When was the last time you saw a mezzanine fund invest only in senior subordinated debt? For that matter, when was the last time you saw a senior lender who didnt provide a second lien loan, or wasnt insisting on the right to invest in common equity? Welcome to the world of Crossover Investing, a new phenomenon that has emerged in the private equity business.
Crossover Investing, and the new products this term has spawned, can be very beneficial in the right circumstances. Their overuse, however, can be a recipe for trouble. We define Crossover Investing as (a) the act of investing in multiple securities issued by a single company or (b) the act of investing in a variety of securities issued by different companies depending upon the perceived risk/reward ratio. In other words, senior lenders, mezzanine funds and buyout shops are all now providing a range of investment products which they can either invest in a single company or use selectively for different companies depending upon the circumstances. The days of pure bred funds are over. But who are the winners and losers as this new trend becomes pervasive?
Lets start with the issuers. For many years, the only debt financing available to middle market companies consisted of low-priced (but difficult to obtain) senior debt and higher-priced (usually in the low 20% IRR) senior subordinated notes. Both corporate clients and buyout funds would beg for something in between as they wrestled with putting together their capital structures. Beginning in 2003, their prayers were answered and a plethora of new products emerged including tranche B loans, second lien paper, rate-only subordinated notes, and a variety of PIK securities. Today, borrowers can access numerous different types of securities depending upon the aggressiveness of their capital structure and their tolerance for risk. The new products, originally spawned by new providers such as hedge funds, have more recently caught on with traditional financing institutions as they struggle to maintain the market share lost to these new products. As a result, more and more financing sources have discovered the need to provide a broader range of these new securities, competition has intensified, required rates of return for the products have declined and issuers have become the big winners. Or have they?
Most of these new products are debt-oriented securities. Whatever they are called, they are all additional forms of borrowing and usually take the place of an equity-like security. We believe that rate-only subordinated debt, the prevailing structure today, is also a switch from an equity-like security to a debt security. But while borrowers applaud this trend, and lenders are eager to fill the ever increasing need, both sides should be careful what they wish for. Because the simple fact is that, unlike equity securities, the interests of the borrower and capital provider are no longer aligned. As long as borrowers are meeting their business plan, this misalignment is unnoticeable. However, when a company veers off course, either for better or worse, the difference between using these new debt instruments versus the old equity like products becomes paramount. Ask the providers of these new instruments, after a company has paid down its senior debt, to consent to the borrower re-leveraging the senior tranche so it can add a product line and see what the response is. More importantly, see how patient these new debt providers are when a company misses its financial covenants and asks for some relief. The simple fact is, unless a capital provider has an equity upside, they have no economic incentive to deviate from the original business plan.
As for the capital providers themselves, it may be a case of eat or be eaten. Many of these new debt products were created by new entrants to the market, such as hedge funds, and the number of providers continues to increase. As a result, many old-line funds, particularly mezzanine providers, have been forced to deviate from their traditional investing model in order to compete in todays market. Having the ability to offer borrowers a wider range of options certainly helps their ability to structure different securities for different circumstances. However, the overall lower rates of return inherent with these new structures will certainly have an adverse effect on the general partners compensation and may result in their switch to more aggressive investments in hopes of recouping this lost remuneration.
And how have fund investors fared? Its probably too early to tell. The main problem for fund investors is they may not be investing in the type of fund they thought they were. For example, an investor in a traditional subordinated debt fund that invests in non-sponsored transactions and obtains a controlling interest in the company through their purchase of a large piece of preferred, may be involved in a higher risk fund than originally contemplated. Likewise, an investor in a buyout fund that invests in subordinated debt may be decreasing the funds risk, but at the same time lowering its overall returns. Investors in hedge funds also need to evaluate the effect of their managers investing in rate only deals where, without the upside potential provided by a warrant, one bad deal can dramatically alter the funds total returns. Fund investors must conduct an even greater amount of due diligence to see how their fund investments are handling this new era of crossover investing.
The phenomenon of Crossover Investing seems to be with us for the long haul or at least until the next market downturn when the true returns on these new investments are known. In the meantime, both capital providers and borrowers should be cautious when entering in to these new securities transactions, because the ramifications may be greater than originally understood. v
Ron Kahn heads Lincoln Partners Private Placement Group. Lincoln Partners is an investment banking firm, specializing middle market M&A advisory services and private capital raising. Headquartered in Chicago, Lincoln Partners focuses on select industries including automotive, aerospace, building products, chemicals, consumer products, engineered products, food products and electronics among others.