Mezzanine managers losing places at table

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.

$49.8 billion in dry powder

Altogether, mezzanine managers had $49.8 billion in dry powder as of Feb. 14, including $36.6 billion in North American mezzanine funds alone, Preqin said.

Crescent Capital Group LP has more than $3 billion in dry powder to invest in mezzanine. ​

"Every so often the credit markets get very aggressive, and everyone tells us mezzanine is dead," said Jean-Marc Chapus, Los Angeles-based co-founder and managing partner of Crescent Capital. "The credit markets today are very, very aggressive. But they have been in the past, and we continue to deploy capital successfully. This time may be different, but our experience tells us selectivity will be key."

The competition in the market has pushed mezzanine managers to adjust. Indeed, some new entrants might exit the credit market, he said.

"We are very flexible and have adapted to the changes in the mezzanine market," Mr. Chapus said. As interest rates charged by the mezzanine lender have moved down, "our pricing moved to the low end of our range, but we have not gone through our historic range," he said.

Dropping rates does mean managers and their investors will have to adjust their return expectations, industry sources said.

"We've seen some compression in pricing in the last 12 to 18 months," said Christopher G. Wright, a Los Angeles-based managing partner at Crescent focused on mezzanine investments. "At the same time, we've moved investments from fixed to floating rate, and we've seen an uptick of LIBOR that has helped a bit. However, we are at the lower end of our return expectation."

There is still demand for mezzanine debt in very large transactions. But in the middle market, mezzanine is being pushed out of deals, Mr. Koenig said. In the past, a typical deal financing had a combination of the majority senior debt, mezzanine and equity. These days, some private equity and other buyers are financing transactions with senior debt and equity — leaving no room for mezzanine, which can be higher cost, Mr. Koenig explained.

Crescent Capital aims for upper-middle-market companies with $75 million to $100 million in earnings before interest, taxes, depreciation and amortization. KKR & Co. LP also is aiming to provide credit for larger companies.

Middle market or smaller

Still, all but one of the mezzanine funds now in the market aim to invest in middle-market and smaller companies. The outlier is Goldman Sachs' GS Mezzanine Partners VII, which has a $10 billion fundraising target and has had a first close, according to Preqin. The Goldman fund plans to invest in companies with $500 million to more than $5 billion of enterprise value.

The two next largest funds being raised are both targeting about $1 billion each: China-based CDH Investments' CDH Mezzanine RMB Fund V and Blue Like an Orange Sustainable Capital's BlueOrange Capital Impact Fund.

Crescent's Mr. Wright said Crescent invested $1 billion of its latest fund, the $4.6 billion Crescent Mezzanine Partners VII, in January 2017. "That's a significant amount," he said.

However, he acknowledged the investment pace was slower than for past funds. "Last year our deal flow was consistent with past years; we reviewed between 275 and 300 deals. But the hit rate of transactions closed was lower than in past years because of quality and pricing dynamic," Mr. Wright said.

A relatively new and growing financing option, unitranche, which combines senior and subordinated debt, is also eliminating the need for mezzanine in middle-market deals, Monroe Capital's Mr. Koenig said.

Unitranche financing got its start among companies with about $25 million in earnings before interest, taxes, depreciation and amortization, and has since moved to larger companies of $40 million to $50 million in EBITDA, Crescent's Mr. Wright explained. Crescent invests in somewhat larger companies and does not compete with unitranche, he said.

"In the lower middle market, unitranche has become a lot more problematic" for mezzanine managers, Mr. Wright said.

Many borrowers also are turning to preferred equity over mezzanine, even though preferred equity is more expensive to the borrower, Grant Thornton's Mr. Brandes said. Preferred equity has the edge because many preferred equity managers now are issuing evergreen securities that have no mandatory redemption date. By contrast, mezzanine debt generally matures in three years to five years, he said.

This type of flexibility is important to a borrower who does not want to have to pay off a loan during a downturn.

Credit managers, especially those with junior credit funds, can compete only by providing borrowers flexibility, Mr. Brandes said. "It's a unique situation because of the competition," he added.

Middle market credit manager Comvest Credit Partners, for example, closed its fourth fund on Jan. 29 with $836 million, exceeding its $650 million target. The firm not only offers mezzanine but also senior secured, unitranche and second lien debt. "It's a great time to be a seller" of a company, Mr. Brandes said.

'Blank check term sheet'

In some cases, private equity firms are approaching target companies with a so-called "blank check term sheet" giving the seller maximum control over financing of the deal, he said.

The way a transaction is financed affects the valuation of the deal, with preferred equity offering lower valuation and junior capital such as mezzanine offering the highest possible valuation, Mr. Brandes said.

Today, direct lending funds, which raised a combined $54.4 billion in 2017, Preqin data show, the most of any private credit strategy, are filling in much of the financing needs once provided by mezzanine. Indeed, funds created to lend directly (as opposed to investing in distressed or special situations, or mezzanine debt) raised 51% of all private credit capital in 2017, up 25% from the year before, according to McKinsey & Co.'s global private markets review released Feb. 14.

"The private credit market has become more competitive for all capital providers in recent years,'' said Lee Landrum, Santa Monica, Calif.-based managing partner at middle market credit manager Tennenbaum Capital Partners LLC. "As a result, investment opportunities for mezzanine are more competitive today because the market for senior secured lending has expanded aggressively, but mezzanine certainly has a place in the market."