If leveraged buyout activity continues to pick up, there are plenty of mezzanine lenders ready to provide the last few dollars of financing.
In fact, the universe of investors in securities that rank below loans and bonds in a borrower’s capital structure has become quite crowded, with a number of new funds raised, some of them looking to lend with a very specialized focus.
Some bankers and other players remain skeptical that the mezzanine financing will make a comeback any time soon, however.
On March 18, Highbridge Capital Management, an alternative investment platform which is a subsidiary of JPMorgan Asset Management, announced its Highbridge Principal Strategies subsidiary raised a $5 billion fund, Highbridge Mezzanine Partners Fund II, for mezzanine investment. It expects to put half of its fund to work financing leveraged buyouts and the other half lending directly to small and mid-sized companies.
Last fall, private capital data tracker Preqin said it was tracking 69 funds that were looking to raise a combined $25 billion in funds for mezzanine investment. The funds on the market had an average target size of $405 million.
Yet mezzanine financing has declined considerably since the buyout boom years. Global companies raised more than $8 billion via 66 mezzanine deals in 2006 but closed on just $259 million last year via three deals, according to Dealogic.
“Right now there are more funds looking to invest in mezzanine deals than there are high quality mezzanine opportunities in which to invest,” said George Ball, chairman and CEO of Edelman Financial, an asset manager with a focus on private wealth management.
Kristen Campana, a partner with the law firm of Bracewell & Giuliani, represents both lenders and borrowing companies in various deals and often handles transactions that involve mezzanine financing. She said that the mezzanine space is now very active with new entrants to the market. These new entrants are often break-away funds launched by former hedge fund executives or are specialized subsidiary funds launched by hedge funds themselves.
For example, there are new mezzanine funds just targeting the oil and gas industry or funds focused only on distressed mezzanine real estate, Campana said.
“There’s a quite a degree of specialization now,” Ball said. “The larger institutional investors and hedge funds are increasingly prone to fund the more specialized mezzanine deals, with nontraditional lenders believing that they can have expertise in one or two sectors. It’s much more difficult to be truly a stand-out across the board.”
This means that smaller companies have many more sources of funding, but it also means that some of these sources have different approaches from traditional banks.
“Where traditionally companies would have had a hard time getting full financing underwritten by entire banks, they now have other options but have players that don’t work way a bank does,” Campana said. “They can be a little more nimble than a bank. It doesn’t take a week or two to get an answer on a mezzanine or bridge facility. But they have a different process.”
The promise of larger returns is attracting investors. “There’s a great deal of money in hedge funds now looking for some sort of asymmetrical return and direct mezzanine deals offer that opportunity,” said Ball. He said that the mid-to-high teen return on debt not directly correlated to the stock market makes a strong case for investor involvement.
A study of the European mezzanine debt market published by private equity firm Partners Group this month found that investments from vintage years 1989, 1991, 1996 and 2009 all had internal rates of return above 20%, with 2009’s rate of return at 43.5%.
The study, which looked at returns since 1989, found that even the weak vintage years had rates of return well above 10%. Mezzanine investments had a median return of 18.7%. The study examined 439 mezzanine investors between 1989 and 2009.
Ball said that smaller mezzanine investment groups have evolved out of banks for the past several years. “A number of people who were with banks left in the 2009 to 2011 period,” he said. “The traditional banks were unwilling to do mezzanine deals,” he said. “It’s said that they were being discouraged by their regulators from doing them and seeking activity rather than inactivity many of these mezzanine specialists joined hedge funds so they’re there.”
But the deal flow the investors hope for has yet to materialize. “The fundamental issue is a lack of deals. You can’t finance what doesn’t exist,” said Hank D’Alessandro, head of Morgan Stanley Credit Partners, the mezzanine debt unit of Morgan Stanley.
Other market participants warn that mezzanine is going to be outdone by other forms of capital. Stephan Jaeger, head of Americas high yield capital markets for Bank of America Merrill Lynch, and John Cokinos, head of leveraged finance capital markets and syndicate for BofA, said in a press briefing on March 20 that they expect second-lien debt and high yield will out-price mezzanine because the former are more cost effective.
Despite the yield-hungry nature of today’s investors, mezzanine remains largely abandoned because borrowers know they can get financing through less expensive second-lien financing or high yield bonds, Jaeger and Cokinos said. Mezzanine by nature is very risky, by virtue of its subordinated position in a company’s capital structure.
Campana noted that the mezzanine deals she’s seen lately have been a bit different. Mezzanine borrowers today are more likely to treat the mezzanine debt more like a bridge loan and not hold onto it for a long period of time, even refinance it with bonds. Many of these mezzanine deals have also been put together at the same time as the borrower’s first- and second-lien debt, which was not typical in the past.
“It’s still a pricey piece of paper,” she said.
But D’Alessandro said that the mezzanine market will only experience a revival if there is a significant uptick in M&A or LBO or M&A activity across the board. ”If deal volumes normalize, then mezzanine activity will pick up accordingly. There’s a lot of private equity money sitting on the sidelines,” he said.
”Even in this more low-volume world, we still aren’t having problems putting money to work. A normalized deal environment would provide more opportunities, not that there’s not sufficient opportunity today.”