A private equity fund which focuses on mezzanine financing, i.e., it uses subordinated debt with some degree of equity participation (through warrants). This represents another layer of debt financing that may provide for highly leveraged buyout (LBO) transactions. Mezzanine funds target businesses that have a promising potential for growth and revenues, but do not generate sufficient cash flows to be eligible for bank loans.

Similar to hedge funds, venture capital funds and buyout funds, mezzanine funds are typically managed by a general partner who has full discretion with respect to management and investing. Mezzanine funds invest by buying subordinated debentures with equity warrants from their portfolio companies. The subordinated debt is often structured as a pay-in-kind debt, where interest accrues partly and the remaining amount is rolled up so that it will be paid at maturity.

In addition to the debt component, equity participation generates additional returns on the upside in consideration of the higher risk associated with subordinated debt. In other words, mezzanine financing is the most expensive type of debt because it is subordinated (it ranks last among other creditors, directly above equity. Therefore, it is expected to receive a rate of return higher than other types of debt and slightly lower than common equity.