The Mezzanine Machine

Investors are building up mezzanine funds, but companies are turning to them only reluctantly.

In September, Goldman Sachs announced that it had closed the largest mezzanine debt fund ever raised—$2.7 billion. Later that month, Castle Harlan, a middle-market private-equity provider, put the finishing touches on its $1.2 billion fund. The funds are now eager to finance deals, but companies have pursued the financing cautiously.

That’s because the financing instrument, which fills the gap between equity and senior debt, comes at a steep price. Mezzanine is usually used to finance a specific transaction, such as a change of control—for example, when a leveraged buyout firm purchases a company—or an acquisition. Because mezzanine lenders take greater risks than their senior counterparts, they structure the deals with an equity kicker.

The experience of Aviall Inc., a Dallas-based aerospace-parts distributor, shows both the advantages and the drawbacks of mezzanine. CFO Colin Cohen says the management team turned to mezzanine financing after a high-yield debt transaction fell through in the wake of September 11. The company organized gap financing of $80 million from a group of investors, including Blackstone Mezzanine Advisors.

While news of the massive Goldman Sachs fund made a splash, industry experts say the asset class is simply coming back to life slowly along with the mergers-and-acquisitions market. “Compared with 2002, people enjoyed a better year in 2003, but that’s relative,” says Michael Hall, general partner at Norwest Mezzanine Partners. “The recovery is slow.”

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