With all the new regulation, banks are increasingly being pushed out of lending to smaller businesses, particularly businesses that need more than just a senior secured loan. Banks lack the capital (under the new capital rules) and sometimes the sophistication for specialized lending. As discussed earlier, this opens opportunities to mezz funds. These are private equity style funds (different form hedge funds) that for some hefty fees and high interest rates are willing to lend to these companies, sometimes in conjunction with a bank.
Typically a large corporation will borrow via a secured loan and also issue corporate bonds. A medium size business however usually has no access to the bond market but in some cases can get a mezz loan (usually subordinated) if it is willing to pay high rates, upfront fees, and possibly give up some equity via warrants. But things get even tougher for small businesses. That's because the amount of due diligence and structuring work required to lend to a larger business is usually the same as for a small business. Per dollar invested, larger firms require much less work and ongoing monitoring. Mezz funds therefore prefer to focus on larger companies.
A smaller business that is looking for say $5-20mm loan may have a tough time. There is however a group of mezz funds that do focus on precisely such firms - with the help of the US government. They are called SBIC funds, named after the Small Business Investment Company Program. The program has been in place for 50 years and is managed by the Small Business Administration (SBA). Once approved to participate, SBIC funds get an amazing deal from the government. The SBA lends these mezz funds money for 10 years at a rate that is linked to the 10-year treasury. The latest SBIC rate was quoted at 2.25%. And for every dollar of investor capital, the government lends two dollars (up to $150 mm), providing nice leverage to the funds.
Therefore if a fund can raise $75mm from investors, the government adds $150mm to give the fund $225mm of lending power.
The loans provided by mezz funds to small businesses could easily carry something like a 12% interest rate. Add to that the fees and some equity participation and the targeted return gets closer to 18% or even higher. Of course these are risky loans and some will clearly default. But these mezz funds still tend to get double digit or high single digit returns even with defaults taken into account. And now if one adds cheap leverage on top of that, the returns would make most hedge fund managers jealous.
The trick of course is to raise the $75mm from investors - a difficult proposition these days because this amount is too small for an institutional investor. A pension may want to be no more than say 10% of a fund, limiting its investment to $7.5mm - too small for pensions and insurance firms to bother. But those who can raise the money will outperform most hedge funds out there. And unlike a hedge fund, mezz funds generally don't have to mark these loans to market. After all there is no market for this product. Investors can't redeem from mezz funds anyway until investments are realized and cash is returned. They do however generate good current income - thanks in large part to the Small Business Administration.
SBIC program (overview)