How PE Investors Use Mezzanine Debt as a Trojan Horse for Control

Private Equity funds are big players in the private debt market with many having launched mezzanine debt funds to invest in their LBO’s. This strategy gives them the ability to provide the majority capital needed to close a deal. Private equity funds also invest mezzanine debt in non-control deals including acquisition and growth financings. These types of deals pose risk to the company when the private equity group intentionally uses the mezzanine debt investment as a trojan horse for control. Other types of mezzanine debt lenders engage in this practice as well, where they make a loan with an eye towards control and ultimate ownership. This unfortunate event happens more than it should and is an outgrowth of the dual properties of mezzanine debt, with its hybrid debt and equity features.

Founder-Owned Deals: Protecting Against Predatory Mezzanine Debt Tactics

In a founder-owned deal, the mezzanine debt lender usually becomes the only institutional capital provider to the company and can secure more favorable terms and conditions due to the lack of an equity investor. Through taking advantage of the goodwill of the borrower, lenders can perpetrate this loan-to-own scheme while not running afoul of the law. This usually unfolds during credit agreement negotiation when the lender begins to go overboard by inserting inappropriate language and provisions relating to operational and financial events that are immaterial to the creditworthiness of the company. Even though the lender has its standard controls and covenants, they demand rights over picayune aspects of the business, that most lenders usually do not care about.

Often, companies do not even track the requested information or feel it is superfluous yet they accept it to get the deal done. Post closing, the lender has much greater leverage allowing it to easily call a default, accelerate the loan and put the company into a distressed state where the private equity firm can purchase it for pennies on the dollar. This type of nefarious scheme is an unfortunate reality of the private credit market today. Companies need to make sure they only take mezzanine debt from highly reputable and seasoned funds, ideally unaffiliated with private equity funds.