With lenders holding the line on senior leverage multiples, mezzanine providers should be living high on the hog. Instead, they’re slashing coupon rates by hundreds of basis points and considering riskier was to put their money to work to generate yield.
Mezzanine lenders, emboldened by signs of economic stability, and by a growing appetite for subordinated debt from sponsors, have largely emerged from the sidelines in the first half of 2010. But deal flow has not kept pace. The number of announced U.S. LBOs in the first quarter of 2010 actually fell by 21 percent from the fourth quarter of 2009, according to Thomson Reuters, publisher of Buyouts. Market participants tell Buyouts that lenders actually have more mezzanine capital available to deploy than there are deals to invest it in.
The imbalance is fueling a competitive war among lenders looking to participate in high-quality deals involving companies producing EBITDA of $15 million to $20 million and up. The average sub-debt multiple for mid-market LBOs hit roughly 1.5x EBITDA in the first quarter, according to Standard & Poor’s Leveraged Commentary & Data. That’s a 67 percent increase from the 0.9x sub-debt multiple that adorned 2008’s LBOs of companies with EBITDA of less than $50 million, and it’s more than three times 2007’s average 0.4x multiple. Pricing for mid-market mezzanine financing has fallen to between 14 percent and 17 percent, depending on the size and quality of the credit, according to an informal poll of market players conducted by Buyouts for this story.
For buyout shops, the glut of inexpensive mezzanine capital is largely good news. While the senior debt markets have thawed quite a bit, lenders are still maintaining prudence when it comes to company quality and leverage levels. Senior leverage ratios in the middle market tend to top off at about 3.0x to 3.5x EBITDA, while purchase price multiples can easily hit 8.5x EBITDA. At the same time, mezzanine lenders have largely given up on trying to include nominally priced warrants in their deals. Side-by-side equity co-investments, however, are still widely available to mezzanine lenders.
Recent deals that used mezzanine financing include
The turnabout has been remarkable in its speed. Michael Hermsen, a managing director at
No End In Sight
The mezzanine fundraising market remains robust, which will only serve to prolong the oversupply so long as deal flow remains slow.
From January 2008 through May 2010, U.S.-based mezzanine shops raised a total of $32 billion from limited partners, even as disclosed deal value of U.S. sponsored transactions through that period dropped to a depressed $183 billion, according to Buyouts. As of May 26, Buyouts was tracking the fundraising activity of 32 mezzanine funds managed by U.S.-based general partners. The total combined target of those funds is $15.9 billion, of which $5.8 billion has already been raised (see accompanying table).
And that’s only part of the mezzanine market: Insurance companies, business development companies, hedge funds and others also supply subordinated debt directly to companies. Moreover, the buyout market has seen the return of second-lien lenders, which can undercut historic mezzanine coupon rates by at least 200 basis points, said Ronald Kahn, a managing director and head of the debt advisory group at investment bank Lincoln International.
Some mezzanine firms have responded to the less-than-favorable market conditions by taking on additional risk in the search for deals and yield, or simply moving to the sidelines until conditions improve.
“People got spoiled through ’09 and the beginning part of this year because they could command relatively high rates on fairly safe transactions,” said John Capperella, a director at LBC Credit Partners, a provider of senior term, unitranche, second-lien and mezzanine debt. “There was an imbalance between the yield that people were getting vis-à-vis the risk that they were assuming, and that will adjust going forward. So if you want your yield, you’re going to have to start taking on more risk,” Capperella said.
When Wayne, Pa.-based mezzanine provider
One mezzanine lender, speaking on condition of anonymity, said his firm may consider sitting on the sidelines until deal flow comes back and spreads widen—a wait that may not take too long, according to some market pros.
“Evidence we’re seeing in the market indicates that the second half of the year is going to be much, much busier than the market has been in the last six months,” Babson Capital’s Hermsen said, noting the pent-up demand for sellers to hit the market and for buyers to put their dormant capital to work. “It’s a supply demand equation. So if more supply comes into the market, it stands to reason that spreads should widen out a little bit,” Hermsen added.
Indeed, if mid-market buyout shops do end up deploying most or all of their un-drawn capital, then the imbalance between mezzanine debt and deal flow could be turned on its head, said Tom Gregory, a managing director at senior debt and mezzanine provider