Reversing Trend, Mezzanine Debt on the Rise Again

Mezzanine debt financing is on the rise in the private equity market. Global private debt strategies in 2016 are set to see what could be the highest mezzanine debt levels since before the Great Recession, reversing a trend where mezzanine was squeezed by a spike in direct senior debt lending and the maturation of the business development company (BDC) market.

Private equity returns from 2015 were excellent in terms of exits and value returned to LPs — globally and in the United States — but record multiples and uncertain prospects this year have made it challenging for buyers. The 2016 PE market has so far been characterized by sluggish resiliency. Appetite for deals remains steady but there has been a pullback from many traditional financiers and investors because of increased competition and worries about future exit quality.

Mezzanine Debt 101

In a capital financing structure, mezzanine is an intermediate-style solution between equity and collateralized debt. The concept comes from building design, where a mezzanine floor is like an indoor balcony that acts an intermediate floor between the floor and a high ceiling.

Mezzanine options usually fill out space where there is insufficient equity or when senior lenders are reluctant to step up. Suppose a private equity fund identifies a $150 million target company. It finds senior lenders who are willing to put up $100 million in collateralized loans at 7.5%, but the sponsor does not feel comfortable (or may not be capable of) footing the remaining $50 million. Say it can only fund $30 million in equity.

So sponsor identifies a mezzanine investor who agrees to contribute $20 million. To avoid conflicts with senior lenders, the mezzanine investment takes a subordinated position. This allows the sponsor to meet its capital requirements without losing any equity, but the tradeoff is mezzanine debt normally costs much more. Interest rates on mezzanine contributions often fall between 12 and 25%.

How Mezzanine Fits in the Capital Structure

Mezzanine debt serves to enhance the deal’s equity returns. Seth Tutlis, director at Harvest Capital Credit, notes that “equity returns are much more sensitive to the amount of leverage in a capital structure than the price of that leverage.” Mezzanine investors get to earn handsome returns for the right project — it is not unheard of for today’s mezzanine debt investors to earn 10 to 15% more than what U.S. Treasurys are paying.

The market for mezzanine debt has a reputation for constancy and stability. Tutlis says there has been a “relatively consistent supply of mezzanine capital for the past 10+ years in the middle market and lower middle market,” even though the “influx of capital to the BDC market over the past decade has changed the landscape” for subordinated debt.

One reason mezzanine doesn’t ebb and flow as much as high-yield bonds or public equity is its malleable nature. “Mezzanine financing really is one of the most flexible financing options available,” according to Sarita Gavhane, vice president at Canal Holdings, LLC. “It provides a means for owners to achieve a variety of objectives while gaining a valuable partner that has both operational and transactional expertise.”

She also notes that private equity sponsors can “use mezzanine financing as a means to round out the proposed capital structure and get a buyout deal under LOI or closed,” and that “mezzanine investing plays a crucial role in the capital structure” of smaller deals.

There is also the issue of high multiples. Near-record asset prices can make equity investors nervous, since nobody wants to jump in right before a sell0ff. Rather than committing extra equity, buyers can reach for mezzanine partners as a flexible solution. The interest paid on the debt can be used as a tax break, which helps blunt the higher costs.

Mezzanine in 2016

According to Preqin Private Debt, mezzanine debt fundraising as a percentage of total private debt declined from 29% in 2011 to just 12% in 2014. Direct lending rose from 9% to 47% over the same period.

Last year, mezzanine saw a slight resurgence as direct lending waned, especially in Q3 and Q4. The first half of 2016 continued the trend. A Pepperdine Private Capital Markets Report surveyed dealmakers and found “increases in demand for mezzanine capital, general underwriting standards, and flat leverage multiple.” Just as importantly, respondents also “expect further increase in demand for mezzanine capital.”

While activity should remain buoyant, there is a lot of dry powder out there and the higher multiples should squeeze margins on attractive deals. Easy money policies from the world’s central banks have helped push up valuations and corporations are sitting on a lot of cash ready to deploy, which means strategic buyers only add to an already competitive market.

Why Are Dealmakers Choosing Mezzanine?

Mezzanine debt does not dilute equity ownership, so buyers can enhance their return by partnering with mezzanine investors. Of course, enhanced return is always an attractive option, but there are reasons that LPs and funds have been more inclined to reach for the mezzanine option this year.

Global uncertainty is forcing PE actors to focus on commercial diligence. Brexit shook up (and should continue to shake up) attitudes about deal closures and new platforms in Europe. China faces growth problems for the first time in years. Dealmakers must also contend with the unusual 2016 election year and any subsequent fallout.

In the face of all of these challenges, multiples are historically high across the board. Higher entry prices and questionable exit prospects mean can leave dealmakers looking for less expensive alternatives to equity or more patient partners than senior lenders.

“We don’t believe business owners are reluctant to begin the capital process this year,” noted Jay Freund, a partner at Canal Holdings LLC. However, he notes that “senior lenders are the first to pull back given any market uncertainty. This often creates opportunities for mezzanine investors.” This is especially true in our regulatory environment. Tighter underwriting standards should decrease the supply of standard bank loans for margin deals.

Tutlis attributed the rise of mezzanine usage to two factors. “We’ve seen a handful of increasingly aggressive senior lenders put forth credit facilities that, when combined with a tranche of mezzanine capital, make for a compelling financing solution.” He also added that the BDC capital markets are experiencing a “back up” that “slowed down some of the use of unitranche capital.” (Unitranche capital is a hybrid senior/subordinated debt option provided by a single lender. It is common in the middle market and specifically in leveraged buyouts.)

As Preqin noted in its May 2016 Executive Summary, the negotiating power in private capital structures is moving to LPs. This has put added pressure on funds and GPs to pursue creative advantages in capital fundraising. Dealmakers may continue to rely on the flexibility that mezzanine debt can offer — along with concessions and benefits such as co-investment opportunities — to satisfy partners and generate enhanced returns.