I recently spoke a mid-market lending source about what (if anything) is going on in the debt world. I walked away with a few themes worth sharing.
1. Sponsors are raising captive mezzanine funds to finance their own deals. It’s a phenomenon I touched on a few months ago when peHUB reported Insight Equity is raising a mezzanine fund alongside its new buyout fund. The firm is requiring a 1:1 commitment to the equity and the mezzanine fund for new LPs. Then, I read that KRG Capital is raising a captive mezz fund as well. And of course ABRY, Summit Partners and TA Associates have been doing it for some time now. There are several arguments regarding this move. For one, with mezzanine so expensive (we’re talking anywhere from 16% to as high as 20%), sponsors are thinking, why give away the upside to someone else? Furthermore, mezzanine is only slightly less risky than equity, so why rely on others to get deals done if we can have no-contingency financing at our fingertips? But as one sponsor told me, “I’ve never in my life had trouble finding mezzanine debt, so why would I want to attempt to arrange it myself for the very first time?” Not to mention, this is essentially doubling your exposure to a deal. All valid points.
2. The ceiling deal value is around $150 million. Most lenders aren’t willing to hold more than $25 million to $35 million on deals right now (excluding exceptionally strong corporate credits). That figure is even lower for the middle market, with lenders tapping out at around $10 million to $25 million. Requirements to underwrite a large check include very wide flex terms and enough wiggle room to back out. The result is firms resorting all-equity or all-mezzanine deals, meaning they’ll be antsy for a recap in a year from now. That does not bode well for predictions that it’ll take until at least 2010 before lenders are fully confident. However, not many expect deals larger than $100 million to get signed in the near term.
3. The few senior lenders that do have money to lend are looking at the secondary debt market with greater interest. The debt on old large cap deals is trading at such a discount that lenders are wondering, “Why bother with new issuances?” For secondary debt, “It’s a buyers market with a capital B,” my source said. Deals like Clear Channel and Wrigley are in the mix. Not to mention, there’s also the “eBay” market of bonds held by hedge funds, Lehman Brothers, etc. Even though my source’s firm doesn’t play in the secondary market, it receives calls from sellers of deeply discounted secondary debt all the time. On new issuances, he said, “I’m lucky to get a return phone call.”
4. Lenders aren’t agreeing to add-on deals without refinancing a company’s original capital structure. Deals struck in 2006 and early 2007 had debt priced at around Libor + 300. Now that market is around Libor + 650. This gap is turning negotiations for pricing on bolt-on deals into a game of chicken between lenders and sponsors. No sponsor wants to renegotiate for higher priced debt. No lender wants to let a chance to refi at market prices slip through the cracks. Sponsors eventually come back to the table, realizing they don’t have many options to make add-ons happen. “We’re seeing them settle somewhere in the middle, around L+500,” the source said.
5. Asset-backed lending (ABL) isn’t as hot as everyone expected it to be. The risk profile is lower, yes. But ABL requires a lot of capital, so it’s a “very scarce commodity.” Since banks are trying to find ways to do less with more, ABL isn’t a high priority, especially with the demand for DIP financing increasing.