Oaktree Strategy Primer: Investing In Mezzanine Debt
In this paper we seek to provide information on investing in mezzanine debt. Any reference to mezzanine debt should only be considered with regard to investing in the North American middle-market, as some of the information discussed may not be applicable to other markets. We will also only briefly mention preferred equity, which can sometimes be considered mezzanine capital. We will explore the following six topics in order to provide a foundation for investing in mezzanine debt.
- What is mezzanine debt?
- What are the characteristics of the middle-market in North America?
- What are the potential benefits and risks of investing in mezzanine debt?
- What are the different ways to invest in mezzanine debt?
- What is the current opportunity in mezzanine debt?
- How does Oaktree approach investing in mezzanine debt?
What Is Mezzanine Debt?
As its name implies, mezzanine debt is situated between the senior secured bank debt and the equity in an issuer or borrower’s capital structure. Mezzanine debt is typically used to finance leveraged buyouts, recapitalizations and corporate acquisitions. It is also an alternative to public or private equity for companies seeking growth capital. Typically junior in credit standing, mezzanine debt provides additional capital beyond senior secured debt. As shown in figure 1, mezzanine debt typically takes the form of senior unsecured or subordinated notes, or second lien debt. From an issuer’s perspective, mezzanine debt can reduce overall capital costs by providing additional debt financing that can enhance equity returns.
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For middle-market businesses, mezzanine debt typically takes the place of the high yield bonds used by larger companies. As highlighted in figure 2, the minimum issuance size for a company to access today’s high yield bond market is generally $200 million or more. In other words, most middle-market businesses do not have the financing need or the ability to access the high yield bond market. By creating a capital structure with a ‘‘right-sized’’ combination of mezzanine debt and bank borrowings, middle-market companies can leverage their equity capital to generate attractive returns for their owners.
What Are The Characteristics Of The Middle-Market In North America?
Middle-market companies account for the vast majority of businesses in the United States and represent approximately 33% of private sector GDP, 48 million jobs and, on a standalone basis, would be the world’s fifth largest economy.1 According to the U.S. Census Bureau’s 2012 economic census, there were approximately 41,100 middle-market companies in the United States with annual revenues between $50 million and $1 billion. This compares to just 1,450 companies with annual revenues above $1 billion.2 Most middle-market businesses that employ mezzanine debt have earnings before interest, tax, depreciation and amortization (“EBITDA”) ranging from $10 million to $50 million.
Middle-market companies are usually closely held by their founders, families or by private equity firms. The majority of middle-market companies are privately held due to their limited resources and the costs associated with being a public company. Middle-market companies can be found in almost every industry sector.
What Are The Potential Benefits And Risks Of Investing In Mezzanine Debt?
Some of the potential benefits of investing in mezzanine debt include the opportunity for attractive total return, downside risk management through privately negotiated transactions, and less-volatile performance through a high current coupon component.
Potentially Attractive Total Return
Due to their subordinated or junior position in an issuer’s capital structure, mezzanine debt investors generally demand higher prospective returns compared to senior secured debt investors. As shown in figure 3, total returns on mezzanine debt typically come from (1) high current coupons (typically fixed-rate and paid quarterly, mostly in cash), (2) commitment or arrangement fees (often paid in the form of original issue discounts) and (3) call protection (i.e., premium payments if the mezzanine debt is repaid early). Mezzanine debt, in contrast to senior secured debt, will most often come with an “equity kicker” in the form of the opportunity to purchase equity in the underlying borrower. This results in the potential for additional returns beyond those contracted for by the junior debt investment by itself. Mezzanine investors have historically targeted blended gross annualized returns in the mid-teens. Similar to other debt investments, we feel the avoidance of defaults and subsequent losses, sometimes referred to as the “negative art of bond investing,” can be the most important aspect for mezzanine investors striving to achieve attractive total returns.
Private Structures Provide Downside Risk Management
In the middle-market, mezzanine debt is typically issued through privately negotiated transactions. A mezzanine lender’s decision to extend credit to a borrower is usually based on the issuer’s ability to generate free cash flow (as opposed to being based on asset backing) and on the growth prospects for the business and industry. Compared to what is often less than a week of limited, public-side due diligence for broadly syndicated loans, mezzanine debt investors typically are able to perform extensive private-side due diligence over a four- to six-week period. As part of this due diligence, mezzanine lenders receive greater access to company information, such as historical financial statements, earnings and audit reports, and environmental or other expert analyses. This gives mezzanine debt investors the ability to better understand the borrower, negotiate terms and structure loans in ways that are appropriate for the underlying business. In addition, mezzanine debt investors also have the opportunity to interact with the company’s management several times before an investment is made.
After making an investment, mezzanine debt investors usually receive monthly or quarterly financial statements. In addition, many mezzanine lenders negotiate board observation rights as part of the terms of their investment. Receiving board of director materials and attending the meetings, alongside what is often frequent dialogue with company owners and management, gives mezzanine lenders the ability to closely monitor their investments and stay ahead of potential business issues. It also helps the investor keep up to speed with company performance and knowledgeable should amendments to the credit documents be necessary.
Lastly, although debt financing to large corporate issuers has increasingly become covenant-lite with no maintenance financial covenants (e.g., a maximum leverage ratio), loans to middle-market businesses continue to carry both incurrence and maintenance covenants. These covenants give mezzanine lenders additional tools should the business underperform. Mezzanine lenders often work with owners to take proactive steps to upgrade the borrower’s operating performance and maximize liquidity. These proactive steps may include cost reductions, divestitures of less productive assets, and changes to operations or management. Additional steps to address underperformance may even include voluntarily deferring the cash portion of interest due on the mezzanine debt in order to help the company avoid defaulting on its senior secured debt. Senior secured debt for larger issuers is more likely to be syndicated and may include lenders who are less willing to work through cyclical downturns.
High Current Coupon Reduces Volatility
More often than not, mezzanine debt is structured with a fixed coupon that is paid quarterly (mostly in cash). This coupon compensates lenders for subordinating their position in the capital structure. In today’s market, coupon rates are running from 11.0% to 12.5%, on the low end of the historical range. Still, for investors targeting mid-teen gross returns in a low-yield environment, mezzanine debt is an attractive alternative to other debt instruments. Furthermore, since mezzanine debt coupons are usually paid quarterly, the high current coupon component reduces the overall volatility of returns to investors.
Potential Risks of Investing in Mezzanine Debt
First and foremost, mezzanine debt is junior in the capital structure and typically in a first-loss position after the value of the company drops by more than the amount of its equity. Second, since mezzanine debt is provided through privately negotiated transactions, it is far less liquid than more public securities if it needs to be sold. Lastly, middle-market businesses often face greater idiosyncratic risks compared to larger companies. For example, due to their smaller size, loss of a customer or increases in the cost of raw materials may have a larger impact on the borrower’s EBITDA than it would on a larger company. In certain instances, due to their size and ownership structure, middle-market companies may also have less professional or less seasoned management teams.
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