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Current Trends in Middle-Market Mezzanine

What are the risks involved in middle-market mezzanine lending?

Investing in middle-market mezzanine debt may involve greater overall leverage levels than in the high-yield market with risks that range from fixed income investments to mezzanine debt characteristics. Mezzanine investors or lenders are paid a higher yield and in most cases, are given a small participation in the growth of the borrower’s equity value. Mezzanine investors are hence prepared to assume more risk than senior debt providers but with their enhanced return expectations.

The high-yield market has been a wildly productive option for large-cap issuers, refinancing senior debt, and extending maturities. But smaller companies are finding non-equity linked, pre-payable alternatives to mezzanine debt from sponsors. The biggest challenge for issuers in the small cap mezzanine market is finding pure senior cash flow providers to go along with the mezzanine debt. Most banks and finance companies just won’t go that far down the financial food chain.

How has the recent election in the US or the impending fiscal cliff influenced mezzanine lending?

Post-election, there has been a flood of motivated sellers eager to complete their transactions prior to the expiration of the Bush Tax Cuts. Business owners who were on the fence about selling, are now driven to sell because many believe that taxes are headed in an upward direction.

There is no definitive guide or standard cost, so knowing the full effect is challenging for business owners. This is having a negative impact on valuations because buyers are now pricing-in this additional cost into their valuation models. The uncertainty that surrounded this issue for so long until the elections has been cleared. However, the issue has now become a large time suck for many small and medium sized businesses as they identify ways to cope with the additional cost.

Many owners believe that the cumulative effect of this economic realignment will create another recession, which they have no interest in participating in. Selling is a better alternative for them than continuing to own their businesses. These forces will create a large uptrend in M&A activity in the middle market, which will stimulate demand for mezzanine lending.

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