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Mezzanine funds: in the spotlight

In an environment in which investors are wary and need liquidity and in which senior debt lenders are cautious, mezzanine is becoming increasingly attractive. But for investors considering investment in mezzanine funds, there are various aspects to take into account, says Jennifer J Burleigh of Debevoise & Plimpton.

Mezzanine funds have recently become an increasingly popular vehicle on the private equity landscape. Even the most casual observer of the private equity marketplace can explain part of that phenomenon - a precipitous decline in the senior debt market for leveraged financings, the volatility of the high yield debt market, and the vast amount of uncommitted equity capital raised by sponsors primed to effect leveraged transactions. At the same time, average private equity fund investment returns have receded, and many investors now see in mezzanine funds an opportunity to achieve relatively strong risk-adjusted returns. In addition, because the mezzanine funds marketplace is not over-saturated, mezzanine providers have the luxury of negotiating favorable terms and of selectivity.

Mezzanine funds, however, differ from traditional private equity funds in some significant ways.

What is Mezzanine Financing?

A typical mezzanine investment consists of a debt or debt-like instrument, paired with an equity “kicker.” The equity component of the investment gives the mezzanine lender upside potential, while the debt component - which generates steady interest payments and ranks senior to the company 's common stock - provides a measure of downside risk protection. The most common formulation is a note which may provide for both current-pay cash interest and pay-in-kind, or PIK, interest, paired with warrants to acquire stock of the borrower. Mezzanine investments can be made using other types of securities as well, such as with preferred stock in place of a debt instrument.

What Makes Mezzanine Funds Different?

From a fund investor 's perspective, mezzanine fund terms are generally similar to those of buyout funds. But there are a few basic differences that may affect an investor 's appetite for investment in this asset class.

Current Income. A typical mezzanine fund will generate significant amounts of current income for its investors (from interest payments on the debt) during the entire life of the fund, starting soon after the first investment is made. Buyout funds, on the other hand, almost never generate income on an investment until it is sold, often years after its purchase. This principal difference between mezzanine and equity funds accounts for most of the novel issues investors will encounter when they invest in mezzanine funds.

Interest income (whether current-pay or PIK) is not eligible for capital gains tax treatment, which may be important to some taxable investors. Also, taxable investors will be taxed on all interest payments - even if the interest is not payable currently - and may find themselves without sufficient cash to pay the tax. Taxable mezzanine investors need to weigh these risks against the protection afforded by investing in debt as opposed to equity. Non-U.S. investors in a mezzanine fund may confront additional issues relating to withholding taxes on the receipt of current income, which may be mitigated by tax treaties between the U.S. and their home countries.

Current income can also complicate the distribution mechanics of a fund agreement. Whereas proceeds from the ultimate disposition of an investment will generally be distributed in the same way as they would be in a buyout fund (return of capital followed by a preferred return in the neighborhood of 8% for limited partners; then a catch-up to the general partner and an 80%-20% or 85%-15% split of all remaining profits), there is no true market standard for the distribution of current income for mezzanine funds. Some general themes hold true, however. For example, it is common for current income to count first towards the fund 's preferred return rather than towards a return of capital. This approach makes intuitive sense, since the fund 's invested “capital ” is the principal amount of the loan, which is repaid as the principal is repaid, whereas interest is paired with the investor 's return on the investment. Some funds match interest on a particular investment to the preferred return on the investment, while others count all current income towards a fund-wide preferred return.

As a general matter, however, the fund 's “major ” distributions - those that result from the disposition of investments - tend to overtake these differences in the treatment of current income, making them important more as a matter of timing than of significant
economic impact.

Leverage. More aggressive mezzanine funds often use leverage in an attempt to boost returns. Leverage can make a mezzanine fund more competitive with straight equity funds, and can reduce investors ' tax exposure to current income. The fund sponsor can use all or a portion of the fund 's current income to pay interest on the fund 's borrowings, and thereby reduce the amount of current income being distributed to limited partners. Leverage increases risk, however, and may also result in unrelated business taxable income, or “UBTI,” to tax-exempt investors. A prospective investor will want to consider whether a fund 's proposed borrowings are consistent with the investor 's appetite for risk and tax objectives.

ERISA Issues. To facilitate investment by private pension plans and other ERISA investors, private equity funds typically commit to qualify as “venture capital operating companies,” or VCOCs. Mezzanine funds are no different. However, because mezzanine funds invest principally in debt, and because their investments are usually small relative to the portfolio companies ' overall capitalization, the management rights they need to qualify as VCOCs tend to be harder to come by. To be a VCOC, a fund must have qualifying “management rights ” in at least 50% of its investments, valued at cost. An equity fund that makes a control investment in a company will almost invariably get representation on the company 's board of directors (which is widely acknowledged as sufficient to qualify the investment for VCOC purposes). However, a debt fund that supplies financing for the same transaction may need to seek a number of other, lesser means of influencing management in order to achieve the required level of management rights. Normally, this takes the form of a combination of rights to appoint a board observer, to advise and consult with management, to inspect the company 's books and records, and other similar rights. How much is enough to make the investment a qualifying VCOC investment will depend on the facts and circumstances of each deal. Notably, in a recent Department of Labor (“DOL ”) advisory opinion the DOL concluded that contractual rights including the right to receive extensive financial information about the company, the right to access and copy any documents about the company, the right to visit and inspect the company 's properties and examine the company 's books, and the right to consult with and advise the management of the company and its subsidiaries constituted management rights because they were “more significant than those normally negotiated by institutional investors with respect to investments in established, credit-worthy companies.” Mezzanine funds therefore must be vigilant about achieving the required level of rights, and ERISA investors may want to inquire closely about a mezzanine fund 's status as a VCOC.

Conflicts for Captive Funds. Some private equity sponsors form so-called “captive ” mezzanine funds - funds that will invest a significant percentage of their assets in transactions in which the sponsor 's buyout fund is making an equity investment. These funds can be attractive to investors who believe in the quality of the sponsor 's portfolio and management skills - investing in the mezzanine fund gives them another way to benefit from the sponsor 's strengths. However, all parties need to be aware of the potential for serious conflicts of interest that can arise if an investment goes bad. In a bankruptcy or workout situation, debtholders and equityholders have competing desires, and almost any decision made by the sponsor will necessarily disadvantage one or the other of its funds. Investors should understand what the sponsor 's obligations are to the mezzanine fund investors before investing in a captive fund.

Mezzanine funds present certain challenges to sponsors and investors accustomed to more traditional buyout funds. By staying attuned to these differences, however, both sides can make fund formation a smoother, more efficient process.

Jennifer J. Burleigh is a partner with Debevoise & Plimpton and a member of the firm's Investment Management Practice Group. Her practice focuses on advising sponsors of leveraged buyout, international private equity, merchant banking, mezzanine and other private investment funds.

Debevoise & Plimpton, an international law firm, was founded in 1931. The firm, which now has more than 500 lawyers, provides international services in corporate, litigation, tax, and trusts and estates law. Debevoise & Plimpton offices are located in New York, Washington, DC, London, Paris, Frankfurt, Moscow, Hong Kong and Shanghai.

Reprinted with permission from The Debevoise & Plimpton Private Equity Report.  © 2002 Debevoise & Plimpton.  All rights reserved.  No portion of this article may be reproduced without the express consent of the authors.