Once again, the mezzanine debt space has proved wrong the naysayers who foretold its demise. “There was a time in late 2015 when folks were declaring mezzanine dead,” Peter Antoszyk, a partner at law firm Proskauer, told PDI in February. “But it’s clearly not.”
That was then, and as of 27 September, US-focused funds with mezzanine or subordinated debt strategies have raised a total of $15.33 billion this year, according to PDI data. That number guarantees 2017 will show more money raised for this space than any year since the last financial crisis.
Investors don’t appear to believe mezzanine debt is dead, and fund managers are clearly not turning away their money. But where is all this mezzanine capital going to invest in a late-cycle, increasingly competitive credit market?
Mezzanine fund managers are not the only ones in the mid-market looking for private debt-like risk with private equity-like returns these days, and senior and unitranche have proven to be fierce competition.
“My sense is that mezzanine activity is still robust,” says Chuck Morton, co-chairman of the corporate practice group at the law firm Venable, which represents private lenders and borrowers on mezzanine deals. “But I think senior debt and unitranche are taking deals away from mezzanine.”
As terms on senior and unitranche deals loosen, this takes away opportunities for mezzanine lenders charging more for debt. “The mezzanine guys don’t get invited to the party if they are targeting returns in the teens and a unitranche lender is targeting at 8 percent returns,” Mortin adds.
Unitranche lenders have “absolutely” taken share, particularly in the lower mid-market, says a head of the credit group at a global asset manager active in the mezzanine space who did not wish to be named. Not only can unitranche lenders undercut mezzanine lenders on price, but they have more ability to club up with large-scale players on deals, making them more attractive to borrowers focused on a blended capital rate.
Finding opportunities to invest in junior capital with increasing competition from senior or unitranche providers was a recurring theme at a panel on mezzanine debt at the Pension Bridge conference in Chicago in July. Despite this competition, mezzanine returns have remained steady, though leverage levels have increased, panellists argued.
“The BDCs had a boom, then bust and now they’re booming again, and unitranche is booming too,” FT Chong, head of structured capital at PineBridge Investments, which targets mid-teen returns on junior debt investments in the lower mid-market, told the panel. “So we’re used to competition.”
But even with a flood of capital into the mezzanine space, mezzanine fund managers have a great opportunity to find excess yield in the lower mid-market, where companies are smaller, less developed, less sophisticated and have less credit quality. Unlike a $100 million enterprise firm that can borrow 5x of debt at L+500, many companies in the lower-mid market can only borrow ABL facilities or mezzanine loans, according to one source.
Morton says there are more deal opportunities for mezzanine lenders in the lower mid-market, where the law firm is most active. On the mezzanine deals to companies with $50 million EBITDA or less, there are fewer lenders chasing deals because the businesses are less mature and therefore more risky.
But some mezzanine managers in the lower mid-market disagree that the space is less competitive than the upper end of the market today.
Chris Wright, managing director at Crescent Capital Group, also said on the panel that his mezzanine strategy has “migrated up” market over time “to mitigate the late cycle risk”, as default rates in the upper mid-market are 40 percent less than in the above-$50-million space. The firm’s strategy has completed $1.5 billion in deals over the last 15 months, showing an average yield on investments of 12.5 percent.
In the more liquid, larger capital markets, a financing void has also created opportunities for mezzanine lenders. Though large sophisticated borrowers continue to have access to liquid capital and senior debt, firms are still looking for a second-lien loan for acquisitions and other such deals. This is a result of consolidation among banks and other investment firms in the high-yield bond markets, while private equity buyout firms have exploded in size, meaning all three have shifted focus to larger and larger deals, leaving a financing gap for mezz lenders to fill.
But in all parts up and down the mid-market, mezz lenders should be wary of loose terms and leverage levels.
“Mid-teens gross returns seem to be largely held at the lower part of market,” Tom Cawkwell, head of private markets research at Albourne America, said on the Pension Bridge panel. But “the real risk in this space is the amount of leverage going up and equity cushion shrinking”.
Leverage has certainly crept up in the last few years, as high as 6x-7x turns, Wright added on the panel. Though prices have come down, as second lien spreads were roughly around L+825 basis points in the second quarter, he said. For a mezzanine lender to be relatively competitive in this environment without piling on leverage, one strategy is to add a risk premium to a deal because of its complexity, and have the right management team to recover the asset or company in case of a downturn, Cawkwell said. “When things go wrong with a lot of leverage, there are less levers to pull.”
Playing the property market
Real estate junior debt is another strategy luring credit investors and one that has become a more attractive investment as the credit cycle matures and competition heats up.
“Corporate credit spreads have tightened significantly and investing in real assets is increasingly attractive,” says Brian Sedrish, managing director at Related Fund Management, a real estate company. “As the senior market has tightened, with less participants or providers of traditional loans because of regulations, those banks that do participate appreciate groups like us financing with them as a mezzanine provider and as a qualified operator.”
Related Companies’ credit strategy focuses on junior debt positions on deals that add some degree of transitional value to a property as it develops and gets ready for prime performance. These include construction mezzanine loans, attached to a senior loan provided by a bank or fund manager, or a land loan on a property acquisition and pre-development project. Or if an asset is already developed, a transitional mezzanine loan could finance a “lease-up” play, where a building is 20 percent leased and needs to fill in the gap to meet the sponsor or borrower’s cashflow needs.
The Related credit platform focuses on the US, with a strong focus on gateway markets like Chicago, Florida, Boston, New York or San Francisco. The firm’s credit platform is generally agnostic as to lending to a particular asset type, but focuses on multifamily, hospitality or combined office, retail or hotel properties. Related recently provided a transitional loan to a Courtyard by Marriott hotel by 34th and 10th avenue in Manhattan.