Mezzanine financing can shine when macro clouds loom

A distinctive marker of the current tightening cycle is its sharp trajectory: zero to 500 basis points in 16 months. Leading economic indicators are starting to show the strain. The U.S. Treasury yield curve is inverted. Manufacturing orders are down. New home sales have slowed. And recent surveys of senior loan officers reveal that banks are lending less.

Capital is harder to come by today, and those who need it—including middle market businesses pursuing acquisitions, organic growth initiatives, or refinancing—are feeling the squeeze. That presents an opportunity for non-bank lenders, including investors poised to extend private credit.

More companies are seeking mezzanine financing now

Investment opportunities in private debt include direct senior lending, on the one hand, and junior credit investing, or mezzanine financing, on the other hand. While both approaches involve making loans to companies without participation from banks or bond markets, what distinguishes senior debt from mezz is where the loans reside in a company’s capital structure. Investors in senior loans get paid first, and the coupon rate floats along with short-term market yields. By contrast, mezzanine investors are lower in priority and usually compensated with higher contractual coupons—at a rate that’s typically fixed for the life of the loan.

Direct senior lending still accounts for about a third of the private credit market, but many businesses in need of financing today are more inclined to pursue mezz in the current liquidity-constrained environment than they were before. While overall deal volume across the private credit markets is down relative to what we’ve seen in recent years, a greater proportion of the deals getting done today include mezzanine financing, given the sharply higher cost of senior debt capital. From the perspective of sponsors and portfolio companies, mezz financing also offers other advantages that meet the moment:

• Additional mezz financing typically doesn’t alter existing senior loan terms.
• Mezz interest can be paid in kind, in cash, or both, giving the company more flexibility.
• Mezz interest payments can be paused in certain circumstances.

Investors in private markets are taking notice of the increased demand for mezzanine capital. Over $30 billion was raised by global mezz funds last year, nearly double that of 2021.¹

What are the benefits for mezzanine investors?

Current benefits of mezzanine finance’s comeback aren’t limited to companies seeking it. Investors providing it are finding advantages that aren’t available in other asset classes. Mezzanine’s high contractual coupons make it attractive to income investors in most market environments. What makes mezz particularly compelling at this point in the cycle is its fixed-rate feature, often with call protection: An investor providing mezzanine financing now is entitled to today’s high current coupons throughout the life of the loan, locking in the income stream until it has matured or been refinanced.

High current income is just one component of mezz’s total return profile. Equity kickers can result in capital appreciation and attractive multiples on invested capital. The combination has served mezzanine investors well over time. In fact, mezz outpaced other private debt asset classes for the 15 years ended December 31, 2022.¹

When it comes to risk, it’s worth noting that leverage is down almost one turn in the capital structures we’ve seen this year to date, which points to lower attachment and detachment points, a favorable development for mezz investors. Sizable equity cushions also provide investors in mezz with extra support, making it less susceptible to risk of impairment.

Mezz has proven its mettle in other difficult markets before

Mezzanine financing has proven its mettle in tough markets before. We saw it hold up much better than many other asset classes during the global financial crisis, and we believe investors allocated to mezzanine are poised to weather a mild recession, should one materialize in the months ahead. We believe mezzanine’s characteristics tied to this year’s vintage—higher coupons and better terms for lenders—make it one of the most attractive entry points into the asset class in years.

Mezz investors who back leading businesses with strong free cash flow generation, room for operational improvements, and multiple ways to create value can pursue attractive expected returns with a measure of correction protection, a pairing difficult to find in today’s challenging macro environment.

1 PitchBook, December 31, 2022.