Unitranche lenders have been trying something new, and it’s one more reason traditional mezzanine firms have been feeling competitive heat of late.
According to Ronald Kahn, a managing director in the debt advisory practice at Chicago investment bank Lincoln International LLC, unitranche lenders have been trying to become more competitive with lower-cost alternatives by tranching a loan out on the back end. While the lenders still present the loan to the borrower as a single, blended loan, the high-yield investor, perhaps a hedge fund that has promised an 11 percent return to its investors, may seek a partner to take a “first out” position in the unitranche loan, which may also involve a revolving loan as part of the overall structure.
“They tranche it out internally, and it’s not always transparent,” Kahn said. It remains to be seen if this kind of structure will catch on in the market, he added. “It’s not the easiest thing to do because there are not that many people willing to do the first-out piece.”
For mezzanine debt providers, it’s one more reason that they are finding it difficult to find desirable financing opportunities, as low interest rates provide buyout sponsors and other borrowers with a range of alternatives that they seem to be finding more attractive.
With interest rates at historic lows, income-oriented investors have been looking increasingly to higher-yield alternatives. William H. Gross, the co-founder of PIMCO, one of the world’s largest bond fund managers, has all but abandoned the security of government bonds in favor of higher-yielding corporate issues.
Still, mezzanine fundraising remains strong. Year to date, mezzanine fundraising stands at $4.4 billion, up 26.4 percent from the comparable period last year, according to data collected by Buyouts (see table). And even a year ago observers were warning of an oversupply of mezz money.
“Mezzanine is being squeezed at the high end by high-yield bonds and at the low end by unitranche and second lien,” said one market watcher, asking not to be identified by name because his firm too is in fundraising mode. But he noted that mezz finance is long-term money. “They say we just won’t invest. We’ll just be patient.”
Mezzanine lenders say that they are willing to do that. “We feel this is a pretty attractive environment, but we will maintain discipline,” said Marc Ciancimino, a director at
KKR is in the market now and has raised $575 million toward a targeted $1 billion fund,
Refinancing activity has been strong recently, Ciancimino said. “For genuinely new LBOs, the first half of the year has been pretty slow, but deal flow has picked up in the last month.”
In any case, sub debt like mezzanine is best for special situations. “To say mezzanine is getting specialized is to miss the point. It’s always been specialized,” said Ed Cerny, one of the managing partners of
Kayne Anderson Mezzanine tries to lend at interest rates of 15 percent to 16 percent to borrowers with leverage less than 3x EBITDA, and 85 percent of the lender’s investments historically have included warrants, giving the firm an equity upside in its borrowers’ success, said Cerny, who launched the lending practice for the firm along with David Petrucco, both of whom are alumni of
The fund seeks to invest $10 million to $35 million in companies with $100 million to $500 million in sales and $10 million to $50 million of EBITDA, and Cerny said the group seeks out “niche-y” deals. “They need money for something that’s really important, and we can generate a nice return for them.”
Alternatives To Mezz
In today’s environment, sponsors are able to do their deals with only a sliver of subordinated debt at all.
In the first quarter, middle market LBO deals were drawing 6.5x trailing 12-month EBITDA in leverage, according to statistics from Standard & Poor’s Leveraged Commentary and Data. Of that, equity contributed 2.4x and senior debt 3.8x, leaving subordinated debt and other contributors to the capital structure at less than a 0.3x contribution. (LCD cautioned that low deal flow in the first quarter could cause some irregularity in the statistics.)
“Nobody is going to use subordinated debt if they can get senior debt,” Lincoln International’s Kahn. Asset-backed loans are pricing these days at Libor plus 250 basis point in the mid-market, and cash flow loans at L-500 to L-700. Mezzanine, by contrast, typically carries an interest rate in the low to mid teens. As a result, borrowers are turning to other forms of subordinated debt.
For instance, middle market second liens have been growing consistently since the first quarter of 2010, according to data compiled by sister service, Thomson Reuters LPC, which tracks the loan market. By mid-May, mid-market second-lien volume had reached $430 million for the second quarter, nearly matching the $473 million total for all of the first quarter. And adding in the $777 million of volume in the pipeline, indicated volume for the current quarter would be the highest since the third quarter of 2007, before the U.S. economy fell into recession.
Second-lien financing is more appealing than mezzanine to the borrower because spreads are lower; to the lender, because it provides a secured claim against the borrower’s assets in case of default.
Another alternative that has been showing strength comes from business development companies, which are closed-end investment funds that are publicly traded on stock exchanges. Historically a source of mezzanine financing for LBOs, existing BDCs have raised more than $1.3 billion in 2010, according to data compiled by Lincoln International. Because BDCs can borrow against their equity at a 1:1 leverage ratio, that gives them nearly $2.7 billion of potential lending capacity.
Unitranche also has proven popular in the new year, whether offered by partners working in concert, such as GE Antares and Ares Capital Corp., or by single lenders offering both the senior and mezzanine pieces of the loan, as Golub Capital Inc. does through its Golub One Loan Debt Facility, which it calls “Gold.”