Mezzanine financing is a form of "junior" or "subordinated" debt that plugs the gap between stock issuance and conventional or "senior" bank loans. It has long been around, but its profile has risen in recent years as banks have grown more conservative about what they were willing to lend to private equity transactions. At the same time, the high-yield bond market remains inaccessible to buyout firms trying to raise smaller tranches of less than $150 million to help finance small to middle-market deals - thus creating a gap that mezzanine funds seek to fill.

Consider the following: Goldman took just seven months to raise GS Mezzanine Partners III. Net returns from its first two funds - raised in 1997 and 2000 - were in the mid-teens percentage, although the firm won't be more specific. Aside from $600 million committed by Goldman and its employees, two-thirds of the balance was raised from high-net-worth individuals, while the remaining third came from institutions like pensions, endowments and insurance companies.

As the capital layer between common stock and senior bank loans, mezzanine debt often takes the form of bonds with attached warrants that can be converted into stock under certain circumstances. And because it includes certain risks that banks may not want to shoulder, it can offer yields higher than those of conventional bank loans.

Among its draws, "investors like the low-volatility aspect of the fund, and the fact they're investing in a security that's steadily income-producing, especially in this market," says Muneer Satter, managing director and head of Goldman's mezzanine group.

For some institutions and individuals, "investing in mezzanine funds is an alternative to investing in corporate or treasury bonds," said Lawrence Golub, president of Golub Associates, a New York firm currently investing a $200 million mezzanine fund.

Demand for mezzanine funding show signs of picking up as LBO dealmaking increases, say people who run these vehicles. According to Standard & Poor's LCD unit, the percentage of deals that included mezzanine debt is about 33.33% so far this year - up from last year's 29.55% and approaching 2001's 38.78%.

"The demand for mezzanine financing has been very strong in the past 16 months," Satter says. During this period, Goldman invested $1.1 billion of mezzanine funding in some 14 private equity deals in Europe and the U.S. These range from a $350 million financing in the $3.7 billion restructuring of Cincinnati Bell, to a $75 million tranche in the leveraged buyout of baked-goods company Otis Spunkmeyer by private equity firm Code Hennessy & Simmons.

Golub, which targets smaller deals, said it invested in 10 deals last year and 12 so far this year, and the $200 million fund it raised in 2000 is already two-third invested.

Bank Debt Stays Tight

The appetite for mezzanine funding is driven in part by a constriction in bank loans. "The banks have opened up a little bit more in the last six months about what they are willing to lend, but they're still not lending near levels three years ago or during the 1990s," says Ronald Kahn, a managing director at Lincoln Partners, a Chicago investment banking firm that specializes in small to mid-market transactions.

Currently, banks provide senior debt that are typically two to two-and-a-half times the target company's trailing cash flow (although companies perceived as better quality might get up to three times). Such senior debt levels are still down from multiples of more than 3.5 times from 1996 to 1998, Kahn says.

At the same time, purchase prices have climbed and the amount of equity buyout firms invest in deals are pushing toward a high of about 43% of transaction prices, according to S&P. "As a result, sponsors have seen their target returns decline and are, therefore, more anxious than ever to enhance their returns by using mezzanine to lower their equity contribution," Kahn says.

Filling that void in capital structure with high-yield debt, or junk-bond issuance, isn't always an option. "It's very difficult in the current environment for private equity firms to access the public market for high-yield issuances of less than $100 million or $150 million," said Greg Cashman, a Golub Associates principal. For these smaller tranches, private equity firms trying to close deals often turn to mezzanine lenders.