Leveraged loans - Mezzanine debt re-emerges as senior lenders turn more cautious

Mezzanine financing is making a comeback.

In recent years private credit lenders, which have been gobbling up leveraged loan market share, have focused on other types of financing, like unitranche deals, which combined senior and junior debt into a single loan.

But as interest rates have risen and lending conditions have tightened, mezz financing, which is situated in a company’s capital structure between senior debt and common equity, has found new life. Recent turmoil at regional banks may further open up investment opportunities for mezzanine lenders.

Fundraising in the segment has followed the growing demand. Last year, private credit managers raised billions of dollars of dry powder for mezzanine financing.

A total of $30.1 billion was raised by global mezzanine funds in 2022, almost double that of 2021, and the most since 2016, according to PitchBook data.

Capital raised by mezzanine funds accounted for 16% of the total raised across all private debt strategies last year, surpassing distressed debt as the second most popular private debt sub-strategy, behind only direct lending.
A number of mega-funds have reached final closing in the last year, topped by Goldman Sachs’ $15.2 billion fund, West Street Mezzanine Fund VIII, which focuses on originating second-lien and junior debt to large-cap companies backed by private equity firms in non-cyclical sectors. UK-based credit specialist Intermediate Capital Group also closed a sizable fund targeting mezzanine financing last year.

The growing heap of dry powder comes alongside the rise in demand for mezzanine financing from private equity firms and their portfolio companies as other parts of the credit world — from the syndicated loan market to direct lenders — have become more risk-averse.

Why mezz, why now?

Junior capital, which includes mezzanine financing, can range from second-lien loans to holding-company level PIK (payment in-kind) notes to preferred equity. Mezzanine capital has uses for both performing and stressed companies.

There are several factors currently driving demand.

Shrinking access to senior debt and unitranche loans is one. Many first-lien loans in recent years have been governed by MFN or “most favored nation” clauses that prevent new debt from being issued at more attractive levels than existing lenders receive. An MFN clause could make it impossible for a borrower to bring in new senior debt without repricing an entire first-lien facility, an unattractive prospect at this time, as interest rates are significantly higher today. (The chart below details broadly syndicated leveraged loan yields and spreads.)
A mezzanine loan would be useful when a delayed draw facility (DDTL) is tapped out.

Although a DDTL is possible to obtain today, companies are more easily able to place DDTLs in strong market conditions, enabling them to borrow at the same level as the original first-lien loan. These are useful for private equity firms seeking buy-and-build strategies, so they know a credit facility is at the ready, at a known interest rate, for an acquisition.

Another reason for mezzanine’s popularity now is that mezzanine lenders are more willing to allow PIK interest. They are also willing to provide a larger PIK component, such as financing with 8% cash interest and 6% PIK. That is a useful feature as companies face inflation and higher borrowing costs and need to save cash.

“Mezzanine debt has become more popular in liquidity constrained environments,” said Christina Lee, who is assistant portfolio manager for Oaktree’s US Private Debt strategy. “Mezzanine is more viable in a rising interest rate environment.”

“Firms are probably deploying mezzanine capital faster because there’s a large opportunity set,” Lee said.

A typical mezzanine loan for a performing company that closes now would likely yield 12.5-14%, with a three-point original-issue discount and up to 6% PIK. In the first half of 2022, when credit markets generally were stronger, it would likely yield 10.5-12%, with a two-point OID, and zero to 2% PIK.

Mezzanine debt generally includes covenants. Language surrounding debt incurrence has tightened in the current market, with borrowers able to add potentially a half-turn of leverage, moving to 5.5x from 5x, vs. a full turn of leverage previously, to 6x from 5x.

“There’s a lot of interest in how to avoid dragging the entire facility up because of the incremental needs of the company,” said White & Case partner Vincenzo Lucibello. “People are also looking at it again for special-situations uses. Firms are adding it because it provides a differentiating service for private equity sponsors.”

Mezzanine debt allows for an increase in leverage in a buyout or M&A transaction without more senior debt.

“Leverage levels for traditional first-lien type senior debt securities have moderated considerably, but valuations for best in-class properties have not moderated to the same degree for the PE firms buying those companies, which has created larger middle-of-the-balance-sheet opportunities,” said Jason Strife, who heads Churchill Asset Management’s private equity and junior capital platform.

In January, Churchill closed a $737 million fund dedicated to providing junior capital solutions to PE-backed companies in the middle market.

“It is a good time to have activated a new pool of capital investing in this asset class,” Strife said.

Mezz loans mushroom

There have been a host of mezzanine credits put to use this year.

·      Dairy distributor Worldwide Produce completed a $180 million credit that included a mezzanine debt component. The financing comprises a term loan, delayed-draw term loan and revolver. Pricing is Sofr+625 (1% floor), with an OID of 97, market sources said. Leverage is 5x total, including mezzanine debt, and 4x through the senior debt, market sources added. Mezzanine debt was sourced from outside the senior lender group. Senior debt financing was provided by Ares Management Credit Funds, NXT Capital, Kayne Anderson Private Credit, Manulife Investment Management, PNC Erieview Capital, Yukon Partners and BMO. Proceeds backed a recapitalization of the company by private equity firm Ridgemont Equity Partners. EBITDA is roughly $30 million for the borrower, market sources said.

·      Viking Fence received junior capital backing a buyout of the company by private equity firm Crossplane Capital. Yukon Partners provided the investment.

·      The Yandell Family of Companies obtained debt financing supporting an investment in the company from private equity firm Fort Point Capital. Live Oak Bank and NorthCoast Mezzanine provided debt financing.

·      Prince Industries received financing to support the company’s acquisition of Precision Shapes Inc. Wintrust Financial Corp. provided debt financing backing the transaction, and Midwest Mezzanine Funds provided subordinated debt and equity.

Mezz deals are not without risk, of course. Mezzanine deals are typically structured to be sensitive to financial metrics to protect lenders on the downside. Earlier this month, FS KKR Capital Corp. reduced exposure to a mezzanine investment in online real estate platform Opendoor Technologies Inc., which uses software and analytics to price and buy homes, as the housing market cools.

In October 2021, FS KKR led $2.2 billion in asset-backed mezzanine term debt facilities for the borrower, which more than doubled the borrowing capacity of Opendoor’s subsidiaries. As of Dec. 31, the structured mezzanine investment to Opendoor was $71.1 million. Interest is 10%. Maturity was April 2026. A quarter earlier, the holding was $106.6 million principal.

The reduction was due to cancellations and debt repayments at par plus repayment premiums of the Opendoor mezzanine facility.