Why Mezz, Why Now?

In today’s lending landscape, mezzanine financing is emerging as a promising option for investors. While private credit lenders have been dominating the market with leveraged loan deals and unitranche financing, mezzanine financing is gaining traction as interest rates rise and lending conditions become stricter. Positioned between senior debt and common equity, mezz financing offers a balance of risk and reward for investors. With recent turbulence in the regional bank sector, there may be even more investment opportunities opening up for mezzanine lenders. As the trend continues, it will be interesting to see how mezzanine financing evolves and continues to make a comeback in the world of private credit lending.

The fundraising in the segment has been on the rise, given the growing demand for mezzanine financing. Private credit managers have raised billions of dollars of dry powder to invest in this space. The latest PitchBook data reveals that global mezzanine funds raised $30.1 billion in 2022, almost double that of the previous year, marking the highest fundraising since 2016. Further, mezzanine funds accounted for 16% of the total raised across all private debt strategies in 2022, surpassing distressed debt as the second most popular private debt sub-strategy. With these numbers, it is evident that mezzanine financing is gaining traction among investors as they look for higher yields and relatively stable returns.

Demand For Mezzanine Financing

Mezzanine capital has uses for both performing and stressed companies. In today’s financial landscape, several factors are fueling demand for business loans. One of the primary drivers is the shrinking access to senior debt and unitranche loans. This is due in part to the prevalence of most favored nation clauses in many first-lien loans. These clauses prevent new debt from being issued at more attractive levels than existing lenders receive, putting borrowers in a bind when it comes to bringing in new senior debt. With interest rates on the rise, the prospect of repricing an entire first-lien facility is unattractive, making alternative lending solutions an increasingly attractive option. 

Another major factor contributing to its newfound popularity is the willingness of mezzanine lenders to allow PIK interest. This means that companies can now access a larger PIK component, allowing for financing with 8% cash interest and 6% PIK. This is a useful feature in light of rising inflation and borrowing costs, as it allows companies to save cash without compromising on their financial obligations. The professional tone of mezzanine lending indicates a growing trend in the industry, with lenders adapting to the evolving needs of their clients.

For performing companies seeking mezzanine loans, the current market offers an attractive yield of 12.5-14%, along with a three-point original-issue discount and up to 6% payment-in-kind (PIK). However, it’s important to note that this type of debt often includes covenants, and borrowers will need to navigate stricter language surrounding debt incurrence. That being said, the current market allows for a slightly higher level of leverage, with the potential to increase from 5x to 5.5x. Despite the shifting market conditions, mezzanine debt remains a popular financing option for growing, performing companies.

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While mezzanine deals may offer higher potential returns than traditional lending, they come with a fair amount of risk. These transactions are typically structured to protect lenders on the downside, with financial metrics carefully considered to limit exposure to possible losses. It’s important for investors to thoroughly analyze each opportunity before committing capital, ensuring that the potential rewards justify the level of risk involved. Ultimately, successful mezzanine investing requires a deep understanding of the market, careful attention to detail, and a willingness to take calculated risks.

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