Mezzanine Madness: Competition Grows Despite Diminishing Returns –

Perhaps the only group within private equity facing more competition than private equity sponsors right now are the mezzanine providers. Between the existing players, new entrants, high yield providers and BDCs, as well as the boom in second lien loans, the mezzanine sector has become a challenging place to do business. But despite shrinking yields and a growing number of alternatives to mezzanine, more and more firms are getting into the mezz game.

Just ask Ron Kahn, a managing director at Lincoln Partners, about the competition in the mezz market and he rattles off at least 10 new market entrants. “There’s no end to it,” he says. “The money just continues to pour in.”

Just last week, MFC Capital Funding, which is backed by the Polad family in Minneapolis, dove into the market. Other new entrants include North Fork Business Capital; Freeport Financial, which is funded by the Stark hedge fund; and Citicorp, which after 10 years away from this business wants to get back into asset based lending. A less recent but still significant newcomer this year was Goldman Sachs Specialty Lending. And with more banks focusing on the middle market, private equity pros expect the trend to continue.

Not surprisingly, this phenomenon is taking its toll on mezzanine providers, despite the overall increase in LBO volume. Mike Hermsen, a managing director with David L. Babson & Co., a Mass Mutual subsidiary, admits that while his firm is extremely busy, it is less productive now. “We are looking at a lot of things with multiple sponsors. This is a different market than it was two years ago. Private equity firms used to be able to win one out of four deals they looked at. Now it’s more like one in 10 deals,” he says. “In this environment we are even with pace from last year. We’ve done about seven deals done for about $100 million in commitments.”

Lawrence Golub, founder of Golub Capital, which just closed an $800 million fund, says his firm is losing deals to hedge funds. “Sponsors are making a decision when they select a lender, and sometimes that decision is a trade-off between the current pricing hedge funds offer and the future flexibility of working as a junior lender. We provide second-lien debt, our price is competitive, but on a regular basis we will lose a deal to a hedge fund who is willing to provide higher leverage than we think is appropriate,” says Golub.

Second Liens

But the bigger problem-and a more frequent complaint from mezz providers-is the increasing popularity of the second lien loan. “In 2000, we only had to offer senior debt and mezz to our clients-there was nothing in between. But then the second lien came along in 2002,” says Kahn.

In 2003, there was about $3 billion in the second lien market, while last year there was about $12 billion in the arena. This year that number is expected to skyrocket to $20 billion. “The second lien market is buying everything up,” says Jeff Dickson, a managing principal with Prudential Capital Partners, which just closed its second mezzanine fund, Prudential Capital Partners LP II, at $775 million. “This competitive pressure is driving the price of mezz down, and you are seeing IRRs come down to 14 percent.”

The second lien market didn’t exist five years ago in large part because senior lenders didn’t like the idea of another institution with their hands out right behind them. The feeling was, if we, the bank, have to foreclose, then the junior lender would want a piece of the pie no matter how small. That whole notion started to change, however, as unregulated banks came into the market and made regulated banks the minority providers of junior debt. Once the new crop of mezz providers sprouted, it made it that much easier for other entrants like hedge funds to find a foothold. The second lien’s benefit is lower pricing-just 12% rather than 14 percent.

“All this new capital is allowing for high leverage ratios of 5x EBITDA and the equity sponsors are enjoying terrific liquidity, but what happens when there’s a default?” says Dickson.

Furthermore, Stephen Boyko, co-head of the mezzanine group at Proskauer Rose LLP, says he has seen leverage ratios soar as high as 7x for the first time. “We are seeing a lot more variety in the mezz product. When you combine all of these things going on it’s no wonder we are seeing tremendous activity,” he says.

Is it Worth It?

While non-traditional entrants are definitely giving mezz a run for its money, it’s certainly not without its downside. Critics say it may put private equity firms that use the financing at risk down the road. The debt is almost certainly priced better, but there’s no protection if a portfolio company has cash flow problems and there’s no real room for a relationship with a hedge fund or a second lien provider, which could hurt in the long term.

“The problem with the second lien is that private equity firms are liening up all the assets now so if a portfolio company got into a bind and needed working capital there would be no excess collateral to attract new lenders,” says Dickson. “The second problem is that payments can’t be blocked. In the mezz market we give a secured note and agree that if there is a default we will wait to collect our money. With a second lien the senior lender can’t stop the company from paying the junior debt. There’s no blocking provision, so companies need to make interest payments even if they are in default with the senior bank.”

Another valid problem is lack of relationship with a non traditional lender. “Hedge funds will prove out to be a good or bad idea on a deal by deal basis. Without question there are going to be some good companies that blow up because of lack of aligned interest. If there’s a cash flow problem with a company, subordinated lenders are going to react, which will hurt the sponsor and the senior lender,” says Golub. “If a sponsor is working with a traditional lender when there is a problem they will be able to work with lenders. With hedge fund money, will the sponsor even know who is holding the debt or will 30 people on the public market own it already?”

Despite all the criticism, there are pros who think these new forms of financing are here to stay and are worth using. David Rubenstein, a co-founder of The Carlyle Group said recently, “Hedge funds are getting into the private equity space. And they have a number of advantages, including the fact that they can move more quickly because they don’t have to secure debt for each transaction. Ultimately, what you’re going to see in 10 years is not private equity funds and not hedge funds, but alternative investment funds, which will give investors the best features of private equity funds and the best features of hedge funds. The general partners who manage them will have a lot more flexibility than they might have today.”

Others say they don’t care who provides the debt just as long as it’s creative. “Many of our clients do not have readily identifiable access to capital. So although we look for institutions that can provide us with a quick yes or no, it is more important to find institutions that can work with us to identify an innovative structure. This presupposes that the institution will be flexible, regardless of whether it’s a senior lender, a hedge fund or a mezz lender,” says Robert Smith, managing director with, SSG Capital Advisors.

While some private equity firms have used a non-traditional debt provider because it’s an easy way to get a company financed quickly, other firms plan to stick with what they know. “The benefits of a high yield offering include a lower cost of capital as well as the fact that they are typically callable with no pre-payment penalties. The negatives include a highly structured, non-negotiated, limited customization instrument that is more canned’ in nature and where it is also hard to amend terms and conditions after the fact,” says Mark Jones, a partner with River Associates. “We preferthe consistent and relationship oriented perspective of a flexible mezzanine source. As with the emergence of hedge funds as a source of capital and Canadian Income Trusts as a source of liquidity, we don’t know if the presence of high-yield financings is here to stay. I suppose the question will ultimately be if there will continue to be an ample supply of this capital, even in a rising interest rate environment.”

Indeed, most market pros expect these alternative financing providers to eventually fall out of popularity, in part because of rising rates. Many believe that when that day comes, some private equity firms are going to be in hot water.

“The second lien market and straight coupon money will start to go away when conditions start to deteriorate,” says Hermsen. “People go away very quickly when market conditions tighten. I am not sure when it will happen, but it will happen.”

Prudential’s Dickson agrees that it’s only a matter of time before hedge funds move on to the next thing. “This capital is fleeting. When you need some savvy, patient capital they are going to find that hedge funds aren’t going to do the trick. It’s tempting to go with the lowest price, but easy money isn’t always the best answer,” says Dickson. “Eventually it could mean a whole write-off if a hedge fund insists on getting paid and a portfolio company has to file for bankruptcy.”

Until Then, Head Out Of Town

Because of the competitive nature in the U.S., some firms have decided to look outside the U.S. for places to invest. American Capital Strategies just opened an office in London as did Babson, which bought Duke Street Capital Debt Management, an investor in the European leverage loan market. Duke has more than E1.5 billion in assets under management.

“There is definitely a movement to Europe. Our institutional investors see value there and would like to see us allocate some funds to the European mezz market. There aren’t that many people active there,” says Hermsen.

Darby Investments Overseas, as its name suggests, has always focused on mezz opportunities outside the U.S., has a $175 million fund focused on Latin America and a $246 million fund focused on Asia in additional to raising a Central and Eastern European fund.

“I certainly wouldn’t characterize mezz investing in other countries as easy, but it’s better than it was a year ago. And it’s radically different than the U.S. where you have a tremendous amount of money raised in the last few years. It’s too crowded,” says Robert Graffam, a managing director with Darby. “We’re practically in these areas by ourselves.”

Boyko says his firm has also seen more activity in Europe these days. “Mezz in Europe is bigger than it’s ever been, there aren’t as many funky issues there like you have here. Additionally, we have a lot of clients talking to use about Asia. They are looking at it as the next place to be.”

Despite the all the players in this market right now expect to see new entrants. Kahn says, “People are still coming in to play because the markets are great and everyone is buying and selling and it’s great to be right in the middle of that.”