Despite the overall popularity, mezzanine financing has been experiencing some trouble recently. The strategy that thrived in the hot buyout market has struggled to maintain its relevance in today’s cooler conditions. “Overall, traditional mezzanine is in a tough spot right now,” explained Joe Burkhart of Saratoga Investment Corp.
Mezz has largely been forced into a corner by PE firms chasing returns and unitranche lenders rising in prominence. To counter the squeeze, many mezz firms have already dropped warrants from their agreements or lowered their return goals — but with little success.
The two primary challenges facing mezzanine right now are the rise in unitranche lending and the focus on returns.
The Rise of Unitranche Lending
One of the biggest threats to mezzanine right now is unitranche lending, the strategy of combining senior and subordinated debt into one package with a blended interest rate. As Burkhart explained, “The success of unitranche lending…has continued and has now moved into the lower middle market.” While it can be a little more expensive than traditional mezz, this more complete package has become more appealing for both lenders and borrowers alike.
The rise of unitranche lending has been particularly important in the lower middle market. “Unitranche is generally more useful for smaller deals, because the strategy is not suitable for broadly syndicated loans,” explained Steven Bills in a recent Buyouts article.
Bills noted, “the emergence of unitranche financing has put additional pressure on mezzanine…Unlike conventional senior-subordinated capital arrangements, lenders can present unitranche deals to borrowers at a single, blended interest rate…while eliminating the inter-creditor agreements that can cause difficulties in bringing a deal to close.”
The lackluster M&A activity in recent years has impacted the decisions of many business owners and investors, especially with regards to valuations. The desire to make up returns — amidst a relatively cold market — has caused many equity investors to blur the traditional debt-equity line.
As Burkhart explained, many mezzanine lenders are getting squeezed as PE shops begin moving into the smaller markets. “The pressure PE sponsors have to deploy their capital in a low volume market,” is causing them to “write larger equity checks which closes the gap between the senior debt and the equity — where traditional mezzanine usually exists.”
Bills also noted the impact of the returns picture. “In the past, subordinated debt promised investor returns in the mid-to upper teens, while returns from private equity sponsors approached 30 percent. Today, top-quartile equity returns are more like 20 percent, so that the kinds of returns once delivered by mezzanine are now going to the equity part of the capital stack.”
Learning to Survive
As traditional mezz shops get squeezed by this unintentional pincer attack, they will need to adapt. Burkhart believes that one of the best solutions would be for these mezz shops to move away from pure lending, a strategy which he is already seeing. “Many traditional mezz shops are evolving into more growth-oriented investors,” he explained. “They are structuring their investments as debt with a significant equity component and the use of proceeds will be for growth purposes. This investment style requires different skill sets, has more risk, but has better upside for the investor.”
John Thornton of Tregaron Capital agreed. “If you want to do mezz in the lower middle market, you have to be willing to get skin in the game,” he said. “Even though it is structured as debt, the risk is much more like equity. Because they are tiny companies, the risk return is such that you need to do work. There are generally better returns, but more risk because they are smaller, more fragile companies.”
Thornton is versed in this strategy because Tregaron has jointly issued mezz and equity in several of its own deals. He explained, “For control deals, we typically provide both the equity and the mezz debt. Since these are typically small companies and small deals, there are not many third party mezz players out there that would be interested, so providing all the required junior capital is the only way to get deals done.”
Still, it’s important to note that mezzanine isn’t going away. Ronald Kahn of Lincoln International explained those best suited for mezz loans are, “The highest quality deals backed by well-capitalized, well-known sponsors. Because these are the most sought after financings, senior lenders are eager to lend to these credits, making it easier to club up the number of lenders needed to complete the financing, while the increased competition among lenders tends to result in more favorable terms for a borrower.”