Mezzanine: Stuck in the middle with unitranche

Fund managers in the mezzanine space are experiencing some sharply contrasting fortunes.

If you think the EU referendum debate in the UK is dividing opinion, then talk to private debt professionals about mezzanine and you’ll discover just how stark competing visions can be.

To some eyes, mezzanine is enjoying a golden age; to others, it has rarely been under more pressure to justify its existence. So what’s the truth? In reality, as with the referendum, there are different versions of it.

A good place to start is with the hard facts, courtesy of PDI Research & Analytics. Here, we discover that mezzanine fundraising is in fine fettle, with almost $30 billion raised last year by 57 funds. This represented the largest number of funds closed annually since 2008 and the third-highest total sum since then (beaten only by 2008 itself and 2013).

It also appears that the momentum is being maintained. PDI Research & Analytics reports that there are currently 11 global and 29 Americas funds in the market seeking a total of $45 billion. Earlier this week, we reported that Highbridge Principal Strategies had raised more than $3.6 billion for its Mezzanine Partners III fund, which launched last year with a $5.5 billion target.

Highbridge is one of an elite group of large mezzanine players along with the likes of Goldman Sachs, GSO Capital Partners and Crescent Capital Group. Goldman collected an $8 billion haul for its GS Mezzanine Partners VI fund at the beginning of last year, while GSO is seeking $6 billion for its third GSO Capital Opportunities fund.

At this large end of the market, few other alternative lenders can compete. With long track records, established relationships and the size and depth of resource required, the barriers to entry are high. Market observers note that these firms are currently finding a lot to feast on, especially in the form of re-financings of large leveraged buyouts.

Meanwhile, operators in the lower mid-market tell us that demand for junior capital is outstripping supply for companies with EBITDA in an approximate range of $25 million to $40 million.

Also prospering in the mezzanine space are insurance companies, which have identified high returns and low historical loss rates at lower volatility than equities as very much to their liking. Hence, strong mezzanine activity can be seen within in-house private debt groups at the likes of Northwestern Mutual and Prudential.

But (given where we started out, there had to be a ‘but’), PDI has had plenty of conversations with mezzanine managers complaining of low transaction pipelines as a result of too few deals to go around. The common denominator appears to be that these firms are stuck in the ‘squeezed middle’, unable to access the fertile ground being tilled at the larger and smaller ends.

In the middle ground, mezzanine firms are facing strong and growing competition from ‘last-out’ unitranche and second-lien loans. Consequently there is talk of the ‘zombie effect’ (whereby funds, deprived the lifeblood of new deal flow, peter out over time, unable to invest their funds).

There is also the risk that these funds may end up needing to charge fees on committed capital in order to keep the lights on. This is a difficult step to take in a market where fees only on invested capital has become the norm. “It’s also hard for them to dig out of the J-curve,” once source remarked.

In the June 2016 issue of PDI, you will find an in-depth exploration of the mezzanine market and its many nuances – including, as you would expect, a wide range of opinions.