Ever wonder how private equity shops can generate such impressive internal rates of return? The answer is mezzanine debt.

When PE funds make a purchase, it is typically a combination of equity and debt financing. Debt comprises the largest portion, and is usually sold to investors looking for a low-teen return with commensurate risk. The small portion that remains is equity, and PE funds usually keep that for themselves. If the return of the investment is greater than the interest rate of the mezz debt, the balance goes to equity holders – and since there isn’t a lot of equity, returns can be quite extraordinary.

This is the same way financial institutions are being managed today. A recent article on Goldman Sachs does a great job describing how banks are incentivized to finance much of their capital markets activities with debt, so that their return on equity can be astronomical. 

This goes a long way in explaining why Wall Street compensation is off the charts. After all, if things don’t go as they should, banks can just get bailed out – in a way, using the U.S. government’s balance sheet as a backstop. From a risk-return standpoint it’s a great trade, but from a moral hazard standpoint it’s a disaster. The bottom line: More equity in large banks is needed to further stabilize the financial system.