A Back-up Quarterback View of Mezzanine Finance

Mezzanine finance is ubiquitous. Traditional arguments describe the purpose of Mezzanine debt as completing the market, specifically as ``plugging'' a financing gap. According to that view, intermediate seniority claims add to the available menu of risk-return combinations hence helps cater to the needs of heterogeneous investors and generates additional sources of capital for productive investment projects. We describe a completely different yet equally fundamental role for Mezzanine debt which creates economic value even in a world where all investors are homogenous and risk-neutral. According to our theory, Mezzanine financiers serve as substitute managing agents -- ``back-up quarterbacks'' of sorts -- ready to replace the original borrower when the project underperforms. They enable senior borrowers to provide incentives to the original agent without resorting to inefficient punishment such as foreclosing on the project even when its NPV as a going-concern remains positive. The fact that Mezzanine lenders tend to be industry-specialists while senior borrowers tend to be traditional intermediaries, we argue, constitutes direct evidence that Mezzanine stakeholders provide the expertise senior lending need to efficiently mitigate agency frictions.