Alternative Investments: CAIA Level I, 3rd Edition

CHAPTER 24 Debt Types of Private Equity

Two primary types of debt are detailed in this chapter: mezzanine debt and distressed debt. These debt instruments can be referred to as private equity due to their equity-like risks.

24.1 Mezzanine Debt

Mezzanine financing, by definition, defies generalization. Some investors, such as insurance companies, view mezzanine financing as a traditional form of debt. Insurance companies seek preservation of capital and consistency of cash flows, and they invest in mezzanine debt that tends to meet these priorities. Other investors, such as mezzanine limited partnerships, leveraged buyout (LBO) firms, and commercial banks, seek potential capital appreciation. Issuers often structure mezzanine debt so as to offer enough potential capital appreciation that it becomes equity-like.

24.1.1 Mezzanine Debt Structures

Mezzanine debt becomes equity-like when an equity kicker is attached to the debt. This equity kicker, introduced in Chapter 22, is usually in the form of equity warrants to purchase stock, with a strike price as low as $0.01 per share. A warrant is a call option issued by a corporation on its own stock. The number of warrants included in the equity kicker is inversely proportional to the coupon rate: The higher the coupon rate, the fewer warrants need to be issued. The investor receives both a coupon payment and participation in the upside of the company, should it achieve its growth potential. The equity component can be substantial, ...