BANGALORE (Reuters) – As the credit crunch makes it harder for companies to secure financing necessary for leveraged acquisitions, high-yield mezzanine debt is fast becoming the only viable alternative for buyout firms who need a constant source of funding.
Mezzanine debt, which comes with a fixed interest rate and warrants tied to a company’s equity, is rising in popularity among mid-sized business-development companies like American Capital Ltd (ACAS.O), Allied Capital (ALD.N) and Apollo Investments.
These unsecured instruments are not very susceptible to market ups and downs — a quality that has made them especially attractive in the wake of the crisis engulfing financial markets worldwide.
“(As) senior debt is less available, it (mezzanine debt) is practically the only option. It is a tremendous advantage to the market,” Mathew Howlett, an analyst with Fox-Pitt, said.
The popularity of mezzanine loans, which sit below bank loans and above equity on a company’s capital structure, began to rise as the high-yield bond market slowed down and blocked bank debt. Banks were stuck with billions in leveraged loans, making mezzanine more viable as a means of funding.
The first half of 2008 has seen a massive increase in mezzanine debt raised by U.S. buyout firms and corporations. The firms have raised a total of $24 billion in the first half of 2008, up from $2 billion in the first half of 2007, according to data from Dow Jones.
“The nice thing about mezzanine financing is that it earns a high amount of income… if you do experience any losses, the income itself could overwhelm those losses,” American Capital Chief Executive Malon Wilkus said.
The credit crunch has also wiped out second-lien debt, a form of debt more secured than mezzanine, helping lenders of mezzanine gain more ground.
And buyout firms seem to be taking notice.
One-third of American Capital’s overall portfolio is in mezzanine debt, while the instrument occupies half of Allied Capital’s portfolio.
“We are increasing the amount of mezzanine investment in our portfolio,” American Capital’s Wilkus said.
Fox-Pitt’s Howlett said American Capital will be able to trade at a premium to book, issue more stock and grow with the help of mezzanine debt.
RISK WITH REWARD
Reaping the benefits of mezzanine debt, which gets its name from the Italian word meaning “middle,” depends on the quality of the company invested in and the assets backing the investment. Some analysts do not rule out the possibility of defaults. “The question is whether you are being compensated for the risk,” John Stilmar, an analyst at Friedman Billings Ramsey, said.
Pablo Mazzini at Fitch Ratings said, “For sure there is interest for mezzanine in general, but there is also a question about asset quality, when it comes to comparing old transactions and new transactions.”
But despite the risks, buyout firms are surging ahead with portfolios featuring heavy mezzanine exposure.
Allied Capital sees mezzanine capital as an attractive asset class because of the returns it provides.
“We find mezzanine investments and buyouts interesting over the next couple of years. It provides for long-term capital needs of a company, especially in the middle market,” said John Fruehwirth, managing director of Allied Capital.
The company is routing its portfolio into senior and subordinated debt with a new $3.6 billion fund it has started with GE Commercial Finance, Fruehwirth said.
“We will continue to harvest our assets and reinvest in mezzanine,” he said.
Mazzini, who is senior director of leveraged finance at Fitch Ratings, said, “The burden on a company’s cash flow is lower, if it uses mezzanine in a buyout.”
(Reporting by Adheesha Sarkar; Editing by Pratish Narayanan)