As private equity transactions increase, the need for junior capital (second lien loans and mezzanine debt) has risen exponentially. According to Standard & Poor’s, the average middle market deal for the second quarter of 2006 ($50 MM in EBTIDA or less) was funded using 40% equity, 40% senior debt and 20% junior capital. The recent historically low interest rates made second lien financing attractive in larger deals with greater collateral. Therefore, the need for traditional mezzanine financing was reduced and was primarily used to bridge the gap between the second lien and the equity.
However, for various reasons, the mezzanine market appears poised for a rebound. The recent rise in interest rates drastically reduced the spread between second lien lenders and mezzanine financers. Traditional second lien loans are floating rates, making them less attractive than the fixed rates charged by mezzanine providers. Senior lenders have begun to challenge many of the gains made by second lien providers regarding rights over collateral due to tightened credit underwriting policy and a higher prevalence of defaults/bankruptcies. Additionally, the decreased attractiveness of second lien loans has initiated an exodus from the junior capital market by hedge funds and other non-traditional lenders.
Trends in Mezzanine Pricing and Structure
The introduction of new forms of junior capital has created downward pricing pressure in the mezzanine market. As late as 2000, the only financing sources bridging the gap between senior lenders and common equity investors were mezzanine funds. Today, the introduction of last out senior, Tranche B (similar to second lien), and second lien debt has created enough competition in the supply of junior capital that mezzanine providers have been forced to reduce their pricing. In 2000, mezzanine funds were charging an average of 22% for subordinated notes. Today, similar funds charge 12-16% for subordinated debt and 15-19% for subordinated debt with warrant attachments.
Current structures for mezzanine financing generally provide no security, although occasionally a silent second lien, in which the mezzanine fund can take priority over trade creditors but sit second to senior lenders, can be secured. Covenants are normally at a 10- 15% discount off the senior lender (i.e. if total debt to EBITDA for senior is 5:1, the covenant would be 5.5:1 for the mezzanine lender) and excess cash flow recapture is not provided. In the event of default, most mezzanine funds provide 180-day payment blockage and standstill provisions.
Sponsored vs. Non-sponsored
The vast majority of today’s mezzanine funds take a sponsored approach to investing. The sponsored approach means that the fund will primarily write loans on deals that are brought to them through a preferred equity partner. This approach supplies the mezzanine provider with ample deal flow while creating a more efficient process for closing and a comfort level with continuing management. In return, many equity funds are requiring equity co-investments by the mezzanine provider in an effort to better align the interests of each party. Sponsored funds tend to supply larger pieces of capital in excess of $10 million.
In contrast, non-sponsored mezzanine funds generate deal flow without the use of a sponsoring fund or equity partner. This allows for a more flexible approach to lending, with deal parameters and pricing varying based on the needs of the borrower. Non-sponsored funds tend to be more regional in nature and supply smaller pieces of capital in the range of $3 million to $10 million. Due to the smaller size of investments, non-sponsored funds tend to utilize warrants more prevalently in their deals in an effort to compensate for additional risk. In utilizing warrants, non-sponsored investors look to generate returns between 20-30% depending on the size and security of the investment.
Mezzanine and the Florida- Based Business
The Florida marketplace has been traditionally underserved by the non-sponsored mezzanine market. Much of this can be attributed to the regional nature of such investments. Most non-sponsored mezzanine lenders prefer close proximity to their investments in an effort to monitor their operations and – assist with business decisions.