Mezzanine debt, sometimes referred to as junior debt or subordinated debt, came into vogue during the “go-go” 1990s buyout boom.   The origins of mezzanine debt are rather cloudy, but the instrument was invented to allow private equity firms the ability to limit the amount of equity dollars they put at risk in a deal.   Once a purchase price was agreed and senior debt (bank financing secured against the assets of the company) was arranged, buyers would offer mezzanine debt funds the opportunity to get 15% – 20% return by taking an unsecured position ahead of the equity slug.   Interest rates on mezzanine debt was in the low teens with 66% – 75% of the interest being cash pay and the balance paid-in-kind interest (interest that accrues and is added to the principal and then paid when the debt is retired).  The balance of the targeted returns were achieved by issuing at-the-money or penny warrants to the debt provider.

Limited partners (pensions, endowments, and the like that make up the capital used by institutional funds) liked the mezzanine concept as it enabled them to get attractive risk adjusted returns, with the cash interest protecting them on the downside and the warrants juicing their returns on the back end.  In a strong bull market of rising tides, mezzanine funds did very well as default rates ran very low and equity returns exceeded expectations.  Many hedge funds got into the act by making similar investments in operating companies with a more risky profile.  These investments targeting slightly higher returns than institutional mezzanine.

Shortly after the Internet bubble burst, mezzanine debt, in its traditional form, went in to decline.  A flood of cheap bank debt made mezzanine less attractive to sponsors and the emergence of publicly traded Business Development Companies, offering one stop financings (senior debt, junior debt, and equity — often referred to as unitranche debt) , cut into mezzanines traditional markets.   Any gaps between purchase price multiples and bank availability was bridged through the emergence of second lien notes (debt that took a second position on fixed assets and real estate), which offered a lower cost of capital relative to mezzanine debt.   Traditional lenders, including second lien, were offering to cover as much as 95% of the purchase price, so there was no need to offer excess returns to anyone.  Between 2005 – 2007, mezzanine debt went in to hibernation.

By 2007, mezzanine began to make its comeback.   As purchase price multiples reached into the stratosphere mezzanine returned to filling its initial mission.  Any incremental dollar of debt meant an incremental $0.50 – $0.75 of purchase price.  Based on this improving demand function, mezzanine debt funds raised $15.7 billion in 2007.  In 2008, nearly 60 funds raised over $34 billion.  These funds were meant to fund the last mile on leveraged buyout transactions but then the music stopped.  By 1Q2009 the buyout market was bone dry.

Flush with capital, mezzanine debt providers were left to contemplate a “buyoutless” world.   In response to these changing circumstances funds separated into two camps — those determined to define their own identity (Camp I) and those intent to wait out the storm (Camp II).

While Camp II sat dormant, Camp I’s initial response was to seek to make stand alone mezzanine investments.  After all, mezzanine looked like a good tool to achieve short term liquidity relative to taking equity at depressed prices, if it was even available.   However, these funds were not well situated to do de novo deals, having historically relied on the diligence of their equity partners to get comfortable with a transaction.  As a result, targeted returns spiked and mezzanine debt became visually and economically unpalatable.   Lenders began targeting returns of 25% – 30% to compensate for their diligence risks (after all there was no equity to save them).   Many awesome deal stories followed.

However, as the buyout market has roared back to life, Camp I has shown that its evolution has staying power, while Camp II has returned to business as usual.   In fact Camp I is pitching itself as an alternative to institutional equity — faster, cheaper, without the governance hangover.  Notably, terms sheets from Camp I funds look much like those from the old public traded business development corporations, only without the senior debt.   Today a typical mezzanine term sheet will have a subordinated debt component, with cash and paid-in-kind interest and dollars allocated to an equity investment in lieu of warrants.   These mezzanine funds can stretch far on valuation because they have the downside protection of the coupon and no private equity partner to be beholden to.  The script has flipped.

As we enter into a period of uncertainty with respect to how this cycle will build and how long it will last, mezzanine debt players are better situated than their counterparts to take deal volume from other parts of the capital structure.   As a result, I expect to see standalone mezzanine debt volume grow dramatically through the balance of the year.

/bryan