How investing in mezzanine funds can diversify and enhance portfolio returns

There are compelling reasons why investors should consider investing in mezzanine debt - it can not only provide portfolio diversification but can also substantially enhance yield while reducing volatility. 

Mezzanine debt fund managers will generally target gross returns of around 17% to 23% per annum.  

And it makes a timeous and compelling investment case as traditional Johannesburg stock exchange (JSE) investments continue to deliver poor returns as the economic outlook remains uncertain, constraining future returns. 

How does a mezzanine debt fund work?

The best way to describe it is as a ‘best of both worlds’ hybrid between equity and a business’ senior debt. It falls under the ‘private assets’ category of investment products which means it is not listed on a public stock exchange.

 A mezzanine investment has two parts to it:

  • A debt component, generally a subordinated loan, which has an interest rate set somewhere in the mid-teens. This instrument has an interest component and provides the investor with regular cashflows in the form of interest payments; and 
  • An equity component, which provides the investor with longer term capital gains in the form of equity related upside should the equity in the investee company rise in value. 

Because the core of a mezzanine investment is a loan instrument which generates around 60% - 70% of the total return, even if the equity does not perform, the mezzanine investor should still achieve a 15% per annum return (about two-thirds of the targeted return) from the contractual interest coupons. 

Mezzanine investment funds are therefore less volatile and are expected to outperform equity even in a low growth environment such as South Africa continues to experience. 

While investors should keep a portfolio of traditional assets, which are liquid, it is important to add an alternative asset such as a mezzanine fund. 

Mezzanine funds have a low correlation with South African equities which makes them an invaluable diversification tool, better than traditional SA government bonds. South African government bonds may be under selling pressure in the years ahead as SA’s borrowing continues apace and as we face the growing threat of a ratings downgrade.