Some of the private debt market’s biggest hitters — Blackstone, Apollo and KKR — are predicting a revival this year of mezzanine lending, but others in the market question where the opportunities will come from.
Several leveraged credit fund managers have held interim or final closes in recent months for vehicles dedicated to junior debt, or that have flexible mandates allowing them to make subordinated investments.
At the big end of the spectrum, Goldman Sachs held a final close in January for its eighth mezzanine fund, West Street Mezzanine Partners VIII, with $15.2bn of investible capital.
At the beginning of February, All Seas Capital held a $400m final close for its first fund, while Accession Capital Partners held a €150m first close for its fifth flagship fund, aiming to reach €300m later. Both these have flexible mandates that let them make junior and equity investments.
Market participants believe this is no accident: market conditions are driving this renewed interest.
The first impulse is falling company valuations. “Junior capital makes more sense on a relative value basis if enterprise values compress, and with senior lenders trying to reduce exposure and keep their loan to value [ratios] in check,” said an executive at a private debt fund.
Senior lenders have been spurred to trim their risk partly by fast-rising interest rates.
At the time of Accession’s final close, a partner on the private credit team at a global private investment firm told GlobalCapital senior debt could no longer reach the same level in a company’s capital structure.
“When interest rates were close to zero, you could leverage exclusively using senior or unitranche and maintain your interest payments at below 50% of Ebitda,” he said. “Now that the cost of borrowing has gone up, it naturally means the amount of senior debt you can borrow has come down.”
Rather than cut leverage, sacrificing returns, private equity sponsors are turning to alternative forms of debt from more risk-hungry lenders to fill up the hole.
Michael Small, a partner in KKR’s London credit team, said in a recent blog that high levels of dry powder in private equity funds and dwindling availability of senior debt would spark interest in junior debt.
“We believe acquirers will not be able to raise as much senior financing as in recent years — and in many capital structures, junior capital will fill the gap,” he said.
Junior lenders are willing to accept more risk and can agree to their interest being paid in kind, meaning the company does not need running cash but can pay at maturity.
Yet some are sceptical about how much junior lending many of these funds will actually do.
A head of direct lending in London said the increase in vehicles with explicit mandates to make junior loans might be partly a ploy to market the funds, rather than based on real investment opportunities.
“I have seen people pushing niche strategies as a solution to higher interest rates,” he said. “Direct lending funds generally have the ability to do a good amount of mezzanine, although it might cut across their mainly senior pitch.”
A debt adviser in London also questioned whether the pipeline for these strategies was as strong as many people think. “We haven’t put any mezzanine in a deal this year or last year,” he said. “And we haven’t had any sponsors asking about it.”
The executive at the private debt fund said less senior lending would not necessarily translate to more junior debt. “Sponsors still have a ton of capital to deploy,” he said. “They may decide to just go all senior [and put in more equity].”
Small at KKR disagreed. He argued that, with M&A activity compressed and senior debt more expensive than in recent years, junior investors could get into deals when they were refinanced.
“As maturities come due, we anticipate that many borrowers will have to reduce the amount of senior debt on their balance sheets, resetting coverage ratios back or refinancing their debt,” he said. “Private junior debt seeks to accomplish this, reducing or avoiding the need for significant new equity.”
At the time of Goldman Sachs’s final close, Matthew Smith, a partner at law firm Cadwalader, Wickersham & Taft in London, said that, while mezzanine lending may not have been strong in recent years, market conditions were conducive to its return.
“We have been expecting to see more mezzanine activity in the market, and we are starting to see signs of that now,” Smith said. “Given the wider macro picture and market volatility, the need for more creative debt solutions is only going to increase, and mezzanine debt is certainly in that camp.”
Part of the reason the pipeline is less visible, and its extent is disputed, could be that the opportunities tend to be bilateral and secret, so do not get shown to as many lenders.
Some deals may even appear outside the private equity world.
Blackstone and Apollo are receiving more approaches from listed companies in Europe, Bloomberg reported last week. Some want additional capital for bolt-on acquisitions on more flexible terms than traditional senior lenders will give.
Whether the mezzanine trend this year in fundraising translates into more diverse deal flow remains to be seen. Either way, having flexible capital to deploy can only be a plus for direct lenders as they enter another year of uncertainty.