Life beyond the grave for mezzanine

The “mezzanine is dead” mantra has been uttered many times around the private debt universe, although in the junior debt world the story is more nuanced. For one thing there are still plenty of mezzanine funds and managers out there. According to PDI Research & Analytics, there are 11 global and 29 Americas mezzanine funds currently in market, seeking a total of $45 billion. Some of these funds are huge and quickly amassing large piles of assets.

But sceptics abound, claiming that mezz has been replaced with last-out unitranche; that there isn't enough issuance to go around; that risky junior debt isn't a good idea when markets are volatile; or that mezz firms must be investing in something other than mezz, if they are investing at all. Ultimately, perception of the market depends on who you talk to.

Some large mezzanine managers are still raising funds and doing deals. At the other end of the spectrum are dozens of small managers, some of whom focus on the lower mid-market area where they can still find dealflow. Far from being zombies walking toward a slow death with funds raised years ago, many have widened their scope.  

The “big four” in the mezzanine market are Goldman Sachs, GSO Capital Partners, Highbridge Principal Strategies and Crescent Capital Group. They have scale and tenure on their side, and do large deals where few other alternative lenders can compete. People familiar with their strategies say they are experienced in their particular niches and have long-term relationships with sponsors, intermediaries or borrowers where they can still get deals done. 

GSO is in market seeking $6 billion for its third GSO Capital Opportunities fund, which is said to be approaching a first close.  Highbridge, which recently spun out of JPMorgan, is targeting $5.5 billion for its third mezzanine fund, while Crescent is raising $3 billion for its seventh mezzanine fund. The firm has been gathering a lot of money in Asia and the vehicle is expected to be nearer to $4 billion when it reaches a final close. 

Goldman, which closed its GS Mezzanine Partners VI fund on $8 billion at the beginning of 2015, is said to work on a lot of private high-yield type mezz transactions. 

The firm is reportedly getting more aggressive on large deals, filling a void left by banks avoiding junior debt and lent $750 million to Petco Animal Supplies, backing its buyout by a consortium of private equity firms last November. 

Goldman also arranged $580 million for the sale of business software company SolarWinds to private equity firms Silver Lake Partners and Thoma Bravo and a $210 million loan for the $1.3 billion acquisition of 1-800-Contacts, a contact lens retailer, by AEA Investors. 

Crescent is also said to be working on private high-yield type transactions and has long-term relationships with private equity sponsors. Leonard Green & Partners is one such firm that often uses Crescent on junior debt deals for its buyouts. Crescent's and Goldman's deals tend to fall in the refinancings of large leveraged buyouts category, sources say.

Highbridge often works on non-sponsored deals and competitors say it competes on pricing by offering lower interest rates to borrowers. The firm also mixes preferred equity in its mezzanine strategy. Last year, it worked with Partners Group on a $500 million mezzanine debt deal backing the merger of two fibre-optics providers. 

Blackstone-owned GSO tends to do large deals and hold the entire tickets on its books, rather than sell pieces down to other lenders. The firm's executives say it is a more manageable process in the event of borrowers getting into trouble or needing to restructure. 

The mezzanine strategy at GSO has posted returns in the high teens since inception, according to Blackstone's earnings reports. GSO tends to invest at least $200 million per mezz deal, with its average ticket size falling between $300 million and $400 million. 

Outside the Big Four, Audax is also raising a $1 billion mezzanine fund and KKR has launched its second mezz fund with a $2 billion target, the KKR Private Credit Opportunities Fund II. It has so far gathered $350 million.

SMALLER DEALS  

At the other end of the spectrum there are smaller managers working on lower mid-market deals where they think companies still need junior capital and transactions can be found away from the mega-funds. These tend to fall for loans made to companies in the $25 million to $40 million EBITDA range. 

Chicago-based Maranon Capital, which lends $12 million-$25 million per loan, has been seeing strong demand in this area. The firm has already deployed 88 percent of the capital in its latest $159 million fund and co-founder Tom Gregory tells PDI that demand for mezzanine debt in the smaller end of the market actually outstrips supply. 

Mezzanine also tends to deliver high returns with low historical loss rates and at lower volatility than equities, making it a good bet for insurance companies, Gregory says. In fact, many of the large US insurers, including Prudential and Northwestern Mutual, have their own in-house private debt groups that invest primarily in mezzanine. Not that everyone is keen on smaller mezz deals. Susan Kasser, head of private debt at Neuberger Berman, who used to oversee mezzanine at The Carlyle Group, invests across the capital structure at NB. 

She tells PDI that small deals and the incremental return that can be made on more risk and more leverage (5x or 6x debt to equity) in mezzanine are not economical. She would consider deals in the 4.25-4.5x leverage range if the company looks attractive, but otherwise isn't interested. 

“Other people will stretch for yield,” she says, but when the extra return is around 100 basis points, it's probably not worth it. 

Bill Sacher and Shahab Rashid, who used to manage mezzanine strategies at Oaktree Capital Management, are also planning to invest across the capital structure in their new roles in the private credit business of Adams Street Partners.

At Oaktree, Bill Casperson and Raj Makam who now oversee mezz, say they can find more opportunities in smaller deals. 

The firm closed its fourth mezzanine fund on $842 million in January. The platform targets companies with enterprise values between $150 million and $750 million, which are either too small to access the public markets or too large for most other mezzanine funds, the executives say. 

THE ZOMBIE EFFECT  

At this this year's ACG InterGrowth event in New Orleans (see feature in this month's magazine, p. 19), mezz managers were split between those who boasted to PDI about the number of deals they had done in the last year and those complaining of a low transaction pipeline. 

Atlantic Conferences' Symposium on Mezzanine Finance, which took place in New York last month, was apparently more sombre. It was also well attended by junior debt providers, but attendees told PDI that spirits among many mezz managers were low, as there weren't many deals to go around.

Between the mega-funds doing large-cap mezz deals and the smaller managers working on lower mid-market transactions, sources tell PDI that mezz may indeed be dead in the mid-market space where it's been overtaken by last-out unitranche or second lien loans. 

Many of the fund managers still with mezz funds are suspected to have fallen victim to the private equity “zombie effect”, where they don't have high-profile blow-ups or closures like hedge funds, but can peter out over time by just taking longer to invest their funds. 

While deals are hard to come by, the small firms that only manage mezzanine products will probably have to charge fees on committed capital to finance their businesses. 

Charging fees only on invested capital has become the norm in private debt, so having to charge on commitments makes firms less competitive when raising money from LPs. 

“It's also hard for them to dig out of the J-curve,” says one private debt manager.

A few players, however, can still be successful in mezzanine strategies and some experts think mezz is actually poised to make a comeback. 

“We have seen a gapping out of pricing on second lien loans due to volatility in the market. Mezz rates have been more consistent and are close to historical levels,” says Gary Creem, partner in the multi-tranche finance group at Proskauer. 

“With the spread on rates narrowing between second lien and mezz, we expect to see more mezz. 

“Further, second lien loans are tied to LIBOR. Floating rates create more uncertainty for second liens in an era of expected rate rises, further enhancing the appeal of mezz.”

Recently, senior lenders have been pushing back on the rights of second lien lenders, who have more creditor rights than mezz lenders. 

“With default rates on the rise, we expect to see more senior lenders push sponsors to use mezz over second lien to strengthen their creditor rights relative to the junior capital in the capital structures,” Creem says.

It's possible that recent market volatility could yet be beneficial to some mezzanine players, but there is no doubt that there are far fewer firms that can compete in the space.