Friday letter: A rough sub

Low rates have created a difficult environment for providers of mezzanine debt.

Earlier this week, the Federal Reserve once again reduced its monthly purchase of mortgage-backed and Treasury securities by $10 billion, bringing it down to $35 billion. As has been the case with previous reductions, the Fed’s statement emphasised how important the gradual tapering of quantitative easing has been to maintaining a low interest rate environment. 

In regards to interest rates, the policy colloquially referred to as “the taper” has been successful. Market rates remain well below historical norms, and the taper has allowed the Fed maintain downward pressure while the economy makes its slow trudge towards normalcy. Normalcy, of course, will almost certainly come with rising borrowing costs, which the Fed has kept at historic lows for much of the financial crisis and the subsequent recovery. 

Of course, still no one knows when that will happen. The Fed has yet to provide any clear indication as to when it will raise rates, having linked future policy decisions to the health of the US economy. And while some indicators of economic health — such as the US unemployment rate – have improved, others – such as the rate of inflation – fall short of what the Fed considers healthy. 

It is sound policy, and it’s helped fuel the refinancing boom that drove private debt activity through much of 2012 and 2013. Unfortunately, it’s also fostered a fraught situation for lenders of subordinated debt. 

“Favourable credit markets have spurred more debt financing recently, much of it in the form of senior debt,” according to a Pitchbook report released earlier this week. “A smaller percentage of debt is going toward non-senior debt like mezzanine or high-yield bonds. As the credit spigots have opened up, senior debt, which is cheaper and more abundant, has proved more alluring to PE sponsors.”

Indeed. The average subordinated debt levels for private equity deals peaked at roughly 35 percent during the first quarter of 2012. That average has since fallen to around 10 percent through the first quarter of 2014, which marked the third straight quarterly decline for that form of financing.

Which brings us back to the interest rate issue: as soon as rates go up, the demand for subordinated debt will start a recovery also. 

That increase is bound to be gradual, however. The Fed’s median estimate on where interest rates will fall by the end of 2015 was only in the 1 percent to 1.25 percent range, and only a small number of the Fed Open Market Committee members indicated a belief that rates will rise above 2 percent over the next 18 month, which would still be well below historical averages. 

Many higher risk borrowers will continue to tap mezzanine lenders for financing, but until rates return to normal levels, expect private equity firms and sponsors to rely on senior debt to underpin their deals.