Mezzanine Debt Trends in 2019

Mezzanine debt is a perennial acquisition funding favorite due to its unique properties and long lasting value it delivers.  These loans are capable of being molded into a variety of structures, which are highly advantageous for businesses with transitional funding needs.

Rather than fit into the conventional loan structure molds of traditional banking, you construct the loan that works best to unleash your growth.  You can lengthen your growth runway, finance an acquisition, and invest in activating hyper growth.  Mezzanine lenders are free thinkers and are able to participate in deals that most banks would shy away from.  They eschew formula approaches to buy-outs which allows them to add value with a variety of acquirers including companies, search funds and fundless sponsors.

The mezzanine debt segment, has increased in size dramatically over the last decade, is somewhat captive to the changes in adjacent private capital markets including private equity and bank lending.  As these larger markets ebb and flow, the mezzanine or junior debt market adapts to ensure its competitiveness in the capital market ecosystem.

During the Financial Crisis when bank lending contracted greatly, mezzanine lenders stepped into the market breach.  As Banks now become less regulated and more swashbuckling in their lending, mezzanine usually pulls back and finds new creative uses for their capital. Despite any current changes, mezzanine is a great equity substitute for growing middle market companies that require a long term capital partner to fund growth.  So what are some of the new changes in the market as we enter the New Year?

1. Pushing down the balance sheet – mezzanine lenders, due to bank competition in providing cash flow loans are moving closer to providing equity funding to acquirers. This means they are funding at higher levels of EBITDA, beneath the bank. They are effectively providing equity like funding at mezzanine debt like rates which is a big win for the borrower.
2. Preferred Equity – Due to the Tax Law changes, interest expense deductions are limited to 30% of EBITDA. As a result, mezzanine lenders are increasingly providing bundles of loans and preferred equity to their borrowers, to help optimize tax treatment.  This reduces interest expense but also provides a company with higher quality source of preferred equity as opposed to raising preferred from a private equity fund.
3. Focus on Acquisition Platforms – mezzanine debt has always been great at supporting companies doing roll ups with multiple acquisitions. Now more than ever they are using their ability to scale the size of their loan as a competitive differentiator as a lender.
4. Lower Pricing – mezzanine lenders are funding at higher multiples due to market competition but are generally not charging more in pricing. Due to the sheer size of debt capital in the market, pricing has come down from 14% to 16% all in, to 11% to 13% all in.  In addition, as interest rates have increased, their rates have not increased as they tend to price in fixed rate terms.
5. Direct lending & Focus on non-Private Equity Sponsors – Mezzanine lenders are shifting to working with companies or small firms that lack significant equity investment for a deal.  They are increasingly focused on providing direct lending to middle market companies that need that extra level of hard to raise “Gap capital”.

All of these changes are helping mezzanine lenders reposition themselves in the market, so they can thrive.  As they go deeper and think more creatively, they provide greater growth value to the middle market ecosystem.