CAIA Level I: An Introduction to Core Topics in Alternative Investments, 2nd Edition

CHAPTER 22

Debt Types of Private Equity

Two 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. For each type, additional details are provided in the introduction in Chapter 20.

22.1 MEZZANINE DEBT

Mezzanine finance, by definition, defies generalization. Some investors, such as insurance companies, view mezzanine financing as a traditional form of debt. Insurance companies are concerned with the preservation of capital and the consistency of cash flows, and they invest in mezzanine debt that tends to meet these priorities. Other investors, such as mezzanine limited partnerships, LBO firms, and commercial banks, focus on the potential capital appreciation of mezzanine debt. Often these firms demand that an equity kicker be attached to the mezzanine debt. This kicker is usually in the form of equity warrants to purchase stock, with a strike price as low as $0.01 per share. The number of warrants included 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, representing 5% to 20% of the outstanding equity of the company. For this reason, mezzanine debt is often viewed as an equity investment in the company as opposed to an unsecured lien ...