In seeking investment opportunities, investors are often called upon to trade prospective long-term returns for short term liquid­ity. Private equity, hedge funds, and real estate partnerships are all examples of asset classes where investors have been asked to com­mit their capital for a substantial period of time in exchange for returns which are presumably greater than they could obtain from more liquid investments. Yield oriented investors, who generally have a good selection of liquid investment vehicles, are also some­times presented with illiquid investments which offer the potential for juicy returns.

One such area is so-called “mezzanine lending,” a form of finance which has been around for a long time. Mezzanine loans are typically unsecured loans made to privately held companies. The loans are junior to other debt issued by a company, but senior to equity. Because of their subordinated status, mezzanine loans generally have higher yields than senior debt, which is typically secured by plant and equipment, inventory, and/or a first call on a company’s cash flow. In many cases equity warrants are attached to mezzanine loans which give lenders the potential for increased re­turns. Lenders are attracted by the high yields, which are scarce in today’s economy. Borrowers like them because, in theory, they are less expensive than selling equity and don’t require all the rigorous terms of typical bank loans.

Which brings us to today’s situation. With today’s low yields on most fixed income instruments, investment companies have been hard pressed to develop products which offer substantial yields. At the same time, the credit crunch has made it difficult for all but a small number of investment grade companies to ob­tain loans on the terms which have traditionally been available to them. With the demand by investors for high yields and a con­current demand by private companies for capital, guess what has happened? A huge supply of mezzanine loan products has been created to fulfill the needs of both parties.

Of course, there is nothing inherently wrong with this situ­ation. At its best, the financial services industry exists to match those with capital with those who have productive uses for it. However, it is important to analyze the situation more carefully. For investors, the search for yield can lead them to make unwise decisions. While an opportunity exists to make loans to private companies at favorable rates, lenders must carefully scrutinize the trade-offs they face. Liquidity and credit quality are two im­portant ones. Also, the inherent risk in lending to small private companies on an unsecured basis should be considered. This problem may be exacerbated by the competition to make loans to the best quality companies in this space.

The situations of borrowers should be considered as well. Faced with a difficult time obtaining bank loans, private com­panies may be quick to take on debt from mezzanine lending funds and other investors. In many cases these loans are made by funds that seek to generate returns for their investors of 10-12% or more, after fees. This means the cost of this debt must be in the mid-teens to the actual borrower. How many private companies earn sufficient returns on capital to enable them to pay interest costs this high, much less repay principle in two to three years time as is often required in these loans? We don’t have a definite answer, but it is likely significantly less than the number which will be enticed by mezzanine finance promoters to accept such financing.

As the sub-prime lending boom showed, a financial prod­uct which matches willing buyers and sellers can grow for a long time, creating its own momentum and generating great returns for investors for a number of years. The problem is that eventually such trends collapse of their own weight as lending standards are lowered as more money flows into the asset class. Unfortunately for most mezzanine investors, by the time this happens it will be too late since they will be locked up in an illiquid investment.

Investors seeking income generally have an interest in liquidity, and our advice is to be very cautious in selecting income oriented investments where liquidity is not readily available. If investors follow this advice, then even if they make incorrect decisions they will at least have the flexibility to react to bad news rather than being locked up in a long-term investment from which there may be no exit opportunity.

William Andersen, CFA, Portfolio Manager,
Wanger Income and Growth Strategy and Principal,
Andersen Capital Management