Playing the long game

A limited partner is willing to accept a little more risk. Does the firm opt for private credit and choose a mezzanine fund, or does it go the public market route and settle on high-yield bonds? 

If the LP wants to boost its return profile, it should settle on mezzanine debt, at least according to a recent study by alternatives advisory firm Cliffwater that examined mezzanine returns against other investments, including high-yield bonds. 

“Basically, when we do our analysis, we are looking for incremental risk and seeing if there’s incremental return associated with that risk,” says Steve Nesbitt, chief executive of Cliffwater.

 Taking risk and return into account, the study – which covers 1995 to 2014 – put mezzanine debt well above high-yield bonds, its closest public market equivalent. According to the study, mezzanine debt was able “to demonstrate significant return premiums” within the credit markets for private debt compared with public debt. During the period of the study, mezzanine out-earned high-yield bonds by more than 3 percent.

The study examined performance data through 30 June but, according to the document, did not show returns for vintage 2015 and 2016 vehicles because it is too early to report figures that are representative of long-term performance.

High-yield bonds consistently produced higher returns from 2005, but that trend reversed following the 2008-09 meltdown. After 2009, the study showed mezzanine investments posting better results than high-yield bonds, with funds launched between 2010 and 2014 returning at least 10 percent. Returns for high-yield bonds issued over the same period have been below 10 percent, while those originating in 2013 and 2014 were below 5 percent. 

“On the mezz side, there’s a greater chance of loss [than high-yield bonds],” Nesbitt says. “That’s [risk] number one. Risk number two is liquidity. Risk number three is execution: can I find good managers with good dealflow that can implement a mezz allocation?”

Investors have shown interest in the strategy. Several large funds have closed in recent months. GSO Capital Partners closed a mezzanine vehicle on $6.5 billion in October, while HPS Investment Strategies inched out Blackstone’s credit arm by $100 million when it closed a similar fund on $6.6 billion two months later. Crescent Capital and Carlyle Group locked down $4.6 billion and $2.8 billion, respectively, for their funds.  

Andrew Panzo, a general partner at NewSpring Capital, also notes that mezzanine has seen higher returns in recent years partially due to the illiquidity premium associated with private debt. High-yield bonds are more liquid, giving investors an easier way out if they choose to exit a given position. Deals both with and without a private equity sponsor have hit double-digit returns, he says.

“Sponsored [transactions] are using senior debt and equity and filling the gap with mezzanine,” says Panzo. “We are seeing low to mid-teens returns on those transactions. We are seeing mid to high-teens on the unsponsored transactions.”

The firm announced in March that its latest vehicle, NewSpring Mezzanine Capital III, closed on $257.4 million and that more than $135 million of the capital has been deployed. A market source said the firm added “quite a few” institutional limited partners because mezzanine was proving to be more attractive.

The illiquid nature of mezzanine investments can mean that limited partners will have exposure for some time, but it can also shield investors from the whims of the market.

“Mezzanine is a long-term investment,” says Christopher Wright, a managing director in Crescent’s mezzanine group. “We are not forced to sell or buy during a bad market. Mezzanine investments collect a coupon and we shoot to get par or a premium to par upon exit.”

Wright adds that mezzanine vehicles often also have a return component which can generate upside, such as equity co-investments, which can help boost the return profile of those funds. This is something the high-yield bond asset does not offer.

“Throughout our 25-year history, we have found that the best mezzanine investments are the ones where you believe in the company’s credit and equity story,” he says. “We think it makes a lot of sense to put 10 or 15 percent of our money into the equity, which provides us with meaningful upside potential and aligns our interests with the private equity sponsors we work with.”

Dealflow and LP allocations

“We expect mezzanine financing to remain competitive,” says Gary Creem, a partner at law firm Proskauer who works on mezzanine deals. “The product offers stability and consistency for sponsors with greater certainty around subordination terms, making the product attractive in an era of rising rates and political uncertainty.”

“Purchase-price multiples have increased, so that means sponsors are going deeper into the capital structures,” he adds, causing private equity firms to tap alternative lenders for larger sums.

A December report from investment bank Piercap Partners shows M&A entry multiples have reached 10.2x. Interestingly, larger mezzanine deals have started to resemble private high-yield bond issuances because the terms are looser.

“We have seen a morphing of mezzanine and private high yield at the larger end of the market as financing structures more frequently resemble high yield with no covenant package, or lighter on covenants, and incurrence tests,” Creem says. 

The growing appeal of mezzanine does not come at the expense of high yield, Crescent’s Wright says, but rather from revised allocations for alternative assets. Many investors are devoting a larger part of their assets to alternatives, the bucket in which mezzanine often falls.

“I think that in general investors have realised for some time that high yield is a critical part of a fixed income asset allocation,” he says. “The growth in private credit and junior capital is based on the growing demand for yield, flexibility in structuring and less exposure to capital markets volatility.”

Nesbitt says the high-yield market has drawn capital from other sources.

“Retail money [from mutual funds], if they are taking credit risk, they go into high-yield bonds or broadly syndicated loans or bank bonds,” he says. “You’ve seen a secular increase in allocations there. But on the private side – mezz, direct lending – that’s really the purview of the institutional investor, and they access those primarily through partnerships, through private business development companies.”  n