Mezzanine finance has never gone away completely but is now experiencing a strong revival. Steven Ruby and Rahman Vahabzadeh of Audax Private Debt explain why.
Private Debt Investor
By Steven Ruby and Rahman Vahabzadeh, Co-Heads of Originated Debt
The observation that everything old is new again, ironically, never seems to get old. This is particularly true in 2023, as vinyl records again outsell CDs and acid-wash jeans plot their own unlikely comeback. Heightened interest in mezzanine financing similarly suggests sponsors have a desire to turn back the clock.
A few significant differences distinguish the gravitation to mezzanine debt from other fashion trends. The surge in interest is an outgrowth of more fundamental drivers, ranging from escalating interest rates to the ongoing retrenchment of “traditional” bank lenders. Also, while vinyl records have been collecting dust, mezzanine financing never went away.
Even in benign environments, mezzanine debt holds unique appeal, with attributes that senior-only facilities don’t provide. What has changed amid the economic uncertainty is that these factors are magnified. Mezzanine, today, is being used by sponsors not just for new platform financing arrangements but also portfolio company expansion, when sponsors need to fund M&A but are reluctant to reprice existing credit facilities at today’s higher rates.
Integral supporting role
While this corner of the market may have been overshadowed by the rapid ascent of unitranche structures over the past 10 years, mezzanine financing still makes up a significant proportion of the entire private debt universe, more than 15 percent by some estimates.
But to fully appreciate the pick-up in the mezzanine market, it helps to understand the factors influencing other areas of debt financing. Banks and other senior debt lenders have reduced their risk appetite and pulled back on their commitment sizes. This has translated into widening spreads for unitranche loans and LBO leverage levels generally trending lower.
The increase in the cost of capital for floating-rate debt is also driving weaker fixed-charge coverage and interest coverage ratios. This, coupled with a slower fundraising market and fewer repayments – due to an acute drop-off in change-of-control transactions – is making traditional senior and unitranche lenders more discriminating in the credits they back and more conservative in the amount of debt they will provide.
Paradoxically, the shifting landscape has had little influence on purchase price multiples – at least not for the deals getting done. A flight to quality coupled with a dearth of dealflow means that valuations for businesses with strong growth prospects remain elevated. Adequate leverage, thus, is required to finance new platform acquisitions, and mezzanine debt has helped fill this gap.
The role of mezzanine within the capital structure isn’t always obvious from the outside looking in. Even as all-senior financing structures and unitranche facilities have become more common, mezzanine remains critical within the capital structures of sponsor-backed companies. For instance, despite the appearance of one legal document, some historical unitranche facilities were, at times, carved up into first-out/last-out positions via a separate lender agreement. More recently, mezzanine funds have generally had flexibility to invest in traditional unsecured notes, second lien loans, holdco PIK notes, and preferred and common equity.
The demand for mezzanine today, from borrowers as well as other lenders, is fuelled by the flexibility this form of financing provides. Borrowers can attach mezzanine facilities behind various senior debt levels and ultimately utilise more leverage than all-senior deals. In an uncertain rate environment, the fixed-rate options of mezzanine structures provide an interest-rate hedge, instilling more certainty for borrowers in a dynamic and evolving market.
Moreover, the blended all-in cost of capital can often be lower for senior/junior hybrid structures in which the company or sponsor is pursuing an acquisition strategy and lower-priced senior debt can be used incrementally to finance add-ons.
Two factors in particular underscore the heightened appeal of mezzanine financing today – the partial PIK rate that can lower the overall cash interest burden for borrowers, and the fact that mezzanine tranches can be issued alongside existing senior credit facilities without triggering “most favored nations” clauses, whereby pricing on existing senior-secured facilities is reset to current, higher, market rates. This is an important consideration in a market in which spreads and upfront fees have widened significantly, making MFN clauses costly to borrowers, to the point that certain add-ons would not make economic sense if sponsors were forced to reprice their entire credit facility.
In a high interest rate environment, some borrowers may struggle to maintain adequate FCCR and interest-coverage ratios. Mezzanine’s ability to allow for PIK-interest payments improves the ability of borrowers to cover their current cash interest and fixed charges. Given heightened base rates, the cash interest rate for mezzanine tranches is often lower than unitranche and sometimes lower than senior debt cash interest rates. In this sense, mezzanine structures can preserve cashflow during windows when liquidity dries up.
Senior lenders may also be amenable to mezzanine due to the lack of regularly scheduled, required principal amortisation payments and because the cash interest portion can be blocked by senior debt providers during times of business underperformance. Mezzanine arrangements may also include “pay-if-you-can” features subject to certain interest-coverage ratios, which also appeal to other lenders.
With rates expected to remain high and many traditional banks pulling back on their lending activity, mezzanine debt is assuming a more prominent role to infuse liquidity into the market and provide sponsors with the necessary tools to continue to transact.
In this sense, the so-called “return of mezzanine” is more akin to timeless fashion trends, such as a classic neck scarf; it never really goes out of style, but its role becomes more conspicuous as the need becomes more acute.