Posted on: March 3rd, 2020
Mezzanine debt loans are not publicly traded instruments but are part of the private debt market. As such, loan pricing is influenced by several component costs such as cost of funds, overhead and loan loss reserves. Furthermore, the ultimate pricing for the borrower is influenced by the underlying credit risk of the borrower. The managers of mezzanine debt funds, not unlike any asset managers any financial asset, have a targeted rate of return for all assets they invest. The portfolio yield is set at a level to cover all the fixed costs, costs of funds and investor profits.
A key driver of mezzanine fund costs is the capitalization structure of the fund. Most banks are capitalized with 1 dollar of equity for every 8 to 9 dollars of assets. Mezzanine debt funds, especially Small Business Investment Corporations, are capitalized at roughly half the level of banks with 1 dollar of equity for 3 to 4 dollars of assets. This means that mezzanine debt funds need generally twice the level of equity investment in their capitalization structure. Because equity investment costs more than bank loans, the cost of funds for a mezzanine debt fund is naturally higher than a bank.
Mezzanine Debt Risk Premia
Mezzanine debt funds make loans that are fundamentally riskier than loans made by banks. Mezzanine debt loans are structured not against collateral but against cash flow and rely on long term growth for ultimate principal repayment. Should the company not achieve its growth plan, the mezzanine debt lender may not realize timely recovery of their principal.
Mezzanine debt loan repayment is inextricably tied to faithful execution of the growth plan. Lack of execution means added risk for the mezzanine debt lender. This translates into mezzanine debt lenders having higher loan loss reserves on their balance sheet than lenders. When a loan is priced it reflects an additional risk premium to compensate the lender for this risk. This risk premium reflects not only the higher level of risk inherent in the growth plan but also the capital structure risk that a mezzanine debt lender assumes.
As a lender in second place, mezzanine lenders are behind the bank. In a workout scenario, the mezzanine debt fund often has to standstill and wait for the bank to resolve issues with the borrower. In this scenario, there is greater risk of principal loss and hence a higher risk premium is required. Both borrower performance risk and capital structure risk require the mezzanine debt lender to charge more for their capital in the form of greater risk premia.
Origination and Fund Management costs of Mezzanine Debt Funds
Mezzanine debt lenders, like all lenders, must spend money on generating deal flow. Most middle market funds generally have less than 20 employees, and their firms are not well known in the market. Because they do deals across a wide region, they invest in marketing programs aimed at educating deal gatekeepers of their deal preferences and appetite. This involves having business development people on staff tasked with raising the visibility profile of the firm.
In addition, all mezzanine debt lenders have portfolio management people and internal administrative people. Unlike large banks, the average size mezzanine debt fund does not have massive scale, but perhaps $250 million to $750 million under management. The costs of origination and management add up quickly. Due to the smaller size of the fund, these costs represent a much larger percentage of the asset base and net income, than they would for a bank. This means that origination cost and management cost loads are naturally higher than they are for a massive bank with billions of assets under management.
General Pricing for Mezzanine Debt
As detailed above, mezzanine debt pricing is a function of the costs of its component inputs. The pricing is not artificially high, but reflects higher costs of funds, risk premia and operational costs. In the market today, mezzanine debt rates are approximately 12% with many structures having 10% current interest pay with 2% deferred interest. For more risky equity like deals, the pricing may also include a small equity warrant which gives the lender equity upside in the growth performance of the company. Mezzanine debt lenders are also willing to co-invest in the equity of the company.