Mezzanine managers are increasingly having to compete for an invitation to private credit's transaction party.
Because mezzanine financing — the layer of capital between senior secured debt and equity — isn't cheap, industry sources said those managers are facing tougher competition from firms offering unitranche, preferred equity and other financing strategies that have lower fees or more attractive terms.
Private credit managers worldwide held a combined $236 billion of committed but unspent capital as of Dec. 31, according to London-based alternative investment research firm Preqin. Given mezzanine's historically strong returns, mezzanine managers aren't having too much trouble raising capital, accounting for about 20% of that total.
But the increased competition is forcing mezzanine managers to lower their lending rates as well as their return expectations.
"Mezzanine used to be a strong asset class," said Theodore L. Koenig, president and CEO of Chicago-based private credit manager Monroe Capital LLC. Mezzanine lending in the middle market, in particular, has been eradicated by other forms of financing, he said.
One sign of softness: Only 11% of the $107 billion in U.S. private credit funds raised last year was for mezzanine, compared with 33% in 2016, Preqin said. The research firm's analysis did note, however, that the drop in fundraising was due to fewer large mezzanine funds in the market last year than in 2016.
Meanwhile, the total amount of capital managers hope to raise through mezzanine funds now in the market dropped by 55% in the 12 months ended June 30, compared with the prior one-year period, Preqin data show.
There is so much capital flowing into private credit that "everything is being squeezed," said Ben Brandes, Boston-based national director in audit and advisory firm Grant Thornton LLP's private equity practice.
"There is more capital to be put to use than ever before by more funds, by more firms all trying to put money out," Mr. Brandes said.
Some investors remain attracted to mezzanine for the returns. Close to half, 48%, of investors surveyed by Preqin in 2017 considered mezzanine funds as offering the best risk-adjusted return of any private debt sector. Mezzanine funds have returned an annualized median net internal rate of return of 12.2% in the five years ended Sept. 30, 2016, outperforming distressed debt and private debt funds in the same period, Preqin data show.