2.3 Forms of Funding, Funding Mix, Ancillary Services 9Debt. Increasing debt and gearing can increase return on shareholders’ capital,
provided that the firm makes a profit. Increasing debt is often used as a corporate
governance tool, because regular and compulsory payments to lenders force the
firm to be efficient in order to survive. The market for corporate control, the ac-
tivities of private-equity firms, and corporate takeovers in general can increase the
indebtedness of companies.
On the other hand, a very high gearing increases the risk of business failure and
can make it more difficult for the firm to survive in the long term. A very high
gearing can also increase the cost of debt and reduce its availability. If the firm has
too much debt, the firm must pay more for debt capital. Too much debt can do
many things: increase the risk for banks, suppliers and other providers of debt
capital; decrease the credit rating of the firm; decrease the availability of debt; and
increase its cost.
The risks inherent in high leverage can be illustrated by German takeover targets and the
fate of Carlyle Capital Corporation in 2008. In Germany, companies taken over by private-
equity firms in 2004–2008 were typically highly leveraged following the takeover. In
2008–2009, many such companies filed for bankruptcy.^16 The Carlyle Group is a high-
profile private-equity firm. It operates as a private partnership and is owned by a group of
individuals. Carlyle Capital Corporation (CCC) was a publicly-listed company on Euronext
Amsterdam N.V. Although part of the Carlyle family, The Carlyle Group and CCC were
separate legal entities. A bond fund of CCC had used gearing of 32 times to buy AAA-rated
paper.^17 As a result of the subprime mortgage crisis, the market value of those assets fell
and their liquidity was reduced. At the same time, banks became more risk averse and re-
luctant to lend money to private-equity firms. CCC had to sell assets to meet margin calls.
The Carlyle Group supported CCC by extending a $150 million line of credit. After failing
to reach an agreement with its creditors in March 2008, CCC defaulted on $16.6 billion of
debt. The Carlyle Group said that it expected CCC to default on the rest as well. CCC’s
lenders took possession of CCC’s remaining assets and sold collateral.
Mezzanine. There is a wide range of mezzanine instruments. The purpose of mez-
zanine instruments is to combine the benefits of shareholders’ capital and debt
while avoiding some of their drawbacks.
Equity and debt components can be combined in various ways. Whereas some
mezzanine instruments are regarded as equity in the balance sheet of the company
(equity mezzanine), other mezzanine instruments are regarded as debt (debt mez-
zanine). There are also mezzanine instruments that consist of an equity component
and a debt component (hybrid mezzanine).
As equity and debt components can be combined in various ways, the firm can
benefit from the wide range of investors’ risk preferences. The firm can issue a
wide range of securities with different levels of seniority, that is, different rights to
payment.
(^16) See, for example, Paul H, Am Ende entscheidet die Persönlichkeit des Private-Equity-
Managers, FAZ, 19 March 2009 p 16.
(^17) See, for example, Fehr B, Ruhkamp S, Die dritte Welle der Finanzkrise, FAZ, 14 March
2008 p 29; If at first you don’t succeed, The Economist, March 2008.