Two weeks ago, many of us gathered in New York to attend the Symposium on Middle Market and Mezzanine Finance, an annual event where many of the leading providers of junior capital convene to discuss the state of the market.
Interestingly, the attendees were rather upbeat. Yes, participants were realistic and conceded that leverage levels had risen dramatically, particularly in the last two months and, for larger middle market transactions, are approaching 5.0x total debt to EBITDA. They also acknowledged that pricing had declined during this same period with mezzanine pricing, even on smaller deals, hovering around 14%, and unitranche pricing declining 100-150 bps.
But two themes offset the lament over pricing and terms. First, the almost universal opinion was that deal flow is about to pick up dramatically, providing a wealth of financing opportunities for everyone in attendance. Capital providers were scratching their heads still trying to determine why their phones had not been ringing so far this year. But investment bankers reported a huge uptick in deals in the preparation phase, which is bound to translate in to new financings. Some even ventured that the influx of deals could halt the deterioration in pricing as lenders are able to pick and chose the deals they want to pursue.
More interesting is the trend, particularly of many of the mezzanine funds, on refocusing their attention to non-sponsor deals. Providers often spoke of the better returns these types of deals offer compared to those backed by private equity sponsors. It was hard to gauge the spread differential but, anecdotally, it seems that non-sponsor financings translate in to 150-200 bp higher spread than lending to PEGs.
We’ve always thought it odd that so many capital providers have historically refused to lend to non-sponsors (which not only includes those groups that lack a fund, but also includes management teams, entrepreneurs and family-owned businesses). The prevailing theory has been that PEGs, although not contractually required to do so, often financially support their investments in times of distress, while non-sponsors often don’t have the resources to do so. In addition, lenders didn’t need to worry that an ineffective management team would become entrenched since PEGs are rarely reluctant to replace management when performance deteriorates.
We often argued that this bias against lending to non-sponsors was backwards. Despite the advantages that sponsors offer, not all private equity groups are created equally. A number of PEGs often view their investment returns on a fund basis and don’t hesitate to throw an investment overboard to save the IRR created by the overall portfolio. If you had a few good winners, just let the losers go. Many others may want to do the honorable thing and support the business, but ultimately feel their fiduciary duty to their LPs preclude them from investing more money. Compare that to an entrepreneur who spent his entire life building up a company, has a critical amount of his net worth tied up in his business, and would work tirelessly to save it.
We are thrilled to see the additional capital available for non-sponsor transactions, but caution these capital sources that the increased returns are not without increased risks. Non-sponsor investing usually requires more staffing to accommodate the hand holding these investments often require. Without a PEG, the junior capital provider is usually the sole institutional money in the deal and the burdens of advising, strategic planning, and overseeing execution falls to this group. And if additional capital is required, it usually falls to the junior capital provider to make the investment. So while the higher returns can be alluring, it requires an increased commitment of resources and expertise to make it happen.