Proskauer: leverage creep ‘dampened’ demand for mezz

Leverage inching up in private credit mid-market deals happens every cycle, and as the economic expansion continued, last year was no different.

A new report from the Proskauer law firm released on Tuesday suggests that leverage increase, or creep, in 2016 may have tipped the market in favour of senior and unitranche products at the expense of mezzanine debt.  

Across the New York-based law firm’s 180 deals last year, approximately 60 percent had a closing leverage greater than 4.5x, while nearly half, or 47 percent, had a closing leverage greater than 5.5x, compared to 39 percent of the international firm’s deals in 2015.

“Weak deal activity in early 2016 led to a more competitive environment for lenders when the market recovered,” the report stated, attributing the stiff competition to the firm’s increase in deals levered above 5.5x.

 Steven Ellis and Stephen Boyko, both partners and co-heads at Proskauer’s private credit group, told PDI the upping of leverage in mid-market loans likely caused the decline in the firm’s share of mezzanine deals last year.

“With leverage creeping up, we suspect that the ability of private credit providers to provide a comprehensive credit solution, such as a senior stretch loan or a unitranche, has dampened the need for junior capital,” Ellis said.

The firm saw a drop in mezzanine last year to just 13 percent of deals, down from 21 percent in 2013, according to the report.

Previously, banks traditionally would provide a loan with 4.5x leverage on a deal, and a borrower who wanted another turn of debt would have to line up a mezzanine loan from another alternative lender, the partners noted.

But today, private credit shops are willing to do a single financing with 5.5x leverage, which means more borrowers don’t need an additional junior debt.

Last year, Proskauer share of senior secured deals represented 54 percent of deal volume, while the share of second lien deals increased to 32 percent up from 26 percent a year earlier.

Another mid-market trend from last year the partners highlighted was the large financings that private credit firms executed, often teaming up with other firms on single, high-price deals that used to be the province of large banks.

“Our clients are executing larger and larger transactions and coming together to pull off some of the largest we’ve seen, like the $1 billion Qlik Technologies unitranche deal, which included a number of our clients like Ares, Golub, TPG and Varagon,” Boyko said. “It was a great example of how private credit firms are moving up the market and clubbing up.”

The share of Proskauer deals with EBITDA greater than $25 million increased by 13 percent last year, from 47 percent of deals in 2015 to 60 percent of deals in 2016.

For the year ahead in the mid-market in 2017, the report stated that the firm remains “guardedly optimistic.” Though the mid-market faces the prospect of the new president and Congress loosening US banking regulations as promised, both Ellis and Boyko said private credit firms have the flexibility and speed that well-positions them in the space.

“If regulations are rolled back, we will likely see banks moving back to the middle market,” Ellis said. “But at the same time, the very flexible capital that our clients can provide will still be deployed by firms able to execute quickly on a variety of credit solutions.”