Mezzanine debt has long been an arcane corner of big-time corporate finance, an unglamorous step-cousin to1 bond and equity markets. Issuers of any consequence to Wall Street usually turned to mezzanine financing - high-coupon debt coupled with warrants or other equity rights, less senior in the capital structure than bonds or loans - only when other financing options were exhausted. But several factors, including a dearth of liquidity in the high-yield bond market, a steady flow of smaller leveraged buyouts and growth in the number of buyers for mezzanine debt, appear poised to give mezzanine some permanence as an asset class.
Historically, mezzanine deals have ebberd and flowed with the health of the high-yield market. If companies lacking an investment-grade credit rating could raise capital on attractive terms from junk investors, the prospect of giving up equity to mezzanine buyers proved unappealing. Conversely, when the high-yield spigot closed, mezzanine deals flourished as a last resort. Consequently, mezzanine issuance suffered badly during ebullient times for junk, such as the late 1980s and mid-1990s. “The market all but disappeared during the Milken era, and the low point was really about 1996-1997,” says Michael O’Kane, senior managing director at TIAA-CREF, a mezzanine buyer since the 1960s.
But the double-whammy of Russia’s debt crisis and the near-collapse of hedge fund Long-Term Capital Management in the autumn of 1998 has made investors far more sensitive to risk. Simultaneously, assets under management at many large investment houses have ballooned such that fund managers often cannot buy or sell securities without negatively affecting the price. And Wall Street consolidation is reducing the number of dealers in risky securities.
The upshot for the junk market is that investors have been rejecting deals on the low end of the credit-risk and size continuum, and likely will continue to do so for quite a while. “There was time when you could do a $75 million high-yield deal on good terms,” says Muneer Satter, a managing director of merchant banking at Goldman Sachs Group. “But the buyside no longer wants these kinds of deals. They want liquidity.”
Meanwhile, many lower-rated companies in out of favor sectors, who traditionally have sought to market deals of less than $100 million, are falling upon hard times and undergoing leveraged buyouts. LBO firms, flush cash yet priced out of the biggest acquisitions, are focusing on these smaller deals, boosting supply in the mezzanine market.
And investors are keen for greater exposure. Many are attracted to the asset class’ high coupon payments, combined with the potential for equity-like growth and greater rights than common stockholders in the event of insolvency. “It rewards good analysis. If you’re right, your returns can be far higher than what you get in the coupon,” says TIAA’s O’Kane.
Wall Street, which makes hefty fees advising LBO firms and providing financing for their transactions, is seizing the opportunity. At least seven investment banks either have raised or currently are raising large mezzanine funds to support their LBO banking practices (see table).
A handful of firms, such as Goldman and Donaldson, Lufkin & Jenrette, have had such funds in place for a few years. Others are new to the game. Regardless, each aims to attract clients by having a pool of capital ready to buy the mezzanine pieces of LBOs and other capital-raising transactions. Issuers otherwise often had trouble closing deals. “There is a whole group of investors out there, typically insurance companies, that can commit no more than $15-20 million per deal,” says Goldman’s Satter. “We found that a lot of our clients were frustrated because they wanted to do a $75 million mezzanine deal and they had to go cobbling all these buyers together.”
The proliferation of these funds may help mezzanine finally carve out a lasting niche. Says Robert Redmond, managing director and head of leveraged finance at Lehman: “The asset class is maturing. In the old days, you did a mezzanine deal only when you tried to do a bond deal first but couldn’t pull it off. Now you’re seeing issuers going directly to mezzanine players.”
