Mezzanine | Manulife Investment Management

Key takeaways

The all-cash expense of senior debt has become too burdensome for some borrowers.
More companies are now seeking mezzanine financing, which has more pay-in-kind flexibility.
For investors, we believe mezzanine’s current characteristics—including lower leverage and higher coupons—make it one of the most attractive entry points into the asset class in years.

Financing is harder to come by today, and those who need it—including middle market businesses pursuing acquisitions, organic growth initiatives, or capital structure adjustments—are feeling the squeeze. Flexibility has become more desirable to companies that need fresh capital, and investors supplying mezzanine, or junior credit, financing now stand to benefit.

While mezzanine’s high contractual coupons make it attractive to investors in most market environments, what makes it compelling at this point in the cycle is its fixed-rate feature. 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.

U.S. buyout equity contributions are up—and leverage levels are down

Source: PitchBook, LCD, September 30, 2023. The data is from issuers with earnings before interest, taxes, depreciation, and amortization (EBITDA) of more than $50 million. LHS refers to the left-hand side y-axis; RHS refers to the one on the right-hand side.

While there are pockets of softness in some sectors (transportation and logistics, for example, where both freight volume and pricing are down), certain risk metrics across the mezz market have improved in recent months. Higher equity cushions provide mezzanine investors with extra support, making it less susceptible to permanent impairment. Leverage has come down nearly one turn in the capital structures we’ve seen over the past year, which points to lower attachment and detachment points, a favorable development for mezz investors.

Mezzanine financing also offers sponsors and portfolio companies advantages. It doesn’t typically alter existing senior loan terms, and mezz interest can often be paid in kind, in cash, or both, giving borrowers with constrained cash flow more flexibility. Since many companies designed their capital structures for a different interest-rate environment when senior debt was less expensive, mezzanine is now playing a prominent role in balance sheet restructuring.

We expect a busy 2024 for mezzanine investors. Companies with overlevered balance sheets can wait only so long to trim interest expenses. Private equity sponsors can wait only so long to deploy dry powder. LPs can wait only so long for distributions. We see an active pipeline ahead, consisting of minor amendments and covenant adjustments on the one hand and new deals on the other. Regardless, a partnership approach prevails—especially in an uncertain market. Deep relationships between sponsors and patient mezzanine investors can help prepare portfolio companies for whatever comes next.

Important disclosures

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