Junior debt providers cut return expectations

In its latest quarterly survey of junior lenders, nearly three-quarters of respondents (74 percent) indicated that they expect a total return of 13 percent to 16 percent on their credit investments, in contrast to the historic range of 15 percent to 18 percent for subordinated debt, according to KBCM, the investment banking arm of Cleveland-based KeyCorp.

To be sure, one quarter does not constitute a trend, said Andrew Frawley, managing director and head of private capital at KCBM, but the finding is surprising, in that the higher returns have been a feature of the junior capital markets “since the Kennedy administration,” he said, only half-joking.

In the past, providers of junior capital, such as mezzanine funds, have competed less on price and more on factors such as industry expertise, relationships with sponsors or flexibility on other terms and conditions. But the market has changed since the credit crisis.

“Junior credit providers are getting squeezed out by aggressive senior lenders, as well as a host of other credit products,” Frawley said. The KBCM survey showed the respondents evenly split between viewing aggressive senior lenders and unitranche providers as their biggest challenge, with 24 percent of respondents choosing each.

Three-quarters of respondents in the fourth quarter said they would be willing to provide a unitranche structure, up from 58 percent in the third quarter.

Such changes in the market have diminished the role of warrants or other equity kickers in the junior debt market, Frawley said. While such features were commonplace in the pre-crisis world, in today’s low interest rate environment, companies are much less likely to offer such terms, although the credit providers may buy equity as a way to offset their risk of being lower in the capital structure and to give them a chance to participate in the potential upside of a borrower’s growth, he said.

New competition is coming from business development companies and credit opportunity funds, both of which have boomed since the crisis as investors turn to riskier types of leveraged finance as a way to capture higher yield than other fixed-income vehicles are providing these days, Frawley said.

The KBCM survey was conducted electronically in January. The firm did not disclose the number of junior debt providers that participated.