It’s back! All across the country signs of an improving deal market are appearing. M&A activity has increased and, along with it, purchase price multiples have risen. Senior lenders, long entrenched at limiting their senior debt to no more than 2.5x a company’s trailing 12 month cash flow, are upping their lending multiples. These senior lenders have also relaxed their restrictions on a company’s total debt by permitting greater leverage, a positive development that allows for the greater use of mezzanine capital. And equity capital continues to be plentiful and eager to invest. Unfortunately for these buyout shops, competition for deals is feverish and rates of return on equity continue to decline, often approaching the lower 20% for high quality companies.
So how is the mezzanine market faring in all this hoopla? Depends upon your funding source.
From 1999 to today, when the number of active senior lenders declined from over 100 to approximately 35, our database suggests that the number of mezzanine providers has increased from 55 to one hundred thirty five. This dramatic increase in the supply of mezzanine capital alone would signal increased pressure on returns these providers can obtain. However, many of these new mezzanine providers obtained their capital from sources that have given them a competitive edge when deploying funds.
During the last several weeks, we have seen the emergence of business development companies (“BDC”) as a new force for raising mezzanine capital. Although several public funds have existed for years, the Apollo Fund and nearly a dozen other BDCs are quickly raising billions of dollars from the public sector. This capital is flowing into the mezzanine sector, competing with traditional limited partnership funds. These BDCs will have a lower cost of capital than their limited partnership brethren and, therefore, will be able to deploy capital at a much lower cost to the issuer.
Private equity funds and other issuers are applauding the new BDCs and predict a further decline in mezzanine rates, the first opportunity they have to reverse their own eroding returns by loading up on this cheaper capital. Traditional mezzanine funds, however, are shocked at the sudden and enormous amount of money coming into the sector and wonder if it is a signal that mezzanine, as we now know it, will never be the same.
Last year, in an article that appeared in Buyouts, we discussed the new paradigm for mezzanine capital which differentiated mezzanine providers by their capital source. We suggested that the mezzanine market was actually composed of three groups: Traditional Funds, SBIC Funds, and Non-Traditional Funds.
Traditional Funds are the longstanding funds that, as their name implies, receive their capital from traditional sources such as pension funds, endowments, and insurance companies. These Traditional Funds compete with private equity funds for institutional dollars, and their success is largely driven by their returns.
SBIC Funds have proliferated in the last few years in response to the difficulties Traditional Funds have faced raising capital. By using leverage, not only have these SBIC Funds been able to succeed in raising capital when they otherwise might not be able to do so from traditional sources, their leverage gives them an overall less expensive form of capital and the opportunity to compete with Traditional Funds.
Non-Traditional Funds, on the other hand, obtain their capital from a single source such as the public market, allocations from hedge funds, or commercial banks. These sources are often allocating capital away from lower-yielding investments into the mezzanine market, and therefore, their return expectations are less than investors in a Traditional Fund. Because of these lower return needs, Non-Traditional Funds have been able to encroach on the turf of Traditional Funds by becoming the major source of mezzanine capital for buyout funds, who continually seek the cheapest cost of capital when arranging financing. The proliferation of BDCs only enhances this trend and solidifies their status as the “go to” place for mezzanine capital today.
The problem then becomes, can Traditional Funds survive? The most logical remedy is for these funds to convince their limited partners that their internal return expectations for a mezzanine fund must be lowered. Over the last several years, mezzanine capital may be less risky because of the decrease in total debt multiples and the increase in equity below them. So shouldn’t they be willing to take a lower return? If they are successful with this argument, they can begin competing with Non-Traditional Funds by again providing capital to buyout funds. However, the risk is that the returns may be too low (when benchmarked against other alternative assets) that limited partners will be forced to reallocate capital to other asset classes, making Traditional Funds less able to raise another fund. Traditional Funds can also abandon the private equity market and attempt to deploy capital with unfunded sponsors and management teams, or provide growth capital for corporations. This strategy will increase returns, but along with it comes additional risk.
Traditional Funds can also effectively compete by offering borrowers more than just capital, such as strategic advice, general business counsel, industry knowledge, and corporate finance expertise. Buyout firms learned to offer these services years ago as a means of competing, but mezzanine capital, to date, has only offered their clients money. Mezzanine capital is rapidly becoming a commodity, a downward spiral that will continue the deterioration in returns. To stop this, it is essential that these firms differentiate themselves by something more than the cost for their capital. Many mezzanine funds have amassed a plethora of knowledge and talent within their organizations that can be offered to companies. Others should consider hiring industry executives who can be offered in conjunction with growth capital, or corporate finance expertise that can be provided along with add-on acquisition funds. Regardless of the offering, mezzanine funds, particularly Traditional Funds, must provide more then just capital if they hope to survive.
The proliferation of mezzanine funds is a positive development for the middle market. Competition is always beneficial and fosters creativity and resourcefulness. However, if Traditional Funds are going to survive, they need to step up and figure out a way to compete with their new brethren.
Lincoln Partners is the second-largest investment bank headquartered in Chicago, specializing in middle-market mergers and acquisitions, private capital raising, and financial advisory services for global clients. The firm’s fundamental commitment is to complete assignments on the best terms for clients committing hands-on attention, ingenuity and significant expertise to every transaction. Lincoln Partners’ industry expertise includes aerospace/defense, consumer products, electronics, food products, general industrial and building products, and transportation equipment.