Against the backdrop of a highly volatile domestic and global equity market, it is sometimes hard to think positively.  However, if you are a mezzanine lender, it is probably hard to be unhappy right now.  A golden age is period within any field of human activity where it flourishes and outstanding accomplishments are achieved. The origin of the term stems from the mythology of Greek and Roman poets in their references to an early age of man, where mankind was pure, happy, and immortal.  When people talk of the current mezzanine environment, they are predicting, just that, a golden age.

To the best of my knowledge, I’ve never participated in a golden age, which either makes me younger than I thought I was, or less worldly, in that I have not been involved in a broad enough range of human endeavors so as to have been aligned with one.  However, when I look at the market on its face, and observe first hand how clogged the pipes of commerce really are, I can’t say I disagree with those giddy mezzanine lenders.  Despite recent fund raising in the segment ($20.3 billion 2008 YTD vs. $15.7 billion for 2007), demand will likely far outstrip supply over the next 12 months.

Before we go any further, let’s stop and talk about what mezzanine debt is.  Mezzanine debt is, as the name implies, a debt instrument.  It sits below any secured debt of a company and above preferred and common equity.  Mezzanine debt is unsecured, in that it has no real collateral package associated with it (its claim on assets is only senior to that of the equity).  However, mezzanine investors target “equity like” returns (17% – 20%) through a combination of interest and warrants for the common stock of the company.   In a leveraged buyout, mezzanine financing can make up 30% – 50% of the capital structure, though it  more often tends towards the lower end of that range.   See the summary slides below for more detail on typical mezzanine debt terms and usage.

So why exactly is this the age of enlightenment in deeply subordinated debt about to become a market reality?  The overarching rationale is that the debt market is more frozen than previously thought and is likely to thaw at a slower rate then deal junkies would like.  Despite the best efforts of governments and their central financial authorities, the government assisted delevering and relevering of the banking system will not happen overnight.  As a result, interbank lending and ultimately company and deal lending will take time to reemerge.  In absence of bank credit, second lien financing and high yield debt  (generally not available to smaller private companies) companies will turn to mezzanine as an expensive alternative, albeit a viable one.

In addition to the central hypothesis, there are other sound rationales as well.  First, leveraged dividend recaps can be financed with mezzanine debt.  Rather than stare down depressed equity multiples, an owner with an unlevered/or moderately unlevered balance sheet could achieve a modest amount of liquidity at a cost effective rate relative to prevailing equity multiples.   Second, and in combination with the above, mezzanine lenders make attractive transaction partners because they do not receive the rights package that an equity investor would, including blocking rights on certain corporate activities.  Third, mezzanine  debt will become increasingly relied upon to bridge the funding gaps on leveraged transactions that do move ahead in this environment.  In combination with asset based financing and seller financed senior paper, mezzanine should be sufficient enough to bridge valuation gaps in a subset of opportunities that would not otherwise get done.  Finally, when the leveraged buyout environment returns to some semblance of normalcy, there is no expectation that second lien and high yield for smaller deals will ever return, making it a semi-permanent fixture on the transaction landscape.

When I graduated from college in 1994, I was set on finding a job in the world of finance.  At the time someone suggested that I look at funds that were investing in mezzanine debt.  At the time I had no idea what private equity was, let along mezzanine debt, so I set off, unsuccessfully I might add, for Wall Street.  Maybe if I had heeded that advice I would now be the don of the golden era.  Who knows.

/bryan

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