Private Equity Companies:
Bridging The Business Capital Gap
With great diversity and flexibility, private equity companies occupy a
distinguished position in the array of business financing power tools.
Their combined pockets are deep, with an estimated several trillion
dollars under their active management and hundreds of billions
available at any given time for investing in private companies. Whether
for acquisition capital, recapitalization, or a supplemental commercial
construction loan, private equity funding can fill large voids in a
business capitalization plan that traditional lending sources can’t –
Good projects often fall victim to a shortfall in business capital,
particularly in a tight senior debt market. Private equity companies
are playing an increasingly important role in bridging the gap between
available equity capital and the funding business can obtain from
traditional commercial lenders. For growing companies and those with
ambitious projects, private loans and equity capital can make the
difference between success or failure.
Where Does Private Equity Funding Come From?
Prior to the 1970s, private equity funding came directly from wealthy
individual investors or through other business entities. Once the
investment community formally recognized private equity capital as its
own asset class, private equity firms were created to raise and
allocate equity funding in an organized and methodical way. To furnish
this new breed of institutional investor the legitimacy and expertise
to manage other peoples’ money, the private equity fund was created,
which allowed for specialization in particular types of projects and
industries as well as providing a structure for raising capital,
allocating equity capital, and managing risk.
For the typical private equity fund today, its equity funding
cuts a broad swath across more conservative investments, such as bonds
and public equity, as well as riskier assets with bigger returns, like
hedge funds and commodities.
How Private Equity Companies Work
Because they are largely unregulated, private equity firms are not
constrained in what they can do. So, there is a vast array of types and
styles of private equity companies, each of which can entertain project
requests and proposals that provide a good fit to its investment
Private equity firms can either make loans against or purchase equity
securities in privately owned firms whose shares are not publicly
traded on a stock exchange. And many will use a combination of both
debt and direct investment to fund a project.
Debt and direct
investment. Acquistition capital, leveraged
buyouts, venture capital, growth capital, distressed investments and
loans, etc., etc. ...
The great diversity in private equity companies – what they do
they do it – causes some confusion and debate about the actual meaning
of the term “private equity” in business financing. But if you
understand private equity in its broadest sense, as a highly
customizable method to bring business capital in the door, this
academic debate is not important.
Private Equity Funding In Practice: Mezzanine Financing
As you have seen, private equity companies have no practical limits
(other than those imposed by their investors) on their activities or
funding. One of the most common, if not universal, techniques they use
to provide equity capital to businesses is mezzanine financing.
In its simplest form, mezzanine financing offers a way for business
owners to obtain equity financing for their companies without giving up
ownership, provided the financing is repaid. Most often, it will take
the form of a mezzanine loan, which offers the business benefits of
both traditional debt financing and equity financing:
- Like equity financing, the mezzanine
loan is unsecured debt, with no collateral needed.
- And like debt financing, mezzanine
financing does not require an ownership interest in the company.
In recent years, private equity companies have been using
hybrids of mezzanine financing and equity investments to craft
solutions for their business clients. In commercial real estate
financing, for example, a mezzanine loan might be combined with some
form or participating “kicker,” which entitles the institutional
investor a share of the profits realized from the project.
Mezzanine financing is frequently used by established companies both to
finance growth and as a source for supplemental commercial real estate
financing on larger buildings and developments.
Business Financing Tip
Mezzanine financing can help
business owners limit the financial risk of a large project or
Private equity companies, by nature, are not risk averse,
and in return for an above-market return on investment, are willing
partners in projects that businesses may not want to undertake alone.
For growing companies, mezzanine financing provides business owners
with funds to expand into another production or market area or
acquisition capital to purchase another company without sacrificing
control of the acquiring company. Unlike venture capital funding, which
is generally targeted toward
start-up financing, private equity companies reserve mezzanine
financing for established companies who are able to demonstrate revenue
and operating profits but who are unable to generate sufficient cash to
fund major expansions, acquisitions or other investments.
Business owners often turn to mezzanine loans for the equity component
of a large commercial real estate project. Unlike hard money lenders,
which are focused primarily on short-term loans in a senior position,
private equity companies willingly take a longer-term (four to eight
years), unsecured position behind first – and, in some cases, even
subordinate – mortgages.
A mezzanine loan is really nothing more than a loan to a
business owner with terms that subordinates it to senior levels of debt
from traditional commercial lenders.
Private equity companies will
generally require the borrowing company to give it a legal right (or
“warrant”) it to convert its financial interest in a project into
equity shares at a predetermined price if the loan is not paid on time
or in full.
Again, as unsecured and potentially highly subordinated debt, mezzanine
loans are expensive when compared to commercial real estate mortgages.
In return, though, you:
- Have maximum flexibility in both the
borrowing and the terms of repayment
- Continue to enjoy control of your
company and its strategic direction, with no outside interference as
long as the mezzanine loan is in good standing
- May benefit from knowledge and
strategic assistance private equity companies can provide
Here are some examples of how mezzanine financing can solve business
Access to Equity
Suppose you are the owner of a retail shopping development worth $5
million and a $2 million first mortgage. Your $3 million in equity is
tied up in the property, and you cannot simply refinance the property
because your first mortgage has a lockout clause with a substantial
prepayment penalty. With a mezzanine loan, you could probably free-up
$1.5 - $2 million of the equity to use for other business purposes.
Smart Business Financing
In larger projects, it makes good
business sense to optimize their capital structures – with several
different tranches of financing and equity to obtain the lowest
possible cost of funds.
Suppose you want to build a hi-rise office building to house your
company and generate investment income, but you’re unable to find a
commercial construction loan that will cover more than 70% of the $10
million it costs to build. Ordinarily, you would have to come
up with the other 30% – $3 million – yourself to move the project
forward. If you have only $1.5 million, a $1.5 million mezzanine loan
solves your problem. Once your building is complete and occupied, you
know it will be worth about $18 million, allowing you to refinance the
project with a traditional commercial mortgage, pay off the mezzanine
loan, and not only recover your initial $1.5 million investment, but
pull out $2 million in equity.
Finally, rather than building, suppose you want to buy an existing
office building that is 50% vacant. Once again, assume that the
purchase price is $10 million.
All of the commercial mortgage lenders you contact bring up the vacancy
rate as an issue, and your best loan offer is for 60% of the price, or
Since you don’t have the other $4 million, you find a commercial
mortgage broker to help you with your problem. She arranges a financing
package that includes a $3 million mezzanine loan, reducing your initial
investment to a more manageable $1 million. Even though the total
financing is 90% of the purchase price, the institutional investor
making the mezzanine loan has the expertise to know that the building
is actually worth closer to $12 million when fully occupied, so it is
willing to take a prudent short-term risk for a well-secured long-term
Finding Private Equity Companies
There are several hundred private equity companies and mezzanine
lenders in the U.S. and perhaps hundreds more in other countries
willing to consider proposals from American businesses, particularly in
comparatively safe U.S. real estate. Without too much effort, you can
find many of them online, though some prefer to work in wholesale
channels only, meaning they accept proposals only from business finance
consultants or commercial mortgage brokers.
Smart business owners
turn to private equity firms because they do not
wish to cede ownership and operational control of their companies and
they may lack the collateral or the strong financial position to attract
lower cost business capital from other sources. Though the price of
the money is considerably higher than the prevailing prime lending
rate, it is money that you can use to capitalize on extraordinary
opportunities that would otherwise be out of reach.
As you have seen, private equity companies perform a vital function in
business financing in general, and commercial real estate financing in
particular, by providing funds that fill the void left by traditional
commercial lenders. Regardless of whether your company needs business
capital for a major expansion or restructuring, acquisition capital for
another business or property, financing for a new development or
recapitalization of an existing project, there is a mezzanine or equity
funding solution that should benefit you.