Over the years, the demise of mezzanine has been predicted countless times. Robust cash flow senior debt markets, prolific BDCs, and private equity groups funding mezzanine themselves have all caused the pundits to suggest that the end of mezzanine is near.
And when the Atlantic Conferences Symposium for Middle Market Finance, the mezzanine industry’s nineteenth annual shindig convenes in New York in a few weeks, the same proclamations will undoubtedly be heard. (I’m chairman emeritus of the event.)
Certainly, most would agree that banks, the great provider of senior cash flow debt and the best friend to the mezzanine market, are no longer the force they were before 2009. With senior cash flow debt available to only the best companies and premier sponsors, BDCs, hedge funds and credit opportunity funds are providing increasing amounts of capital to middle market financings. In fact, Standard & Poor’s Leveraged Commentary and Data unit recently suggested that relative-value investors remained the largest funding source at the lower-rated end of the market with an approximately 50% market share. These capital sources have learned that, by combining the senior and junior tranches of the capital in to a single, unitranche loan they can effectively compete against the last remaining senior cash flow lenders, as well as the numerous mezzanine funds, by providing a one-stop solution to PEGs.
So is this the time all the mezzanine naysayers finally become right?
Let’s break the argument down by deal size. First, mezzanine rarely caters to companies with EBITDA greater than $50.0 million. These borrowers often have less expensive options available to them in the high yield or term loan B markets. So, other than a couple of funds dedicated to deals this size, the vast majority of mezzanine funds rarely focus on this market .
At the other end of the spectrum, you could argue that this may be the best time to be a mezzanine lender if you are focused on deals for borrowers with less than $10.0 million in EBITDA. Since the credit crisis in 2008, we have seen lenders of all varieties focusing on companies that consistently exhibit EBITDA of at least $10.0 million, and often $15.0 million. This has left a dearth of senor cash flow funding for borrowers with less than $10.0 million. As a result, sub-$10.0 million EBITDA companies usually are forced to rely on ABL debt facilities. which rarely cover a company’s total financing needs. In these cases mezzanine is the savior and has little, if any, competition from other funding sources. The proliferation of SBIC mezzanine funds has helped provide this needed capital, and despite the emergence of a few new senior cash flow lenders that cater to this part of the middle market, heavy reliance on mezzanine debt by these types of borrowers should continue for some time.
And that leads to the bulk of the middle market – those companies with EBITDA between $10.0 and $50.0 million that, up until a few years ago, were often the main stomping ground for mezzanine. With few alternative junior debt capital providers servicing this part of the market before 2009, mezzanine lenders faced little competition. However, times have changed, and this market is now the playground for just about every BDC, hedge fund and credit opportunity fund today.
But peeling back the onion, we find that these alternative funding sources tend to focus on mainstream deals, which leaves mezzanine with opportunities to fund both outstanding credits and the difficult credits in this segment of the market. Senior cash flow debt, when available, is usually reserved for the best credits with the better sponsors. However, senior debt often does not cover a company’s full financing needs so, for these optimal credits, a slug of mezzanine is the perfect option to fill the gap left by senior lenders. Pricing for subordinated debt to these types of credits has continued to decrease over the years but with no liens and favorable intercreditor terms, both senior lenders and sponsors love having this tranche below them. Conversely, certain mezzanine funds have created a niche lending to storied credits, where the fund’s in-depth analysis can help it discover a hidden gem while garnering premium pricing including an equity upside.
Lastly, almost every lender today focuses on private equity and tends to shy away from unfunded sponsors, management teams and family businesses. Again, certain mezzanine shops have taken advantage of this and have created great practices catering to these non-PEG deals by not only providing capital, but managerial expertise that these companies may not have thought available.
So just as everything in the world either evolves or becomes extinct, successful mezzanine shops have learned to refocus their strategy on those areas where their capital is needed. It may not be the mainstream deals of old, but it is keeping the light bulbs burning.
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