A lifeline for business owners in difficult times

Increasingly, hybrid debt and equity options and subordinated debt are being used by corporates that want to expand their business but for which neither senior debt nor private equity can offer a solution.

Since the covid pandemic hit in early 2020, corporates have been finding it increasingly difficult to access debt to fund growth. There was already a tendency for banks to scale back their lending, particularly in the lower mid-market. Fresh disruption compounded that issue in the form of the pandemic and ensuing macro-economic issues such as recession, surging inflation and rapidly rising interest rates causing banks to once again become more cautious about which businesses they were willing to finance.

With so much difficulty in accessing traditional forms of finance, corporates are looking for solutions that can work for their business and products which can combine the best features of equity investment and debt. The likes of preferred equity and mezzanine are starting to look attractive for both borrowers and institutional investors.

“As pure senior lenders are becoming more conservative on their leverage ratios it creates more space for people like us”

Pablo Vélez
Three Hills Capital Partners

France-based alternatives manager Andera Partners offers just such a hybrid solution to borrowers in the lower mid-market through its Andera Acto series of funds, providing mezzanine financing and minority equity investments to assist management teams with their finance needs.

Stéphane Bergez, partner and head of Andera Acto, says: “Because valuations today are lower due to the economic environment, businesses are looking for more non-dilutive capital so they can finance the business without losing too many shares at too low a price.”

Value declines

Business valuations have dropped substantially since the pre-covid era. This may lead many business owners to feel they are getting a bad deal when they bring in an equity investor, such as a private equity fund, to support their business’s growth.

“We see this happen every so often,” says Pablo Vélez, partner at preferred equity specialist Three Hills Capital Partners. “When there’s a lot of volatility in the equity market, the bid-ask spread will widen and that will impact M&A volumes because sellers and buyers can’t agree on the price.”

“While we might also disagree with the seller on the price, the equity kicker on our deals is often in the form of a warrant and it’s small so we are less concerned with the difference than a pure equity player would be.”

Instead, hybrid debt and equity providers can take an approach more akin to providing a senior loan where the exact value of the business shouldn’t matter provided the overall leverage level is acceptable and the business is generating enough cashflow to service its debt. They can also offer additional flexibility to borrower businesses, such as the ability to buy off the equity kicker over time. It is this type of flexibility in a market environment which has become highly volatile that is driving many firms to seek out new solutions to their financing needs.

When compared with direct lending, flexibility is again a key feature of hybrid and subordinated offerings that is not always present in conventional unitranche or senior loan structures. While private debt funds have prided themselves on being more open to finding solutions for businesses than banks, many still require a financial sponsor as part of a deal, which may not be attractive to business owners looking to preserve their equity stakes. Equity kickers and warrants can also create greater alignment between entrepreneurs and lenders, according to Vélez.

Something different

For LPs, these strategies can offer differentiation within their fixed income and alternatives portfolios but have other advantages over more traditional direct lending strategies. According to fundraising research from Private Debt Investor, the overall proportion of capital raised for mezzanine, subordinated and preferred equity strategies made up a third of all capital raised in 2022, well up from just 29 percent in 2021 – though coming at a time when overall fundraising in private credit has fallen.

Fundraising for these strategies reached a high of 37 percent of total capital in 2020, when fund managers were hit by the effects of the covid crisis, which hampered attempts to raise capital. It is notable that these strategies are able to maintain consistent fundraising through difficult market environments, indicating LPs are not put off by taking on riskier investments during market turmoil.

“Unitranche debt used to offer around a 6 percent return but with rising interest rates they now need to offer more like 8 percent to 10 percent,” says Bergez. “However, direct lending is really competitive right now so it’s much harder for them to increase their pricing despite this more challenging market.”

With government debt now yielding almost 3 percent in some cases with no risk, the spread between direct lending and safe forms of fixed income may be getting compressed, according to Bergez, meaning LPs are looking at other options to achieve the enhanced yields they became accustomed to in the years preceding the covid crisis.

By comparison, Andera’s Acto Mezzanine strategy has been able to increase its pricing.

“We’ve been steadily increasing our pricing for the past eight months,” says Bergez. “We’re up two to three percentage points over a year ago and get warrants on every bond for an additional return.

“We are bringing yield to LPs of above 15 percent with a real risk based on defaults in the portfolio which is very similar to unitranche.”

He adds that while mezzanine loans are above senior debt in the capital structure, by focusing on firms with good cashflow and keeping leverage multiples lower, junior lenders are able to remain defensive and ensure they have good downside protection.

Another benefit for LPs in the current environment is improved terms on loans, according to Vélez.

“It’s easier to deploy debt products in this type of environment. Demand for finance is as high as it has ever been but credit is being rationed, which means we can get tighter terms. As pure senior lenders are becoming more conservative on their leverage ratios it creates more space for people like us and reduces the amount of competition.”

Lastly, as LPs become more sophisticated in their approach to private credit, looking further afield beyond the most popular direct lending strategies could offer institutional investors the edge they need to generate superior returns in a volatile market. As we have seen in the years since covid, demand for private credit among investors is as strong as ever, with a record fundraising year during 2021.

While the story of the past decade has focused on senior direct lending, the market for subordinated and hybrid debt strategies remains highly active and can offer something different to both borrowers and institutional investors in more challenging times.