Mezzanine at a Crossroads?

I was just about to post that article. I will very soon be pursuing a position at a "traditional" shop, whose returns have been very high this year. This article has me concerned, however, and wanted to hear from some of you. There's a particular one-stop-shop in our region, threatlevelmidnight, that seems to be raising funds like crazy; which is troublesome.

To keep this discussion going, the "one-stop-shop" leveraged finance provider I was referring to definitely dips below $10M EBITDA, and even below $5M EBITDA.

With that being said, how many similar players exist out there? Is this a serious threat to the SBICs playing in the $2M-$10M EBITDA space, or just a temporary headache?

I can see why investors would be attracted to the "traditional" shop, and SBICs, because the returns are typically pretty good; definitely higher than "one-stop-shops". However, when cheaper shit is available (unitranche), where do you think sponsors--with attractive deals--are going to turn?

Loving the discussion on this so far... any sponsors want to weigh in on the terms they're getting?

In Europe right now a Unitranche is still overall more expensive than a typical senior + mezz package, however it offers more flexibility (100% bullet financing, less covenants, etc.)

As for the OP's original question. I am at a hybrid shop that will do both "sponsor" and "traditional", though we much prefer the "traditional" route. We have definitely been squeezed out of a number of deals by unitrache shops and in some cases, just shops that are desperate to get money out of the door. Sponsor deals seem to be in the low teens (12-14%) on some of the better quality companies we've seen...which were generally sub $6mm of EBITDA.

Regards

...and yes, mezz only pricing.

Regards

Interesting article on the pressure coming at mezz lenders from senior lenders: http://www.reuters.com/article/2011/04/21/buyouts-churchill-idUSN212006… Churchill's CLOs were more broadly-syndicated loans, but with this BDC they're moving into the MM/mezz crossover space looking to invest on a senior basis.

"We believe that there exists a significant opportunity to achieve attractive risk-adjusted returns in the senior lending space due to the lack of bank financing for growing middle market companies," Churchill Financial said in the filing. "We believe that first lien senior loans represent particularly attractive investments when compared to similar loans originated in the 2006-2007 period due to what we expect to be more attractive pricing and more conservative borrowing terms and deal structures."

Another pretty interesting article from PE hub: http://www.pehub.com/107756/excerpt-sub-debt-coming-in-more-flavors/

State of the Mezzanine Market (Part Two)

"And mezz is dead?" one of our friends, who runs a top middle-market mezz fund, emailed us last week, attached to the news that cash exiting high-yield retail funds reached more than $3.4 billion – smashing an eight-year record for weekly out-flows.

Certainly the persistence and resilience of private sub debt as a source of junior capital for middle market companies over three decades is unmatched. The fragile psyches of junk investors today underscore the benefits of having long-term committed fund LPs.

But at the smaller end of the spectrum, the near-frantic rush by "one-stop" shops to offer both unitranche, stretch-senior, and second-lien alternatives to mezz has given both private equity sponsors and corporate issuers interesting alternatives to sub debt.

So why aren't top mezz investors worried? In one interview after another, the message was clear: we've been here before. As one fund manager put it, "Since I started mezz investing in 1993, we've been through three recessions, irrational exuberance, interest rates all over the map, second-lien markets surging and collapsing, banks thriving and bailed out, CLOs taking over leveraged lending, now struggling to raise funds, and high yield opening and closing dozens of times. And they say our market is dying?"

Another long-time mezz arranger agreed. "We have no problem finding opportunities, and we don't worry about technical factors. High yield can be 6%, 8%, 10%, or 12%, it doesn't affect our market one bit. We lock in the rate and are comfortable holding it."

What's also abundantly clear is that mezz has strong, established relationships with private equity sponsors. In shared histories dating back many years and hundreds of transactions, mezz offers PE two critical things: predictability and partnerships.

"There's a reason that mezz is so popular with sponsors," one sub commander said. "When the world tanked in '08, the mezz didn't take away their companies." And while some PE firms are loath to share warrants or co-invest with mezz, others see the sense, even encouraging the practice. "By being in the equity, you have alignment of interests," he explained. "Then what works for the company, works for us – and vice versa."

Not to say the one-stop pitch isn't compelling. Hot, yield-driven money is offering low-cost, senior secured options. And given how frothy auctions are, a sponsor looking for a competitive bidding edge, can negotiate one term sheet with one provider, and be done.

That works for deals where the arranger plans on holding the whole loan, a mezz veteran warns, but for larger ones, "just watch out for the flex language!"

How about inter-creditor issues? Unitranche eliminates that worry, but mezz claims it's a non-issue. "Just because you're dealing with one lender," he says, "doesn't mean you won't have problems with it in a tight spot. Some sponsors found that out the hard way."

This argument reminds us of the "manual vs. automatic" for car transmissions. Each has its advocates. Automatics dominate the US market; manuals in Europe. Which is better? Our old high-school driving instructor, John "Pops" Powers, had excellent advice. "If you drive a manual shift long enough," he told us forty years ago," it becomes automatic."

Here's Part One (these are from a Churchill newsletter):

State of the Mezzanine Market (Part One)

Beatles tribute guitarist Mark Vaccacio passed away last week, leaving three tips to a happy life: "First: Cleanliness is next to godliness," he told a NY Times reporter in April. Then, "Read, read, read, read, read." Finally, "Dress in layers."

We would only add, for those of us in the world of financing, "Don't forget mezz." Perhaps not a t-shirt-worthy slogan, but with the rise and fall of so many types of capital over the years, the consistency of the private junior capital class has been noteworthy.

In conversations with a number of practitioners of the art recently, we learned how both arrangers and issuers are adapting to the "new normal" level of competitiveness driving leverage, pricing and structures, especially for private-equity backed deals.

At first glance, there should be a lot to be worried about if you make your living supplying private junior capital. For large-cap issuers the high-yield market has been a wildly productive option, refinancing senior debt and extending maturities. For smaller companies, both second-lien and unitranche alternatives are giving sponsors non-equity linked, prepayable alternatives to mezzanine debt.

And for the small cap mezz market – issuers less than $10 million EBITDA - the challenge is finding pure senior cash flow providers to go along with the mezz. Most banks and finance companies just won't go that far down the food chain.

Which at the lower end of the market leaves a capital hole, says a veteran of the mezz space. "We're seeing minor league players stepping up with unitranche structures to compete against mezz. The one-stops are providing a perfect product for that market."

Another mezz pro agreed. Sure there are unitranche and second lien alternatives, she told us, but the real issue is the quantity and quality of deal flow. Private equity has been focused mostly on repricings and refinancings. With fewer new properties for sale, supply/demand takes over as sponsors work frantically to deploy uncommitted cash.

A third mezz partner confided attending a recent auction for a $100 million deal. Bidders (in what he said was a typical mix these days) were a dozen private equity bidders, each bringing eight to ten debt providers. Those included three or four senior debt players, three or four mezz, and at least one or two unitranche funds. "It's a very crowded field," he concluded. "When there's no deal flow, all sorts of people come out of the woodwork."

Yet digging further, we found mezz is playing a very active role in financing the growth of middle market businesses. And it's not just the classic benefits of this class of "patient" capital – no amortization, looser covenants, and ease of negotiating with one party.

Next week, we'll explore how top mezzanine debt arrangers are successfully competing against the "one-stops" by leveraging long-term working partnerships with their private equity clients to provide "win-win" solutions.

Many thanks for sharing this.

Thanks for the articles guys, good shit

Sorry it rolled off the front page and I don't have the archive subscription.

Related, Golub is really pushing it's GOLD ("Golub Capital's One-Loan Debt Financings") structure, which is a good example of the unitranche debt that was talked about above. http://www.golubcapital.com/transaction.shtml

Looking at their portfolio investments, it seems like half their deals are unitranche (at least the ones they put on the website) http://www.golubcapital.com/portfolio.shtml

And another article: Anatomy of a Mid-Market Lender from The Deal Magazine http://www.golubcapital.com/downloads/the-deal-article-anatomy-of-a-mid…

State of the Mezzanine Market (Part Three)

More than competition from alternative capital sources such as unitranche or second lien, what's affecting mezzanine debt arrangers today is a combination of technical factors. "There's no deal flow and no yield," bemoans one player. "If Libor rises, that would help. And more deals would mean more slots for everybody."

For mezz investors accustomed to being part of larger club deals, these technical factors have turned this year into a slog. "It's tough to get scraps from the big guys," one long-time pilot fish remarked. "They're so hungry for paper, they're holding on to every dollar." Of course for a mid-sized fund, say $300-500 million, deal flow is relative. "I only need to do six deals a year, and my LPs are happy," a first-tier manager boasts. "Who cares how many unitranche and second liens are getting done? For me, that's irrelevant."

So what are "market" structures and pricing for mezz? Junior sub debt has historically provided one to one-and-a-half turns of Ebitda above the senior secured tranche. Because of its higher costs of capital, issuers are keeping that ratio pretty close today.

For total leverage, arrangers say, you need the right capital structure going in. Having been through the credit crunch with their portfolio companies, mezz is trying to keep that number below five times. Perhaps a tad higher for the larger, more defensive mid-caps.

Pricing-wise, the cash portion of mezz interest has been 12% since the Truman Administration, but the PIK piece now varies from 1% to 4%, again depending on the credit. Upfront fees have been pretty steady around 2%.

Call protection? That's a key return consideration for sub investors – and a bête noire for sponsors. "I'll be aggressive with pricing at the front-end," one mezz vet tells us, "if I know my asset is sticky." The call premium bid/ask is 105 (year one), 104, and so on – at the issuer-friendly end of the spectrum – with two years non-call at the other end. A typical deal might be a one year non-call followed by 103, 102 in years two and three.

Who are the active pure-play mezz players? Setting aside Goldman with its $15 billion fund, those who have raised money this year include AEA, Audax, Crescent Capital, Kayne Anderson, Morgan Stanley (see Churchill Spotlight, 3/28/11), Oaktree, and Yukon. Other long-time mid-cap arrangers are Arrowhead, Garmark, Golub, LBC, Norwest, and PNC.

For smaller deal sizes, firms such as Maranon and Praesidian distinguish themselves by being able to provide both one-stop and sub debt alternatives.

Throw in the expansion of the SBIC program, which is minting mezz availability, and public funds like Fifth Street, Medallion, and Triangle, and you've got plenty of junior sub capacity at the lower-end of the middle market. Does that bother our six-deal-per-year mezz manager? "Those guys will be chasing the same $2 million Ebitda company in Cleveland," he scoffs. "You know what? Let ‘em."

anyone know the size of the mezz funds of the aforementioned players? "Audax, Crescent Capital, Kayne Anderson, Morgan Stanley (see Churchill Spotlight, 3/28/11), Oaktree, and Yukon"

State of the Mezzanine Market (Part Four)

We ran into an old friend last week at the Buyouts conference in Chicago. He runs his own middle market mezzanine investment firm, so we were particularly interested in his reaction to our continuing series on the state of the junior capital universe.

"You're spot on," he told us. "But you need to highlight how not all issuers are created equal. First, terms depend on issuer size. We began at the higher end when we started our fund in 2004. But when pricing tightened we gravitated to smaller companies. Then the credit crisis shook out the competition, and we went back up-market. Now things are getting toppy again, but we don't want to abandon our larger sponsor clients."

He went on. "Then it's sector-specific. In 2009 only good performing non-cyclicals came to market. For those lucky few, capital providers offered relatively high leverage and low pricing. This year, we're seeing companies that showed poor results coming out of the recession, but bounced back big in 2010. They got less leverage than the previous set, but competition amongst lenders for deals has narrowed the gap."

"It'll be interesting to see what happens to the emerging vintage," he concluded. "Those are the ones that suffered in 2009 and had a partial rebound in 2010. Maybe they fully come back by end of 2011 or 2012. What will leverage and pricing be for those issuers?"

One party particularly interested in the answer to that question is the private equity sponsor. As purchase price multiples have spiked, PE returns have fallen to the high-teens. That has implications for the entire capital structure of their portfolio companies.

"It's all about relative returns," another mezzer said. "GPs are telling me, 'Hey, your risk-free rates are zero right now. Your pricing needs to be lower.' Of course, their returns are being squeezed. They don't want the debt earning 16% when their only pulling 17%."

Which explains PE's current infatuation with unitranche options. And it's not only lower cost. "Let's face it," one mezz pro said, "middle market companies have hiccups. When that happens, they'd rather deal with one class of lenders than two. Mezz can loan-to-own if they have to, and some sponsors worry about that possible outcome."

We asked one client, the managing partner of a leading middle market PE fund, to give us his perspective on where mezzanine capital fits into his firm's financing strategies.

"Getting financing isn't hard," he told us. "But that's not translating to smaller equity checks! We're busier now than we were last December when we sold four businesses."

"We learned from the recession. We're much more prudent about structures and leverage. That philosophy leads us to mezz. You need lenders who can stretch. The problem with unitranche is they can only stretch so far. And if one lender has taken down the whole loan that leaves them with a ton of exposure."

The partner summed up. "If we have a challenging piece of the capital structure to fill, that's where we've successfully employed mezz. It's a good alignment of interests and duration. And we've never had a problem with any mezz investor.

"Of course," he added, laughing, "we've also never given them a problem!"

State of the Mezzanine Market (Last of a Series)

Mezzanine capital is equity dressed up as debt, and vice versa. In good times it offers investors tidy double-digit returns. In a crunch, cash interest payments can go dormant, providing issuer and private equity sponsor a cushion until profitability returns.

That yin-yang relationship is reflected in fundraising cycles. As our Chart of the Week shows, new mezz money tracked new PE money in both the build up to, and the aftermath of, the market top. But in 2005, as PE blossomed, mezz fundraising tailed off.

2011 is looking more like another peak than a slope. Recent data from Dow Jones LP Source shows US private equity raising almost $65 billion through June 30, a 35% increase over the same period last year. Buyout funds drove most of that performance. Mezzanine funds, however, raised only $2 billion so far this year, down 56% from 2010.

This squares with anecdotal evidence. "In this environment, every fundraising is tough," one mezz chief told us. "That's especially true for small higher beta funds chasing $5 million LP tickets. It's much easier going after large pension funds and endowments."

We called one LP for his perspective. "There's clearly money for mezz," was the response. "The overall numbers may be down, but a ton of money has been raised in the past eighteen months. It's just concentrated with a few favored, established GPs."

So are there still compelling reasons to invest in mezz? "Absolutely," the manager said. "Every LP is faced with J-Curve issues. I'm not waiting for five years to get current returns. With mezz I can get them immediately."

Those economics attract private equity GPs as well. TA Associates, for example, is well-known as a sponsor with its own captive mezz fund. The firm recognizes the virtues of investing mezz alongside equity, enhancing returns with a cash and PIK pay component.

Indeed, PE appetite for sub debt competes with third-party providers. "If we like the asset," one PE partner with a similar mezz appetite explained, "why hand over the returns? We might as well benefit from the whole capital structure."

Having both mezz and equity in the same hands also gives comfort to senior debt providers. "When the sponsor also owns the mezz, we'll stretch leverage a bit," the head of a middle market finance shop confirmed. "If it's coming from the same LP pool, a GP treats a loss of mezz dollars equal to a loss of equity. So we assume it's all equity."

PE firms such as Audax and AEA are active mezz investors, but through separate funds. That often limits the mezz to minority positions in deals where their equity counterparts are majority owners.

So how to sum up this unique asset class? One manager put it neatly. "Mezz isn't a panacea and it's not for every company. But trusted providers will continue to play a role in the middle market that syndicated capital can never hope to fill. And when rates rise to more historic averages, you'll see less allure of all the floating rate alternatives."

In the meantime, we suspect there will be plenty of sharp elbows. "You mean is it competitive?" asked one long-time friend in the space. "Uh, yeah," he retorted drily. "Show me a business that isn't, and I won't want to be in it."

Interesting article on hedge funds in the direct/middle-market lending space (Oaktree is the key player): http://dealbook.nytimes.com/2011/08/09/hazards-of-borrowing-money-from-…

Hi guys, a couple questions...I have been reading up a bit on mezzanine debt, but I'm still just learning the basics

1. I'm having trouble understanding why a PE fund needs a mezzanine debt fund? In some of the articles I have read they talk abotu a gap between equity and debt provided by the PE fund (and thats where mezzanaine comes in). Why can't the PE fund just finance everything with regular debt except the equity portion?

2. What are unitranche loans and second liens?

3. If I am interested in this type of finance where can I get more info and what areas should I look into to after college?