Assumptions that the mezzanine market would enjoy a renaissance as one of the few financing options still available, have yet to materialize.
January 26, 2009
Last year, more than $25 billion was raised by roughly 30 mezzanine providers, according to data from Thomson Reuters. While other lending sources have effectively dried up amid the credit crisis, one would think the mezzanine market would be enjoying a renaissance as one of the few financing options still available. Such a scenario, however, has yet to materialize.
"Very few private equity firms will do a mezz and equity deal; they want senior lending," says Andy Steuerman, a senior managing director with Golub Capital. "If you can't get the senior lenders interested, then you have no transaction. That is the situation today."
Another factor is, quite simply, that the deal market has effectively stalled. Economic uncertainty, on top of the credit woes, has both buyers and sellers retreating to the sidelines until more clarity emerges. For the most part, the only deals being pursued are the transactions that are absolutely necessary for a company's survival. "We are telling our clients to hang on, now is not the time to sell," says one banker, speaking anonymously. That in turn keeps the private equity market stagnant, which effectively idles the mezzanine providers, even if they're armed with billions dollars worth of dry powder.
Last year, for instance, mezzanine shops were pricing deals with IRRs of between 15% and 18%, including a pay-in-kind component; rates that were already considered high. Today, mezzanine tranches are being priced between 16% and 20%, according to Ronald Kahn, a managing director at Lincoln International. He adds that mezzanine co-investments are now almost always being replaced with warrants and most deals also requiring higher pre-payment penalties, often starting out with two-year no-call provisions.
Accordingly, sponsors are over-equitizing their deals. "Private equity firms are willing to put more equity in transactions," Steuerman says, noting that the "return profiles [between equity and mezzanine] are converging." He adds, "There is also the benefit of [reducing risk] with less debt."
To some lenders, the current environment bears resemblance to other periods in the market. "This is the same thing we experienced in 1999 through 2001, when firms wanted to patch a deal together to avoid the cost of mezz," says Michael Hermsen, a managing director with Babson Capital Management.
Hermsen, however, does not convey any worry about the future of the mezz. "Everyone came back to mezz then and the same thing will occur again."
Like Steuerman, Hermsen alludes to the role the rest of the market will play. "The senior lenders aren't being very aggressive at all; we will be here to fill the gap," he says, adding "the purchase price multiples are becoming more attractive and pricing is getting better."
Babson is among those prepared for the market rebound, having closed its Tower Square Capital Partners III fund in December with $1.58 billion of capital under commitment.
Mezz is undoubtedly a necessary part of the deal structure. In fact, it is so important that many equity sponsors have raised their own mezzanine funds. Endeavour Capital, a lower middle market firm, is trying to raise between $200 million and $300 million for Endeavour Structured Equity and Mezzanine Fund I LP, which would finance deals sponsored by Endeavour Capital and other firms. KRG Capital Partners, meanwhile, is in the market with a $200 million mezz fund, which would be used to finance its own deals. Other firms such as The Audax Group, Summit Partners and TA Associates have always raised mezz funds, although some, such as Audax, won't invest alongside their equity vehicles.
While the mezz market remains stagnant going into 2009, it has shown signs of life at times during the credit crisis. In the early part of last year, for instance, when the second lien market crumbled and BDCs began showing weakness, the mezz market held strong. During the first two quarters of 2008, for instance, the percentage of mezzanine financing going into deals grew substantially over 2007, roughly doubling its average allocation within the capital structure.
"Prior to the chaos that started in September 2008, the mezz market was getting stronger, and it was starting to shine. We were busy," says Michael Klofas, a managing director with Babson Capital Management. "But since October, we are not seeing a lot of deal activity in general and mezz deals, in particular, have been few and far between."
Indeed, prior to September 2008, Tower Square III had already completed 13 transactions and deployed 11% of its capital under management. Since then the fund has only completed one transaction with three in the pipeline.
The bottom line is that senior lenders need to start lending again before mezz players can make any kind of headway.
"Regular people can't even get mortgages; how is a leverage buyout supposed to be completed?" asks one lender. "We need the entire lending market to start running well again, but who knows exactly when that will happen."
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