Any private equity or venture capital investor will seek a high return on its capital. They don’t purchase debt instruments simply to obtain a yield on interest. On the contrary, the main goal of PE/VC transaction is to obtain geometric returns when success has happened for the portfolio business that results in dramatic rise in their common stock value.  

 

Therefore, a PE/VC transaction generally involves buying of one or more of the following:  

• Common stock;
  
• Convertible preferred stock or subordinated debentures with a relatively low yield but with attractive features that will allow conversion into common stock;
  
• Non-convertible preferred stock or subordinated debentures with a relatively low yield but has warrants to purchase common stock.  

Usually, the PE/VC acquires a risky portion of the portfolio business’ capital structure that is frequently subordinated to a substantial amount of their leverage such as debt. Therefore, they risk losing most or all of their investment if it ends up not being profitable by the time they sell; however, they can obtain a substantial award if it does. So it’s understandable that the PE/VC requires a high return on successful investments to cover loses suffered on those that fail.  

 

Buying risky equity-oriented securities and seeking a high compound yield on successful sales distinguishes those by private equity or venture capital investors from those that purchase debt securities.            

 

One type of transaction that falls short of those by private equity and venture capital investors is mezz lending. Like the PE/VC, the mezz lender generally employs active investment professionals that negotiate the sale of privately-placed securities in PE/VC transactions such as buyouts. However, mezz securities that are purchased are normally directed from the portfolio business and predominately debt securities – high-yield subordinated debt with an explicit equity kicker (slice of common stock, warrants, conversion rights or contingent additional interest).  

 

Generally, the senior bank lender locks in its entire yield in the form of contractual interest payments and specified fees, although they may occasionally take a small equity kicker when financing a buyout. By contrast, the mezz lender takes a portion of its yield in the form of an equity kicker, and thus shares an internet with the PE/VC in the portfolio business’ future equity value.  

 

Remember that mezz debt is at least one level more senior in capital structure than the PE/VC’s investment and hence is significantly less risky than it as well. Furthermore, the mezz lender’s focus is on the high interest yield and relative safer of principal that runs more like the senior lender’s and less like the PE/VC’s. The mezz lender’s equity kicker is designed to augment its interest yield but does not play the central role that it does with the PE/VC.  

 

By contrast, the PE/VC investor focuses on common stock or equivalent securities with any sale of subordinated debentures and/or preferred stock generally designed merely to fill a hole in the financing to provide the PE/VC with some priority over management in liquidation or return of capital.