As mentioned in the previous blog post, I had promised a clarification of the term mezzanine that was used in the Intro to VC blog. In venture capital the word mezzanine is sometimes used to describe the latest round of financing prior to IPO. This same stage can be referenced as merely “late stage” or even just by the round (most likely a Series D or later round).

I have a good friend, NYPE Analyst, who works for a mezzanine firm and was the person who had initially inquired about the difference in terminology. He has been kind enough to write up a two part post on an actual mezzanine firm’s role in the private equity world. Thanks NYPE Analyst!

The Other Mezzanine (Pt 1)

Leverage:
No discussion leading into mezzanine debt would be complete without first a discussion on leverage. As astute Wasatch Girl readers know, using debt as a funding source for the purchase of something will enable the buyer to purchase more of that something than they would be able purchase if they simply used their own cash, thereby “leveraging” the money they currently have. A good example of this is one that most people are familiar with; purchasing a house.

Say that you wish to purchase a house that costs $100,000. A typical mortgage will only cover 80% of the purchase price, so you must supply the remaining $20,000 in cash. When all is complete, you have effectively purchased your $100,000 house for only a $20,000 cash outlay. Now, of course, there is a downside to adding leverage to a transaction. *You are now responsible for making regular payments of principal and interest back to the bank.

A mortgage is collateralized by the house itself, so should you default on your loan, the bank can repossess your house and sell it to reclaim their principal. This adds an element of risk to the transaction that would not be present if you had purchased the house with 100% cash. Using the house as collateral also greatly mitigates the risk taken by the lender, thereby “securing” their investment with the property itself.

You are now the owner of your house (the bank is not, unless they repossess it) and you are in a position, should you sell your house in the future, to realize gains or losses on your $20,000 investment. A fundamental feature of debt is that debt lender’s returns on capital invested are dictated by the interest rate you pay over and above the regular principal payments. Another example will illustrate how this feature leverages your returns and losses on invested capital.

Say that you have owned your house for 1 year and decide to sell it. Say also that your home value has increased to $120,000 and you have consummated the sale. You would calculate your return on invested capital as follows:

Increased Asset Value (Leveraged)

This example assumes that you paid down $4,000 in principal on the loan and made $5,600 in interest payments over the course of the year. Because of the fact that the bank’s return is capped at the interest rate no matter what you sell the house for, you get to keep everything that is left over. This example shows a return on your $20,000 investment of $18,400 over and above the principal amount and making a tidy little profit of 92% on your invested capital. There is another ancillary benefit to using leverage in that interest payments are tax-deductible, however, for simplicity sake; this is not factored into this example.

Let’s look at what the return would be if you purchased the house with all cash:

Increased Asset Value (Un-Leveraged)

As you can see, you still made a nice 1yr return; however, your % return on invested capital is much lower than it is in the leveraged example. The tradeoff is that you did not have to assume the risk of taking on debt and the possibility of defaulting on the loan.

Let’s now look at a downside scenario when the home loses value:

Decreased Asset Value (Leveraged)

In this scenario, where your home loses value, you can see how leverage amplifies your losses on invested principal. Below is an example of the non-leveraged transaction, predictably, you can see your losses as a % of invested capital are much lower.

Decreased Asset Value (Un-Leveraged)

One can see from the previous examples how leverage adds risk to a transaction, however, in return for that risk expected returns on invested capital are also greater. This leads into a discussion on risk versus returns on invested capital.

Certain types of loans (home mortgages, car loans) are asset based loans, where the principal invested by a bank is secured by the asset being purchased with the funds. These loans are inherently less risky to the creditor than an unsecured loan like a credit card, where the creditor does not have rights to the asset being purchased and thus, lenders demand a higher rate of return on the unsecured debt to compensate them for the additional risk they are taking. This same fundamental applies to property holders in the examples above or the equity holders in the purchase of a company.

If an investor is contemplating purchasing a company, they will evaluate the risks inherent to the business they are investing in. Things like commodity risk, economic cycles, seasonality, housing downturns, and competition all add risk to a transaction. The investor will have to weigh the risks inherent to the business with her expected return to decide if she is being compensated adequately for the risk she is taking. Over and above the risks inherent to the business is the risk that is derived through the capitalization of the company itself. As established by the examples above, using debt as a source of capital adds risk to the transaction. The combination of risk from leverage and the risks inherent to the business itself should reflect itself in the expected return on capital for the equity holder.

In the second part of this discussion I will discuss Leveraged Buyouts (“LBO’s”) and mezzanine financing along with its place in the capital structure.

* This is a fundamental difference between leveraged Private Equity transactions and Venture Capital. Start-up companies do not typically generate enough cash consistently to service debt and interest payments and thus, are typically funded with equity dollars.