Private Debt Industry Growth and The Impact on The Mezzanine Debt Market

Posted on: December 10th, 2021

mezzanine debt

The private debt market is growing rapidly driven by increased allocation rates by institutional investors to the asset class. Total private debt assets were $848 billion at the end of 2020 and are expected to increase at an 11.4% annual rate through the year 2025. This is a function of the strong, risk-adjusted returns generated by the asset class over the years.

Private debt offers reliably consistent and high returns to investors. Pension funds, asset managers and endowments have taken notice, especially in a world of low nominal and negative real interest rates. With the 10-year treasury rate of 1.5%, and an inflation rate of 6.2%, real interest rates are -4.7%. Private debt yields are not exchange-based, and interest rates are in 8% to 12% range.

Smart funds are learning that direct lending to middle market companies in a relationship context can mitigate credit risk leading to higher returns. The amount of capital raised by the largest funds is staggering and will have a disruptive impact on current middle market lenders, especially mezzanine debt lenders.

Mezzanine Debt Strategy

Mezzanine debt lenders in the middle market employ either a direct lending or a private equity focused strategy. The direct lending approach is a higher value strategy as mezzanine debt is able to partner with companies and provide debt as well as preferred stock. Due to market inefficiencies, there are no fixed credit parameters for structuring which allows mezzanine debt lenders to provide capital in a shapeshifting manner, straddling the line between debt and equity. Large fund formation in the private debt industry will lead to the following long-term impact on the mezzanine debt market:

Lower target returns – the sheer amount of capital will lead to more competition and lower yields. Middle market mezzanine debt rates will decline from 10% to 12% to 8% to 10% over the next 3 years.
More Mezzanine Debt Fund Specialization – funds that have a proven specialty whether in growth capital, direct lending, or partial recapitalizations, will continue to prosper. Their expertise and reliability will justify higher yields and immunize them from pricing pressure.
Increased Direct Lending Focus – mezzanine debt lenders will shift away from hypercompetitive private equity deals to direct lending to add more value and provide a high touch relationship experience for the borrowers.
Increased Debt Equity Straddling – Mezzanine debt lenders will dive further into the equity layer to increase their upside and differentiate their offering given the overhand of private debt in the market.

In the acquisition financing arena, capital availability is destiny as companies require reliable access to capital to grow over the long term. Unforeseen capital needs usually arise when acquirers least expect it. This can cause some concern for the acquisition financing provider, especially when covenants tighten up and that working capital availability is utilized faster than expected.

Mezzanine debt borrowing is usually a straightforward activity that many companies use for funding of transitional growth. Mezzanine debt lenders are highly transparent about their due diligence approach and their post-closing loan management making it easy for companies to engage with.

Elections have consequences and positive ones at that for the acquisition financing middle market. While much media attention is paid to the direction of the yield curve and the Fed’s likely rate cuts, scant attention is paid to the more important drivers of the acquisition financing market – business psychology and regulatory climate.