Private Debt Industry Growth and Impact on The Mezzanine Debt Market

Private Debt Industry Growth and The Impact on The Mezzanine Debt Market

Posted on: December 10th, 2021

mezzanine debt

The private debt market is growing rapidly driven by increased allocation rates by institutional investors to the asset class. Total private debt assets were $848 billion at the end of 2020 and are expected to increase at an 11.4% annual rate through the year 2025. This is a function of the strong, risk-adjusted returns generated by the asset class over the years.

Private debt offers reliably consistent and high returns to investors. Pension funds, asset managers and endowments have taken notice, especially in a world of low nominal and negative real interest rates. With the 10-year treasury rate of 1.5%, and an inflation rate of 6.2%, real interest rates are -4.7%. Private debt yields are not exchange-based, and interest rates are in 8% to 12% range.

Smart funds are learning that direct lending to middle market companies in a relationship context can mitigate credit risk leading to higher returns. The amount of capital raised by the largest funds is staggering and will have a disruptive impact on current middle market lenders, especially mezzanine debt lenders.

Mezzanine Debt Strategy

Mezzanine debt lenders in the middle market employ either a direct lending or a private equity focused strategy. The direct lending approach is a higher value strategy as mezzanine debt is able to partner with companies and provide debt as well as preferred stock. Due to market inefficiencies, there are no fixed credit parameters for structuring which allows mezzanine debt lenders to provide capital in a shapeshifting manner, straddling the line between debt and equity. Large fund formation in the private debt industry will lead to the following long-term impact on the mezzanine debt market:

Lower target returns – the sheer amount of capital will lead to more competition and lower yields. Middle market mezzanine debt rates will decline from 10% to 12% to 8% to 10% over the next 3 years.
More Mezzanine Debt Fund Specialization – funds that have a proven specialty whether in growth capital, direct lending, or partial recapitalizations, will continue to prosper. Their expertise and reliability will justify higher yields and immunize them from pricing pressure.
Increased Direct Lending Focus – mezzanine debt lenders will shift away from hypercompetitive private equity deals to direct lending to add more value and provide a high touch relationship experience for the borrowers.
Increased Debt Equity Straddling – Mezzanine debt lenders will dive further into the equity layer to increase their upside and differentiate their offering given the overhand of private debt in the market.

As new acquisition financing credit funds pivot to non-private equity sponsored deals, many lack experience with the asset class. Non-sponsored deals such as direct loans to companies or loans to independent sponsors making acquisitions are quite different from private equity backed deals and require a different thought process and engagement style from the lender.

During their underwriting processes, acquisition financing providers analyze probable performance projections for their proposed borrowers. The underwriter often toggles between a few scenarios to sensitize the growth variables leading to slower revenue and margin growth over time. The lender’s underwriting view is usually an extension of its credit intelligence and historical experience.

Mezzanine debt loans occupy the risky echelon beneath the bank but ahead of the equity in a capital structure. They are naturally subordinated to the bank loan via an intercreditor agreement wherein the senior lender retains the power to block their interest or force them to standstill.