As the fourth quarter began, McGuireWoods LLP mezzanine finance and junior capital attorneys from across the nation talked about trends that have emerged in mezzanine finance in 2014. Below is a brief summary of that discussion.
Mezzanine funds raised over $25 billion of new capital over the last two years; however, deploying that capital has been challenging in a competitive environment characterized by encroachment from alternative capital sources. Unitranche lending, where senior and junior priority debt provided by a consortium of first and last-out lenders is combined into a single credit product, has continued to gain popularity, reducing demand for separate mezzanine debt. Second lien lending has also taken on new life in the middle market, fueled by business development companies (BDCs) and substantial capital flows into new CLOs. Pressure on sponsors to deploy capital in a low-volume market has, in some instances, prompted larger equity checks, reducing or displacing mezzanine debt in the capital structure. In the lower end of the middle market, the demand for mezzanine debt has fared better. Small Business Investment Companies (SBICs), in this market segment, are also able to compete more effectively with BDCs due to similar costs of capital. In fact, through the third quarter SBICs have put $5.4 billion to work, a 56% increase year-over-year. Despite a competitive landscape, recent acceleration in M&A activity suggests an optimistic outlook for the fourth quarter.
Increased competition and the low-rate macroeconomic environment led to continued pricing declines this year, although pricing appears to have stabilized for the time being. Rates are trending between 12% and 15%, but some large sponsored deals have dipped as low as 9% to 10%, when accompanied by a true second lien position. Within the lower middle market, in non-sponsored transactions involving high-leverage or storied credits, warrants remain somewhat (although increasingly less) common. Warrant coverage in this market is otherwise rare. While co-investment strips in the range of 5% to 20% are fought for and commonly made available along with mezzanine debt investments, many long-time mezzanine investors are accepting straight-rate deals for the first time since before the Great Recession. Prepayment triggers and carve-outs continue to be highly negotiated and transaction-specific. The associated prepayment premiums have coalesced around the traditional 3%, 2% and 1%, with no-call options being rare. Mezzanine debt secured by a second lien has seemingly become the norm, with the fulcrum issue being whether it will be a silent second lien to merely fend off trade creditors or enjoy greater traditional lienholder rights vis-à-vis the senior lender.
Mezzanine funds are stretching in new directions. Some traditional mezzanine funds are now moving to provide growth capital to early-stage and growth-oriented companies. In these transactions, debt is issued along with a significant equity stake in the borrower. These borrowers are typically high growth, but have limited or no EBITDA, resulting in more risk but potentially greater returns for the investor. Some mezzanine funds are also moving further down the capital structure in companies that fit the more traditional target profile, in some cases even taking equity control positions. This appears particularly common among SBIC funds, as a historically low cost of capital through SBA debentures (and the resultant reduced pressure for current yield) is allowing for increased flexibility and "mezzequity" strategies. On the other end of the spectrum, some mezzanine funds have moved to provide a solo "unitranche" or high-coupon senior debt-like product to riskier borrowers, where a traditional senior lender does not have the appetite for the risk or regulatory approval for the leverage profile of the credit. Bottom line — while mezzanine funds continue to provide their traditional offerings, they are also quickly evolving to find new ways to deploy capital and achieve target returns in today’s market.