Mezzanine Debt Finds Room To Flourish

Recent deals that have relied on mezzanine financing include First Atlantic’s mid-November purchase of Sprint Industrial Holdings, which included mezzanine funding from Oaktree Capital Management and Goldman Sachs; and Arcapita’s purchase of Varel International from KRG Capital Partners, a deal whose financing package was arranged by Lehman Brothers.

The demand for mezzanine debt from buyout shops has skyrocketed in recent months and institutional investors are eager to back mezzanine funds again. Several new players, including High Bridge Capital, a hedge fund majority owned by JPMorgan, are entering the space with opportunistic funds.

Meanwhile, experienced mezzanine lenders like GS Mezzanine Partners, an affiliate of Goldman Sachs Group, and TCW/Crescent Mezzanine are raising larger funds than ever before, allowing them to participate in big-market deals. For their part, mid-market players hope to fill the void they believe the big guns will leave behind.

All told in 2007, fund managers have accumulated nearly $21 billion in mezzanine funds, up from $19.7 billion raised in all of 2006, according to Buyouts research, and closings in the next few weeks should push the 2007 number higher.

Mezzanine debt, located below high-yield debt and above equity in the capital structure, is unique in that borrowers pay not only a high fixed-interest rate but also typically give up a slice of equity in the form of options. Currently lenders are getting 11 percent to 12 percent interest rates on deals, a source said.

Prior to the credit crunch, senior lenders aggressively beat subordinated debt providers in speed, rate of closing and flexibility of terms, said Lawrence Golub, president of Golub Capital in New York. “It was a depressing time to be a traditional mezzanine” provider, Golub said. “Especially if you have no leverage, you’re getting whipped on most deals.”

After this summer’s credit tightening, the markets showed signs of returning to a healthier state, said one mezzanine lender. But in recent weeks, the demand for high-yield bonds and senior debt from institutional investors has again plummeted. It’s safe to assume that any deal larger than $500 million, which would have used high-yield debt before to fill the gap between senior debt and equity, now has mezzanine debt as its only option, said Thomas J. Maloney, president of middle-market shop Lincolnshire Management. Golub added that since July, he’s seen many more opportunities for deals that would not have previously been on his company’s radar. “Sub debt lenders have been invited to the ball,” he said.

Mezzanine is suddenly necessary for dealmakers since providers of senior, second-lien and high-yield debt have pulled back on how much leverage they’re willing to provide. The choice for buyout firms is either contributing more equity to fill the gap, or taking on more mezzanine debt. Since many mezzanine lenders get their capital either from stock offerings or by raising private limited partnerships, they can lock in pools of capital well in advance of having to deploy it; this protects them, to some extent, from the vagaries of institutional appetite.

TCW/Crescent Partners and GS Mezzanine both have plans to move up market as they raise significantly larger mezzanine funds. Goldman Sachs’s GS Mezzanine Partners V, which is in its final stages of closing, is expected to collect $10 billion to $12 billion in equity commitments from investors, then lever it up to $18 billion in total, making it the largest mezzanine fund ever raised. The fund is in an ideal position, said one investor. With high-yield markets practically closed, demand for Goldman Sachs’s mezzanine debt will be particularly strong on mega-deals, where few rivals have big enough mezzanine funds to play a major role.

Another fund benefiting from the increased interest in mezzanine from both dealmakers and investors is TCW/Crescent Mezzanine’s latest, launched several weeks ago. Should it reach the $2.7 billion target, the fund would be $1 billion larger than the predecessor, TCW/Crescent Mezzanine Partners IV, according to sources familiar with the situation. The firm sees a hole in the market developing as Goldman Sachs apparently moves deeper into the mega-deal spectrum, one source said. Credit Suisse has been retained as TCW/Crescent Mezzanine’s placement agent, and a first close is expected within the next two weeks, sources told Buyouts. The firm declined to comment.

Similarly, JPMorgan’s High Bridge Capital elicited strong interest from investors seeking to back its mezzanine fund, which is expected to close on $1 billion to $2 billion. The fund is the firm’s first venture into mezzanine financing. High Bridge declined to comment. Even The Blackstone Group has noted the increasing clamor for mezzanine debt. During the firm’s November 12 earnings call with analysts, CFO Mike Puglisi said Blackstone Group’s mezzanine fund was seeing significant increase in deal flow thanks to the closing of the high-yield market.

Like TCW/Crescent Mezzanine, New York Life Capital Partners also plans to take advantage of what it perceives to be its competitors’ moves up market. On Nov. 14 the firm closed its second mezzanine fund, NYLIM Mezzanine Partners II, at $800 million. Senior Managing Partner Tom Haubenstricker believes Goldman Sachs’s perceived concentration on mega-deals creates a niche for his firm. “We’re doing deals that five or six years ago Goldman would have been interested in,” he said. New York Life has “absolutely” seen an influx in the number and variety of deals since the summer, he noted, but said the firm plans to continue at a measured, prudent investment pace.

Haubenstricker pointed out that during New York Life’s most recent round of fundraising, investors were more interested in mezzanine debt than in the past because of its attractive risk return profile. Lincolnshire’s T.J. Maloney, agreed, noting that mezzanine shares some equity risks, but investors are forecasting it to be safer than equity. There is less competition on pricing, and in a “risky, opaque” time to invest, he said, investors are seeking a more conservative position than equity.

Likewise, the consistency of mezzanine fund returns is more attractive to pension funds during a downturn because there is no “J-curve,” or waiting period, before the investor begins receiving a yield on its investment. The moment an investment in mezzanine debt is made, the investor begins to receive a yield.

That said, James Clarke, director of private equity investments for the Kauffman Foundation, said that because mezzanine debt’s risk is “equity-like” and the return is fixed, it creates a payoff unequal to the risk. Still, Clarke agreed that investors are facing the reality that future returns on senior loans may only be 8 percent to 9 percent. “If a mezzanine fund is offering 15 percent, it looks better by comparison,” he said.

Several mezzanine lending partners acknowledged Clarke’s concernt about risk, but they countered by saying that the risk dynamics for buyouts have changed dramatically since June. Leverage ratios are more rational and deals are being structured much more conservatively, the lenders said.

In the long term, an increased use of mezzanine debt in deals could lead to a higher degree of comfort amoung dealmakers with the asset class, said Haubenstricker. Mezzanine may come to be viewed by dealmakers as a more viable financing alternative, similar to how it is perceivedin Europe.