May 2018 Issue
Used to fill the gap between equity and senior debt, mezzanine funding is a useful, albeit complex form of business financing. Particularly suited to middle market companies that can demonstrate future positive growth and sales, mezzanine funding is a secondary financing option and a welcome lending alternative. It is often deployed in high-risk situations and is a flexible tool for dealmaking. It offers a combination of some of the risk and reward of equity investment, as well as the more predictable middle-term income of a loan. Many companies utilise mezzanine funding as a means of ‘topping up’ funding for large projects or to finance management buyouts. It can be a useful tool to access extra capital and drive down costs.
As it is a riskier form of financing, mezzanine tends to be more expensive and has a higher interest rate attached, however lenders take a more personal approach to understand the borrower and create a more flexible lending solution. Historically, it has been employed by borrowers with little in the way of liquid assets, as it reduces the amount of equity investment required. It is also a vital source of funding for SMEs, allowing them to create jobs and generate economic growth.
In the wake of the credit crunch, many smaller companies struggled to raise finance. They were either too small to access high-yield capital markets or affected by a general unwillingness by the banks to lend. This led to marked growth in the use of mezzanine funding. In recent years, however, it has been somewhat overshadowed by senior debt, particularly in the mid-market. Second lien has been used, particularly in larger European deals, to reduce the cost of capital. However, it is now poised to make a comeback. Given the number of businesses looking for funding, it is not possible for banks and private equity investors alone to provide the capital required. It is in this space that mezzanine funding is returning as a viable alternative.
For example, 45 percent of respondents to Intertrust’s ‘Changing Tides: Global Private Debt Market in 2018’ report believe that mezzanine funding will be the most favoured private debt fund strategy among institutional investors over the next two years. Much of the burgeoning interest in the mezzanine space is in the lower segment of the market where there are fewer active private credit managers. As a result, there are good opportunities for mezzanine funding at this level.
Furthermore, a 2017 Preqin survey found that institutional investors view mezzanine funds as one of the most promising areas of the private debt market at the moment. This renewed interest will likely lead to increased fundraising in the mezzanine space. More than half of the 53 investors surveyed believe that mezzanine funds offer the best risk/return profile. Additionally, four out of 10 investors believe that mezzanine funds offer the best opportunities in the market currently. In 2016, 36 mezzanine funds raised more than $28bn, nearing 2008’s record fundraising total of $29bn. Mezzanine fundraising was down in 2017, year-on-year, though there were still some substantial closes. Crescent Mezzanine Fund VII closed at $4.6bn in December 2017, exceeding its $3bn target. Irrespective of the year-on-year decline in fundraising, investor sentiment remains positive.
Much of the enthusiasm for mezzanine can be derived from the questionable status of high-yield loans. At present, the high-yield market is struggling to attract new issuers. In 2017, the share of new issuers of high-yield bonds from January to September was just 16 percent according to Moody’s, compared to over 25 percent in 2015.
If uncertainty continues in the high-yield market, mezzanine lending should continue to see an increase in interest. SMEs will also drive the mezzanine revival, as they seek funding for growth.
Geographically, the Middle East has seen a particularly strong demand for mezzanine funding. NBK Capital Partners, for example, provided mezzanine capital to Saudi’s energy rental business Energia Model Trading and Contracting LLC. This was the third deal from NBK’s $160m second mezzanine fund. NBK also made similar investments in a private international K-12 school in Riyadh, and Turkish electronic payment systems company Perkon. NBK recently exited its first mezzanine fund, returning a 17 percent gross internal rate of return on investments in the UAE, Saudi Arabia, Kuwait and Turkey.
Mezzanine financing is a complex area of business funding, but for companies in need of capital it can be a valuable source. While the volume of unitranche debt from different credit providers has crowded mezzanine funding out, particularly in the mid and upper-mid markets, in the lower mid-market it remains popular. Different deals will require different types and levels of funding, and mezzanine financing has a seat at the table.
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