Competitive—the word is usually the first utterance from a mezzanine lenders’ lips when describing the current state of their marketplace. Indeed, the past couple years have not been peaches and cream for the lenders. First came the business development companies in early 2004 and, while the BDC bark was worse than its bite, their arrival was followed shortly thereafter by a rush of inexpensive second-lien-lending hedge funds, which have been giving traditional mezzanine lenders fits for the past two years.
But now mezzanine lenders and those who work with them are hopeful that the winds of change—rising interest rates and an impending market correction—are at hand, and that they will bring the lending environment, particularly in the middle market, back to their favor.
“When interest rates were lower and LIBOR was down 2% to 3%, that’s when second lien was dominating the market,” says John Sinnenberg, CEO and managing partner at Key Principal Partners. “They came in saying, ‘I’m going to charge LIBOR plus 8% [interest],’ so sponsors were able to get pieces of junior capital at 10% or 11 percent. [That’s a discount] compared to mezzanine, which is consistently priced at about 14 percent.”
The 400 basis point difference proved enough to get the sponsors’ attention, despite the fact that they would have a lien on their investment. But now that LIBOR is up to about 5%, second lien is not much cheaper than mezz, and some sponsors think it’s worth paying an extra 100 basis points for mezzanine’s unsecured credit.
“We have chosen to go with more expensive debt for the comfort of protecting ourselves in case of a hiccup,” says Genstar Capital Managing Director Rob Weltman, “Second lien blows hot and cold. Right now everything is blowing hot, but I’ve seen it when it was cold, whereas mezzanine is always there. The pricing my change a little, but it’s definitely more stable.
Sinnenberg adds that as interest rates continue to rise, and as the growth part of the economic cycle draws closer to an end, GPs will continue to focus more on the impending downside, which bodes well for mezzanine providers
“They’re wondering how those complicated [second lien] capital structures will perform when they start to hit on covenant defaults or, even worse, payment defaults,” he says. “How will second-lien situations play out in bankruptcy courts? No one’s sure because it’s too fresh. Mezzanine, on the other hand, has already been through a downturn and we all know how it plays out in a bankruptcy.”
But while some mezzanine lenders expect a pullback from second lien market, given the exponential growth that second lien exhibited over the past few years, none expect the competition it poses to disappear completely. According to Standard & Poor’s Leveraged Commentary & Data, last year saw 172 second lien loans hit the market compared to 129 in 2004 and a scant 25 in 2003. That growth is even more impressive when one considers that between 1997 and 2002 only 34 second lien loans were consummated.
Firms that recently tapped the market include Madison Dearborn Partners, which acquired Bolthouse Farms for $750 million, $150 million of which took the form of a second lien loan, and GTCR Golder Rauner, which tapped $160 million in second lien financing to buy Sorenson Communications, a provider of video phone services for the deaf and hearing-impaired.
Given the private nature of the mezzanine market, exact numbers are tough to come by, but anecdotal evidence does support claims that the mezz market could be on the rebound.
Steven Ellis, a partner and co-chair of the Corporate Finance Group at law firm Proskauer Rose LLP, sees the market shift in his day-to-day activities. “Three years ago, we did about 70% mezzanine deals and about 30% second liens. In late 2004 and 2005, it flipped to 70%/30% second lien over mezz, and now we’re seeing a 50%/50% split,” he says.
The fundraising numbers also show an uptick in both the number of mezzanine firms seeking capital and the amount raised when compared to this time last year. As of the close of Q1 2006, Buyouts tracked 30 actively-raising U.S.-based mezzanine funds that closed on nearly $6.5 billion, while at the close of Q1 2005, $4.2 billion was raised by 16 mezzanine firms.
Nevertheless, while the storm clouds over the mezz market may not be as dark as they were two years ago, the sun is not exactly shining on it, either. The competition has permanently altered the lending landscape. Market observers say that today’s mezzanine lenders have a decision to make: either they take a proactive approach to find new ways to put their money to work, or they sit on the sidelines of their own playing field while the competition runs with the ball.
Stepping Up The Game
“We don’t believe that mezzanine is a strategy; it’s an investment product. Strategy is what it will take to succeed going forward,” says Eric Green, a senior partner at FriedbergMilstein LLC.
“The ability to run up and down the capital structure is what you need to be successful in this business,” he adds. “Your capital has to be flexible, which means your funds have to have some leverage on them.”
In December 2004, FriedbergMilstein held a final close on its $584 million FriedbergMilstein Private Capital Fund I, which has an investment mandate that includes first lien senior loans, second lien loans or notes and mezzanine or subordinated notes. And earlier this year, the firm closed on another $384 million for its FriedbergMilstein Leveraged Capital Fund I.
Golub Capital is another lender with an investment mandate allowing to accommodate one-stop financings. Last quarter, Golub closed its first international fund with $340 million and began pre-marketing its fifth domestic fund with a $500 million target.
For some lenders, however, the strategy has been to not compete at all. Instead of bumping heads with the quicker, less expensive second lien providers, more and more traditional mezzanine lenders are talking about sponsorless deals, in which the lender invests directly into a company on its own, typically to provide growth equity to privately-held or family-owned businesses. Some better-known firms that are versed in the sponsorless side of mezzanine investing include Windjammer Capital Investors, GarMark Advisors LLC and Merit Capital Partners.
“The risk/return benefits are appealing with regard to sponsorless transactions, but they’re not easy deals to do. We’ve seen people come in and out of this market,” says Dan Pansing, a director at Merit Capital. “There was a point where a number of firms used to avoid non-sponsored transactions, but as the market has gotten more competitive firms have shown more interest in these transactions.”
But the sponsorless game is not for everyone, as there is much more heavy-lifting involved. In short, when investing mezzanine sans a sponsor, the lender ends up doing all the typical things that a LBO shop would do to protect and grow its investment—things like taking seats on the boards of directors, making decisions on assets and divestitures, capital allocation matters, working with banks and management, succession issues and compensation.
But to some, the challenges posed by the more intensive investment strategies are but growing pains necessary for survival. “Guys with flexibility will continue to challenge the traditional players, and in the end, the guys that will struggle are the guys that will only do sub debt,” Green says.
Less Bang For Mezz Bucks
Yet another modus operandi used by mezz lenders in these tougher times is concession making, says Proskauer’s Ellis. “Three to four years ago, [mezzanine lenders] were getting 18% to 20% interest rates with 6% and 7% warrants. That’s not happening anymore. I see deals getting done today at 14% [interest], with 1%, 2% or 3% warrants.”
The lower interest that lenders are able to command today, coupled with market efficiency, pros say, is contributing to the shrinking returns across the mezzanine market.
John Morris, a managing director at Boston-based fund of funds HarbourVest, says net returns for top performing mezzanine funds in today’s market fall between 13% and 18%, while average performers’ returns register in the high single-digits and low double-digits.
“In mezz’s heyday, lenders were targeting returns in the high teens and low 20 percentiles, whereas today you oftentimes see them underwriting to a 15% gross IRR,” Morris says.
One mezz lender who asked not to be identified agrees that the 20% IRRs that were attainable just four years ago are now all but a vain hope. “As this cycle continues, investors are getting more aggressive. We have these [lending industry] conferences where straight-forward mezzanine guys are saying that they’re getting 17% and 18% returns, but I don’t know anyone who’s really doing that.”
And while the pendulum may have begun its swing back in mezz’s direction, the market’s savior might not actually come until the economy goes to pot. At that time, pros say, the hedge funds currently in the second lien game will likely switch hats and become distressed debt investors, thus giving the traditional sub debt lenders more breathing room.
“The correction probably will be a good time for mezz because there will otherwise be a shortage of credit and liquidity,” Morris says. “That’s when they’ll be able to get the credit they did historically, before second lien came in.”