Market Migration of Mezzanine Debt Lenders

In today’s middle market lending world, interest rate competition is fierce due to the massive amount of capital chasing deal flow. This has influenced the market activities of mezzanine debt lenders, who have reinvented themselves to generate their expected returns. Banks have a huge cost advantage over mezzanine debt lenders which translates into low rates for bankable deals in the 2.5% to 2.75% range.

In addition, many banks are stretching further using generous structuring approaches, which allows them to go to 3.0 or even 3.5 times adjusted EBITDA for a senior facility. The combination of low rates and larger loan sizes is nirvana for borrowers. This has led to mezzanine debt lenders migrating down the capital structure to play at the equity level.

Historically, mezzanine debt lenders could play at the lower end of the middle market and provide a one-stop financing at a sub-$10 million loan size level, for an interest rate of 10% and a small equity warrant. With banks now serving this market, mezzanine debt lenders need to focus on more specialized deal types where they can do more for the borrower than a bank can, at pricing more palatable than straight equity.

In the past, mezzanine debt lenders could make a clear argument of the cost attractiveness of their loans versus straight equity, as most of their return was in their interest rate. As they migrate more to the equity level, their warrants and equity ownership naturally increases, which makes a clear comparison harder to make. Most entrepreneurs do not mind giving up small bits of equity to their lender, provided the level is 5% or less, and they feel they are getting good value. When the equity position of a mezzanine lender rises to 10% or 15%, along with a 10% to 12% interest rate, entrepreneurs think twice.

Rather than seeing the mezzanine debt lender as a provider of a loan, they are seen as a significant equity holder with a high current carrying cost. While these types of loans bring big value to companies and are significantly less expensive than a private equity level of ownership, they are less appetizing to capital thirsty companies. Mezzanine debt lenders will have to work harder to deploy their capital, but will no doubt find innovative and high value-added ways to compete successfully in the market.