Post financial crisis, KKR Credit has been finding attractive relative value in private lending. In our opinion, the opportunity set for private lending is being driven by a secular change across the banking industry.
Regulation continues to be imposed on financial institutions, forcing banks to change the business they pursue. We believe the private lending market will continue to be the direct beneficiary of this secular shift away from the traditional banking market. Specifically, we have seen an increase in the number of mid-market and large corporates seeking capital structure solutions outside of typical bank and capital markets channels.
We believe that mezzanine lending will play an increasingly important role in financings over the next three to five years. From a fundraising perspective, $88.7 billion was raised for direct lending between 2013 and 2015 versus $45.5 billion for mezzanine.1 While the direct lending market has grown substantially, the size of the mezzanine market has stayed relatively stable. In this article, we will address what we believe to be an opportunity for clients to earn attractive rates of return in the mezzanine asset class.
DEFINING MEZZANINE DEBT
Mezzanine debt is located in the middle of a company's capital structure, senior to common or preferred equity, but subordinate to senior secured bank debt. Mezzanine debt typically takes the form of senior unsecured notes, subordinated notes or second lien debt and may include a form of equity participation.
The use of proceeds for mezzanine debt is typically to finance leveraged buyouts, or to refinance existing capital structures.
As financial regulation and bank deleveraging continue to reshape the capital markets and the lending landscape, we believe that the collective ability of traditional providers of debt capital to companies will continue to be reduced.
Prior to the financial crisis, the primary providers of debt capital included national and regional banks, hedge funds, specialty finance companies and investment banks (often through proprietary trading desks).
In the years following the financial crisis, banks have focused on rebuilding their capital ratios and have not prioritised the allocation of resources and capital to make new loans. Additionally, the implementation of Basel III in Europe has resulted in even higher capital ratio requirements for large European banks, creating further balance sheet 'de-risking' within the sector.
As a result, there has been a significant reduction in the size of bank balance sheets and we have seen banks migrate the focus of their lending businesses to broadly syndicated debt financings of large corporate issuers whose risk can be more easily distributed to the market. Proprietary trading activity has also diminished, with banks reducing the amount of capital available for direct investments.
In the wake of the financial crisis, we have yet to see non-bank providers of financing that are capable of adequately meeting current supply and demand needs emerge. Hedge funds have remained active in this space, but, in our view, have played a less meaningful role in the more illiquid segment of the market due to their lack of origination capabilities and redemption requirements.
Similarly, we have observed certain specialty finance companies either contract their lending activity or exit lending altogether.
Partially offsetting this trend has been an increase in the number of private credit funds raised by alternative asset managers as well as the rise of business development companies (BDC). Notably, the assets under management by BDCs increased significantly since the financial crisis, growing from approximately $30.0 billion in 2008 to $80.0 billion in 2015.2
However, the growth of BDCs has appeared to level off in the wake of increased market volatility, further setting the stage for alternative asset managers to fill the void for lending.
In addition to the lending environment described above, we believe there are attractive opportunities to directly finance many types of hard assets or to invest in origination and/or servicing platforms of hard or financial assets. This is a segment of the market where banks have significantly retrenched and where alternative asset managers, like KKR Credit, are well placed to step in.
In addition to these global themes, we have observed regional specific trends driving increased private credit deal flow.
US: In recent years, the traditional mezzanine opportunity set has been more limited than historical periods due, in part, to the weak M&A environment, competition from the 144A market and the growth of BDCs.
However, the lending landscape continues to become more difficult as more changes are implemented in an already-stressed banking system. For example, the implementation of the Leveraged Lending Guidelines in the US has further limited the ability of banks to issue debt in the syndicated markets. These guidelines govern loans where proceeds are used for buyouts, acquisitions or capital distributions and limit the total amount of leverage that can be used in a given transaction.
Going forward, we believe the continued implementation of these guidelines will lead to a greater need for alternative sources of capital to fill the void for lending.
Europe: Europe has an ongoing debt crisis and the structural changes to European Union economies have continued to create attractive investment opportunities. On the issuer level, changes in the lending landscape have made it challenging for over-levered companies to find appropriate financing.
We believe these companies are seeking capital structure solutions outside of regular bank and capital markets channels. We expect this retraction of traditional sources of capital to be conducive to our efforts at originating private lending solutions at attractive terms.
Asia Pacific: In our opinion, opportunities in Asia Pacific remain interesting given it is a less competitive market for flexible private credit capital. Historically, KKR Credit has provided mezzanine financing to companies in Australia and New Zealand and, more recently, sourced its first senior secured direct lending investment in the region.
We believe it is a region where managers can differentiate themselves and leverage regional relationships and firm-wide resources to drive proprietary investment flow.
Finally, we believe volatility in the liquid credit markets has created more opportunities for mezzanine debt as borrowers seek the certainty that may be afforded by working with private lenders.
POTENTIAL INVESTOR BENEFITS
Against the market environment described above, we believe mezzanine investments offer the following investment attributes:
Attractive Relative Pricing: We have witnessed a meaningful dislocation between syndicated and private credit investment opportunities.
Today, contractual coupons for mezzanine debt generally range from 11.0 percent to 14.0 percent, representing a 300-600 basis point premium over the syndicated high yield market.
Additionally, given the typically fixed nature of its contractual coupons and the more permanent holder base, mezzanine pricing is often less volatile than a syndicated high yield investment.
Structural & Lender Protections: It is common for private lenders to seek governance rights when extending mezzanine debt. As an example, we frequently seek board representation which offers more frequent dialogue with the company as well as better access to company financials.
We believe this access not only strengthens our ability to monitor investments, but also helps to identify any potential business issues.
Potential for Equity Upside: As noted previously, mezzanine debt may come with a form of equity participation either through common or preferred equity, options or warrants. This equity participation may offer the potential for incremental return beyond the attractive contractual coupon.
When taken together, we believe these attributes offer an opportunity for investors to earn attractive risk-adjusted returns. Notably, sources of return are expected to come from the contractual coupon (cash coupon and/or PIK coupon), arrangement fees, original issue discount and equity participation.
We believe the mezzanine asset class is poised to benefit from not only the secular shift in the banking industry, but also the volatility in the liquid credit markets.
It is a very interesting environment for sophisticated investors who are seeking consistent yields to consider adding mezzanine debt to their portfolio.
1. Source: Preqin 2016 Private Debt Report.
2. Source: Wells Fargo, “The 2Q16 BDC – Scorecard – New Life Emerging in the BDC Space” as of April 2016.
This article is sponsored by KKR. It first appeared in the June 2016 edition of Private Debt Investor.