Making sense of mezzanine funds
Mezzanine investments may seem like a good way to accelerate
your returns because of their high interest rates. While mezzanine
investments may offer high returns, they also come with a high
level of risk. In this section, we describe how they work and what
to look out for.
What is mezzanine investing?
Mezzanine investing involves putting your money into projects
and ventures financed outside the mainstream financial markets. As
a mezzanine investor, you are being asked to lend money to a
company when mainstream lenders (like banks) will not. Mezzanine
investing usually operates outside the strict financial
services laws that protect you when you invest in superannuation,
managed funds or shares. It's legal, but the law assumes you know
how these investments work, understand the risks and can look after
Example of a mezzanine investment
For example, imagine a property developer trying to finance a
new building on a vacant block of land. To raise the money, the
developer may tap three sources of funds.
First, the developer gets a loan from a bank, which will take
out a first mortgage over the land. To avoid too much risk, the
bank will only lend up to a certain amount, say 50%.
The second lender is the mezzanine investor, who may put up the
next 45% of the money. Mezzanine literally means 'middle' and here
the investor is contributing the middle 'slice' of the money. The
mezzanine investor might get a second mortgage. However, if the
property developer defaults on the loans, the owner(s) of the first
mortgage gets paid out first. If there's any money left over, then
the owner(s) of the second mortgage gets paid.
The third and final level of funds may be a 5% contribution by
the property developer.
Check the rate of
A key warning sign is the rate of return you are being
offered. The higher the rate, the higher the risk involved. The
biggest risk is that you won't get your money back.
This is because you are lending money where a bank won't. The
developer would not be borrowing money from you at say 12% interest
if it was able to get that money from a bank at say 8%.
Mezzanine funds may seem attractive because they offer high
returns but be cautious as they carry more risk than other types of
investments. Do your research, ask questions of the fund manager
and seek external advice before you invest. If you do decide to
invest, remember to maintain a diversified portfolio. We suggest
that no more than 10% of your money should be put into mezzanine
Questions to ask before
Here are some questions that may help you decide whether to
- How does this product fit into your overall financial plan and how will it help you
achieve your goals?
- What are the risks associated with this type of
- What is the risk that you won't get your money back if the
market drops, a project stalls or there is some other issue?
- Do you know exactly what the borrower will do with your
- Can you explain the business model to a friend? If you don't
understand it, don't invest in it.
Case study: John and Dean consider a mezzanine fund
Brothers John and Dean received an offer to invest
in a mezzanine fund. It sounded great: in return for putting in
$500,000, they would receive 15% interest on their investment. John
was eager to sign up, but his more cautious brother Dean said they
should do more research.
The fund was to raise money for a residential property
development. John and Dean drove to the proposed site and
discovered that, while it was in a high-growth area, the site was
not close to public transport or shops. They believed this would
make it hard for the developer to sell the apartments.
After doing more investigation and speaking to a financial
adviser, they found out that they would only receive their
investment return after the developer's bank had been repaid. If
there was no money left, then they would get nothing. In the end,
John and Dean decided that even though the return was very
attractive, the risk was too great. They turned down the offer to
invest in the fund.
It is important to ask the above questions, do
your own research and seek financial advice before you invest in
a mezannine investment.
Last updated: 01 Aug 2016