The convergence of pricing in the mezzanine and second-lien markets and a backlash from first-lien lenders seeking to block second liens are starting to boost the mezzanine financing market. Market participants say they are seeing more mezzanine funds raising capital in anticipation of a growth in demand for mezzanine deals.
The growth is mainly being driven by pressure from first-lien lenders that are increasingly trying to block companies from taking on second-lien debt, according to market observers. The existence of a second-lien lender can give the first-lien lenders less control over a company's capital structure. Eric Green, senior partner at FriedbergMilstein, said he is seeing more deals getting done that have left out second-lien deals in favor of a combination of first lien and mezzanine financing.
"There is a shift away from first liens allowing second-lien deals to occur," said Green, whose firm offers both mezz and second-lien financing. "Over the past nine months there is a bit more conservatism on the part of first-lien lenders and this has led to more mezzanine flow." Brian Cullen, director in the restructuring group at Chanin Capital Partners, said he has also seen an uptick in mezzanine deals. "Second liens are not as prevalent," he said. "Anecdotally, there are a number of mezzanine shops that are starting to be busier."
One concern that first-lien lenders have is the extent to which the new bankruptcy code will favor second-lien lenders. Green said it is unclear how judges will interpret the code. There is a feeling that at least with mezzanine debt, its subordination to first-lien lenders is clear. "Mezzanine may be less rigid; they have fewer triggers. First liens want as much of an equity cushion as they can get," said Cullen. "Mezzanine can look like straight equity. None of the second liens have been tested in bankruptcy."
For the past couple of years, mezzanine funds have lost market share to second-lien financing as that market exploded. But second liens are also risky investments for some investors because of the lack of covenants and other adequate protections that make the recovery rates on some deals low. Atkins Nutritionals and Nellson Nutraceutical are examples of companies that have had low recoveries on second liens.
Green noted more firms are raising mezzanine funds. Indeed, Babson Capital recently closed a $1 billion mezz fund and GSO Capital has a new collateralized loan obligation with a carve out for mezzaine and second-liens. Officials at those firms could not be reached for comment.
The convergence of pricing between the second-lien market and the mezzanine market is also influencing more borrowers to consider mezzanine financing. Cullen said he has seen some second-lien deals that are priced as high as LIBOR plus 1200 basis points meaning that second lien debt is getting to be as expensive as mezzanine financing.
John Brignola, executive v.p. of LBC Credit Partners, said the rise in LIBOR is driving the convergence. "The coupons on second lien and mezzanine are virtually equivalent," he said. "A couple of years ago, the coupon on mezzanine was too expensive for some issuers when compared to second lien. Now that short-term interest rates have risen, the cash-pay pricing on second lien and mezzanine has converged."
The growth of mezzanine is leading some hedge funds to start to offer both second lien and mezzanine funds. Mezzanine financing still lags the volume of second-lien financing, but it is catching up. The volume of second-lien loans grew to $17.9 billion in the U.S. in 2005, compared with $11.1 billion in 2004, according to Dealogic. By comparison, the volume of mezzanine loans grew to $1.56 billion in the U.S. in 2005, compared with $250 million in 2004.
