We’ve seen it before. In fact, every time the financing pendulum swings in one direction or another, the talk starts – “Is mezzanine a dinosaur?”
It happened when CLOs emerged and cash flow senior debt providers dipped lower in the capital structure, minimizing the need for mezzanine debt. It happened again when second lien debt entered the middle market and became a competing product. It happened (and continues to happen) when BDCs became a new source of financing and it’s happening once again as unitranche loans gain in popularity and crowd out mezzanine debt.
In fact, mezzanine’s demise has been predicted so many times, I hate to bring it up. Yet this time seems a little different because more and more mezzanine funds realize they need to morph into one of two models.
We’ll call the first model the “Sponsor Shop.” Acknowledging that rates of return for subordinated debt have shrunk to the very low teens, with no warrants or other potential for any upside, these mezzanine funds have decided to raise larger amounts of money, often in excess of $500 million, and cater to financial sponsors. They hire professionals whose sole job is to call private equity groups in hopes of providing subordinated debt for their next acquisition, refinancing or dividend recap. In essence, they are willing to sacrifice yield for volume and hope that the management fee on this larger capital base, together with a modest carried interest, continues to compensate them for their efforts.
The other model, which we’ll call the “Traditional Shop,” is raising far less capital, often $50 million to $75 million which, by participating in the SBIC leverage program, gives them $150 million to 200 million of total capital to invest. The Traditional Shops have far fewer professionals than their Sponsor Shop brethren and usually source deals through banks, accountants, attorneys and friends. Their goal is to find those smaller deals, often involving companies with EBITDA less than $10 million, where they can get not only better pricing for their subordinated debt, but also can get a warrant or equity co-invest which will enable them to realize returns of no less than 16 percent. In essence, these groups are trading volume for price, although the riskier nature of these smaller transactions justifies the higher required returns. As a result, while the management fees for these funds are modest, the opportunity to benefit from the carried interest is big.
Interestingly, both shops face challenges in raising capital. The Sponsor Shop wrestles with raising a massive $500 million, no easy feat for anyone. And limited partners often lament the modest net returns and opt for the higher returns private equity offers. The Traditional Shop, on the other hand, faces limited partners who often disdain leverage, the SBIC regulations, and the inherent risks that come with smaller deals.
As a result, some current mezzanine providers, concerned about the burdens of continual fund raising and the limitations of just providing a subordinated debt product, are electing to become BDCs. The lower yields BDC investors are happy to accept and access to modest amounts of leverage allow these funds the ability to offer a gamut of debt products including second lien and unitranche structures.
None of these models are without problems and there continue to be a few mezzanine funds that try to thread the needle and cater to both types of borrowing groups. Although mezzanine funds are faced with more competition than ever, it is a testament to the resiliency of many mezzanine players that they are able to read the tea leaves and continually morph into what the market wants.
Ronald Kahn is a managing director with Lincoln International. The opinions expressed here are entirely his own.