Tight credit has led to a surge in mezzanine financing for middle-market deals, according to Watch Hill Partners, a boutique investment bank.
According to Watch Hill’s new report on leveraged lending trends, the decline of collateralized loan obligations and lack of cheap credit have led to a rise in more restrictive covenants, warrants on subordinated debt, and the need for more equity from those sponsoring deals. Of the deals tracked by Watch Hill, mezzanine financing made up 2.9 percent of the capital structure in 2007 and 19.8 percent in the second quarter of 2008.
Mezzanine financing refers to bridge loans that span funding gaps until cheaper capital can be found. Mezzanine loans are short-term debt — usually averaging about three years in length — provided by private-equity firms rather than banks. The loans tend to be subordinated debt, exposing investors to more risk than bank lenders have in case of bankruptcy. So to entice investors into mezzanine funds, returns are set relatively high, between 30 percent and 50 percent. Further, the deals often feature warrants, which are options issued by the borrowers that give the lender the right to buy equity at a predetermined price.
“Mezzanine debt is becoming a greater share of the capital structure and being increasingly seen in a larger number of middle market deals,” the report says.
In the first half of 2007, mezzanine funds in the United States raised a total of $2.3 billion, while in the first half of 2008 they raised $24 billion. The source of funding, usually raised from pension funds and endowments, has been largely insulated from the credit crisis, and in some ways has benefited as cheaper forms of debt — such as second liens — have suffered. Equity tends to represent about 10 percent of total mezzanine investment, according to Watch Hill, and co-investment rights are becoming a universal requirement.
By comparison, when second-lien lending emerged in 2005, mezzanine financing fell by 37 percent, to $3.3 billion in commitments, according to Watch Hill. Other forms of financing that are becoming more widely used include unitranche lending and asset-based lending.