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 – or won’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 objectives.

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 mezzanine
loans, etc., etc. ...

The great diversity in private equity companies – what they do and how 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 expansion.

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 financing problems:

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.

New Construction

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.

Acquisition Capital

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 $6 million.

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 investment.

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.

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