Posted on: March 12th, 2022
The mezzanine debt market is a subset of the private debt industry, which itself is an adjacent market to the private equity world. The people working in the mezzanine debt funds usually are highly accomplished bankers who gravitated further down the risk return spectrum and had a ken for selecting strong companies to financed.
With large inflows of institutional capital that have come into the private debt world, banks are facing a direct threat to their historical hegemony as direct lender of first choice to the corporate market. Given the AUM scale of these funds and their low-cost fundraising, bank’s find their cost advantage diminishing. As large funds encroach further into the direct lending market and offer a more responsive lending approach, they often offer loan structures that go deeper into the capital structure, providing both more capital and better service. This market dynamic has a two-fold effect on both banks and mezzanine funds.
In this environment, mezzanine debt funds are unable to compete on price due to their higher return requirements. They are increasingly resetting their investment focus on equity heavy investments with structured equity-type returns in the 15% to 18% range. Even if the deal has them playing the role of senior lender, they are unable to stretch their pricing low enough on the senior debt risk to provide a viable option. While they are moving more in an equity direction, their counterparts in the bank market are moving more to a mezzanine debt structuring direction.
Increasingly banks are thinking more like mezzanine debt lenders used to think with respect to total debt capacity. A good number of small to medium sized banks are undergoing a credit renaissance and are using structuring approaches that were once solely used in the mezzanine debt market. Banks are now offering middle market loans to independently sponsored companies with total senior debt up to 3.5 to 4.0 times adjusted EBITDA, at low interest rates and modest principal repayments. These loans are only available for very strong companies with excellent financial track records and strong growth outlooks.
The ability to get a bank to provide this type of loan based on a Company’s pro forma EBITDA is in itself a significant milestone, and speaks to the newly found, innovative thinking flourishing at mid-sized commercial banks today. This cash flow lending mindset within the massive bank ecosystem is not easy to locate. It usually is a niche focused team within a smaller regional bank where the team members have joined from larger banks undergoing consolidation. These banks, providing mezzanine like execution at bank loan pricing, are the proverbial needle in the haystack, but well worth searching for.