Down but not out

Senior debt has claimed the fundraising limelight, but junior capital is still popular and mezzanine may be set for a comeback. Claire Coe Smith reports

Senior debt topped junior debt as the most used fundraising strategy in 2017, marking the first time in over a decade that the latter has not dominated volume in the fundraising markets, according to PDI data.

But despite the rapid growth of unitranche, challenging the role of mezzanine and other subordinated debt in the marketplace, there is no sign that junior debt is out of fashion. Junior debt managers raised a total of $42.3 billion across 50 funds in 2017, only the fourth time the market has surpassed $40 billion of fundraising in the past 10 years.

It is the huge amount of capital being raised for senior debt strategies – where cumulative fundraising value in 2017 was nearly three times what it was in 2016 – that has pushed the junior debt market into second place.

Mezzanine is certainly being squeezed in the core mid-market, according to Simon Fulbrook, a partner with law firm Goodwin, which specialises in debt finance for private equity deals. “We are seeing second lien really being used as the stretch on senior to get a bit more of a turn on leverage,” he says. “We aren’t really seeing much mezzanine being used. Clients refinancing deals with mezzanine products are finding senior lenders offering up to 5-5.5x leverage, with second lien providing an extra turn on top of that, so the mezzanine, with its higher pricing, is being removed.”

Death exaggerated

It’s a view shared by Chris Lowe, a partner in the capital and debt advisory team at EY. “Five years ago the market just exploded with managers raising funds on the unitranche product coming out of the financial crisis, and that kind of killed the mezzanine product because the structuring was so much easier,” says Lowe.

“Until a year or 18 months ago, mezzanine looked dead and there were so many places for borrowers to look. But there’s now a supply-demand imbalance, with excess supply of debt and not enough demand for it, so the market is competing with itself to get money to work. We are having many more conversations around second lien, and I wouldn’t be surprised to see an opening up of mezz again as funds are pushed either to move further down the credit spectrum towards equity, or to take on more risks for credits that are perhaps a bit tougher.”

Scott Reilly is president and chief investment officer at Peninsula Funds in the US, where he has specialised in lower mid-market mezzanine and structured equity investing for 30 years. He argues that the heat in the LBO market that has pushed up purchase prices and leverage multiples did drive out mezzanine to an extent, though only insofar as the risks were packaged differently.

Peninsula targets non-sponsored deals in the lower mid-market, where he says demand for mezzanine remains high. “That market has worked out well for us,” says Reilly, “and we will raise our seventh fund this year. If you’re a fund-based subordinated debt provider, you face stiff competition, but I don’t think that is meaningfully different today than it was five years ago. We see consistent dealflow from one year to the next, because we are focusing on a market that is not the focus of so many junior capital providers.”

In Europe, Beechbrook Capital is similarly focused on providing debt and equity capital to small and medium-sized businesses. In January, it provided a mezzanine loan to funds managed by HIG Capital to support the acquisition of automotive parts make Beinbauer Group in Germany.

Paul Shea, Beechbrook’s co-founder, says that mezzanine is faring much better in the lower part of the market. “In the mid-market and upper mid-market there’s a lot of supply of unitranche from different credit managers and that’s crowding out a lot of mezzanine provision,” he says. “There are still certain houses doing mezz deals, but not as many as there used to be. In the lower mid-market there is not the same number of active private credit managers, and as a result there’s still quite a good opportunity for providing mezz behind a local bank.”

Growth in the Middle

In the Middle East, there is also growing demand for junior capital, according to NBK Capital Partners, which has just successfully exited its inaugural NBK Capital Mezzanine Fund I, returning a 17 percent gross internal rate of return on investments in the UAE, Saudi Arabia, Kuwait and Turkey.

Yaser Moustafa, senior managing director at NBK, says: “There are no senior debt funds in MENA and banks are the only providers of senior debt. Our credit investments quite often are the most senior in the capital structure – and remain quite conservative based on leverage levels – while offering returns normally associated with junior debt or mezzanine structures.

“Junior capital in the form of mezzanine financing can be perceived as complex for those familiar with senior debt or common equity, especially as most situations require bespoke structuring. As we continue to take a leading role in educating advisors and borrowers on the benefits of mezzanine debt/structured equity solutions, these efforts often convert into deployment opportunities.”

Crescent Mezzanine, a provider operating across the US and European markets, targets low double-digit returns.

Chris Wright is a managing director at Crescent Capital, focusing on mezzanine. In December, Crescent Mezzanine Fund VII closed at more than $4.6 billion, exceeding a target of $3 billion – the group targets investments in companies that are typically controlled by private equity and have enterprise values in excess of $300 million.

“While the unitranche market has definitely matured over the past several years, there is still a place for mezzanine, as not every transaction can be structured with unitranche securities, particularly larger transactions,” says Wright.

Investors also remain keen on junior debt, he adds. “From an investor’s perspective, LPs have different risk/return profiles and investors certainly seek the types of returns junior debt strategies provide. Some investors are prohibited from making investments in levered funds, so investing in junior debt is a way for them to achieve higher returns without the use of fund leverage.”

The role of junior debt providers is often to introduce innovative and bespoke elements to the capital structure, according to managers.

Alyson Gal Allen, a finance partner at law firm Ropes & Gray, says she sees a lot of flexibility going on in this part of the credit markets. “On a deal-by-deal basis, financing structures are driven by what is appropriate for a given transaction, and many credit managers looking to deploy capital have the ability to propose terms and structures that fit the particular situation, and are not necessarily limited in what they are able to propose,” she says.

“In addition to the range of debt structures which are available beyond classic senior – whether mezzanine, second lien, unitranche or stretch senior – a specific deal might call for a blended approach, where more than one flavour of junior debt is deployed, or junior debt is paired with equity to achieve the desired returns, or a deal may be structured as part debt coupled with a receivables sale. Many credit managers have a lot of flexibility to innovate and pivot to meet deal-specific challenges.”

Certainly, the sense is that while senior debt may have stolen some of the limelight in the fundraising arena, mezzanine and subordinated lending still have a definite place in the market for both borrowers and investors, and may grow in popularity again if the market cools.