s also not as impersonal or mechanical as being a senior lender, since you look at qualitative criteria as well.
They focused on deals, which appealed to me – I saw it as a way to become an investor while still ensuring that I could keep working on deals as much as I had in banking.
In mezz, you also piggy-back on the efforts of the PE guys quite a lot – you might sit as an observer on the Board, but as an observer you wouldn’t be taking an owner’s direct decisions.
This is a pretty standard state of affairs unless the company gets into a restructuring, at which point you may end up in an equity-holding situation. Otherwise, you get pretty much the same information a lender would get – monthly reports on points such as management accounts.
Q: Do you still find yourself wanting to do PE?
A: Actually I came to like mezz a lot – it’s much more diverse, not just in terms of volume of deals, but also in terms of sectors, geographies, deal sizes, and so on, whereas you tend to specialize in PE. I don’t think that would work for me now.
Q: What are the typical entry points into the field?
Some people enter after working for a year or two as analysts at investment banks – this is low-risk for the employer since it’s inexpensive and it’s not such a big deal to train them.
But they don’t want someone straight out of university – from that year or two in banking, candidates gain confidence with modeling, valuation and how the practice of a buyout works.
So M&A, Leveraged Finance or Corporate Finance are all good, but someone from, say, Equity Research, would be less suitable – their models aren’t as deep, and we want people with deal experience, partially for the obvious reasons, but also because they’ll know the realities of a work style that involves peaks and troughs.
For the post-MBA associate, we look for more or less the same qualities – ideally someone who was an analyst at a PE firm or mezz house, or perhaps in distressed debt.
We’re not so interested in consultants with MBAs – they work better in mainstream PE where the operational skillset is more important; we want modelers more than PowerPoint jockeys.
But across the board there seem to be fewer consultants than bankers in PE, with the exception of the German-speaking world. Typically we see more interest from people with M&A and Leveraged Finance backgrounds anyway.
A Day in the Life of a Mezzanine Investor
Q: Speaking of peaks and troughs, what are the hours like? What’s the typical rhythm?
A: The work is deal-based, so you can have flat periods but then you could have two big deals come along at the same time.
On top of that, there’s monitoring the portfolio, which is generally steady and quite light work, but if something blows up then that’s a huge spike in working hours.
So it’s not investment banking – not as extreme as M&A – but it’s more than your typical 9-to-5. So perhaps 9-to-7 in calmer times, all the way up to the full all-nighter when deals heat up.
Q: So what’s the day-to-day nature of the work? How do you raise funds and source deals?
A: As with any fund-based business, everything starts with raising money from investors. This is largely the same as PE – you put together the materials and go out to meet Limited Partners.
An analyst might get involved with putting together the Private Placement Memorandum and presentations, and the more senior staff will be on the road meeting with potential investors.
Once you raise the funds, the next step is sourcing deals, which is primarily a matter of leveraging relationships with PE firms and senior lenders.
You want to be their first call for mezzanine financing, so that involves a lot of networking – networking is important across everything in Leveraged Finance, but for LBO-mezz “networking” consists of meeting with sponsors and lenders, and less so with M&A advisors and the contacts that first bring in the deals.
That’s different for sponsor-less mezzanine players (they’re relatively small in number – examples include Mezzanine Management or MML Capital) – or “networking” will be a smaller area of focus for a larger player like ICG.
Q: So now you have the funding and the deals – what’s next? What exactly do you do on a deal, and how is it different from normal PE?
A: Once the deals come in, you need to do the analysis.
It’s the same sort of analysis that you’d expect at a PE sponsor, but with the advantage of being somewhat prepackaged.
“Prepackaged” just means that when the opportunity comes to you, other parties such as the consultants, bankers, accountants, and lawyers have already done serious due diligence work.
So you get to piggy-back on their work and save a lot of time, which results in lower expenses – but that can also mean lower management fees paid to mezz funds.
The analysis still involves a lot of financial modeling; we need to do plenty of sensitivity analyses to work out how much of a ‘blanket’ we’ll have in different scenarios – financial, operational, macroeconomic, and so on.
Naturally this affects how we structure deals – and of course when structuring such a deal, we often need to negotiate with the other parties, although occasionally we do this on a ‘take-it-or-leave-it’ basis. The legal points are then sorted out once we agree on all the commercial elements.
Q: OK, so essentially if you like modeling and analytical work but you don’t like due diligence or the operational side, mezzanine is a great fit for you.
What about once the deal closes? How much portfolio monitoring do you do?
A: This part is relatively smooth unless there’s a problem – we might review the monthly management accounts, meet with the executives at least once a year, and go to quarterly Board meetings.
When there is a problem – such as a covenant breach or the need to refinance (whether as a restructuring or simply as part of an acquisition by the portfolio company) – then we put in a great deal more effort.
We’ll need to revise and update the model, negotiate with all the stakeholders, and if things get ugly, also negotiate terms with the Restructuring advisors or the buyers of distressed assets.
In the latter case, when people start taking haircuts or when sponsors walk away we’re not automatically in the sponsors’ role as the next-in-line – sometimes a distressed investor will step in to fulfill that role.
So you hope that you don’t end up in these situations, but you need to protect yourself and be prepared for the possibility via appropriate attention to the deal structure and the legal side.
Q: What sort of person tends to thrive in mezzanine investing? Is it just what we discussed before – someone who enjoys modeling but isn’t as interested in the operational side?
A: It’s similar to what’s required to do well in PE; it is less high-profile, though, so you need to be sure that you’re happy with that.
The work itself can be similar, though, so you need to like being close to the action and not just sitting in an office.
It’s social since you spend a lot of time out in the field, but you also need to like the analysis and doing the analysis in a flexible way that lets you look at different scenarios.
That’s a consequence of the greater variety in investment types, meaning that the process is less formulaic. It sometimes appeals to bankers who want a more entrepreneurial environment than what they’d get working at a bank – similar to what you might see in other fund-based businesses.
Q: How are mezzanine firms structured and how much do you get paid?
A: Very direct, I like your style!
The structure is similar to a PE firm, so you’ll see positions for Analyst, Associate, Director and Partner, possibly with some ranks in between.
In my organization the ranks are a little blurry in terms of responsibilities, but generally an analyst won’t get carry, and associates may or may not depending on the firm.
If you don’t get carry, you need to make sure you’re on Partner-track (and if you’re a post-MBA associate, you definitely need to be on Partner-track) – this isn’t banking where we have outsized bonuses, so the main reward comes from the carry.
The base salaries range from around £60k (~$100K USD) for analysts up through £100k (~$165K USD) for the Partners, and the bonuses might range from 30% to 100% of those base salaries.
But the real upside is in the carry, which can be significantly more than your normal bonus depending on the firm’s performance.
In short, base salaries are roughly the same as in PE but lower management fees mean that bonuses aren’t quite what you’d receive at a standard PE firm; of course, that’s balanced by the fact that the hours are often better and that you spend most of your time working on real deals.
Regions, Exit Opportunities, and the Future
Q: How does mezzanine investing differ in other regions? We’re both based in the UK, but I’m assuming mezzanine differs elsewhere?
A: In the US and at some European mid-market funds, you’ll see more regional specificity – these more focused firms sometimes act more like conventional PE firms in their focus and with their increased involvement with portfolio companies.
There are some global firms in the middle market too, and some firms specialize in sponsor-less mezz, but increasingly – across many firms in the wider buyout world – there is a widening of focus by the big players to embrace asset strategies beyond PE, which include mezzanine as well as various credit funds.
Q: What are the exit opportunities in the field?
A: People tend to stay rather than “exiting.”
Some people are leaving now as they’re being forced out or because things are looking less attractive, but when the industry is doing well you tend to stay on the escalator.
It’s rare for people to move back to banks – they tend to come in and stay in, and if they do well they’ll go off on their own and raise their own fund. Occasionally people will go into funds of funds or PE, but that’s quite rare – usually it’s the other way round, and quite a few PE analysts and associates move into mezzanine each year.
Q: Any last words of advice to readers considering mezzanine?
A: Be sure that you’re in a fund that has a good track record and that the market and specific fund dynamics will enable them to raise their next fund.
It’s a fund-based business and if there’s no money you can’t invest, so be certain that your firm – as in PE – can get through both tranquil and turbulent times.
Q: Great – thanks very much, it was really helpful to chat with you.
A: No problem – I’ll see you soon!