There are many similarities between investment banking and merchant banking. Both can bring a business to market using identical processes.
It is easier to distinguish them by their differences. A merchant banker will invest their own capital into either equity or junior debt. While a transaction may be the end game, a merchant banker is typically in for an extended period of time. They will be more involved in the business and maintain a focus of growing value for an eventual liquidity event. Board membership is typical. Investment banking is more transactional.
Banks have sharply tightened their underwriting criteria. Although nominal interest rates are low, capital is difficult or impossible to obtain from traditional lenders. We see this as an opportunity and have formed Joseph Associates Capital Corp (JACC) to facilitate deal making.
The traditional capital structure is debt and equity. The debt may be secured by UCC filings or unsecured such as is typical for trade payables. The equity in most companies is of one class (voting) and type (common). Banks provide senior debt which has a first claim on all assets. The owners (shareholders) provide the equity capital.
JACC will consider investments as either junior or mezzanine debt. These are subordinate to bank debt but senior to equity and will have a second or third claim on the assets. Junior debt is amortized and repaid in installment payments. Mezzanine debt typically does not amortize. The monthly interest payment is below the actual cost of capital. This shortfall is closed through accrued interest (payment in kind or PIKs) and warrants on shares of the company.
At first sight, junior and mezzanine financing could be considered as expensive forms of debt. Both attract interest and their expected yield is much higher than that of senior debt. In reality, however, both are a substitute for equity. Lending banks consider debt junior to theirs as a financial resource equivalent to equity. This can therefore increase the company's borrowing capacity. Equity should achieve the highest return. Use of junior and mezzanine debt helps avoid shareholder dilution. It can close gaps that prevent good deals from getting done. Because it is a relatively small portion of the its cost is diluted into the low cost senior debt.
