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

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“Dozens of people spontaneously combust each year.  It’s just not really widely reported.”

— David St. Hubbins, Spinal Tap

During the period spanning 2H2008 to 1H2009, I enjoyed a steady stream of inbound calls from companies seeking debt.  About half of those calls were from people thinking that I had something to do with a bank that made loans; the balance were from businesses, large and small, seeking additional capital to fund their operations.   Most of them were beyond help, due to the state of their business and/or collateral.  However, a small handful were beyond help, not because they were bad credits, but because the national banking system achieved a level of gridlock not seen in my lifetime, or probably anyone’s for that matter.

The market panic caused a significant contraction in available debt.  Market prices for even high quality credits trading on the secondary market plummeted (30% – 40%); default rates spiked (a 400% increase to ~ 13% in December 2008); spreads widened materially (+400 BPS on Commercial Paper, one of the lowest risk financial investments); capital ratios increased (Tier 1 capital requirements for lenders increased from 4% in May 2009 “Stress Test” to 7% at Basel III); and bank numbers contracted (active cash flow lenders went from 154 in 2007 to 18; FDIC has closed approximately 300 banks as a result of the recession).   No wonder people could not get a loan.

The above should be no surprise to anyone who follows the financial news.  However, today, some 12 months removed from those panic induced calls, people look at me quizzically when I tell them that debt is in fact available.   The looks I receive are a cross between “what you talking about Willis?” and the glare my grandfather bestowed on me when he thought I was pulling his leg.   Yes, debt is available, but like spontaneous combustion it’s not really widely reported.

To be clear, a significant portion of the business ecosystem is still unable to access debt.  Asset based loans remain widely available, with lower advance rates, but there are a lack of lending institutions that write check sizes under $5 million.  For those banks that remain in this market, many of them continue to be saddled by under performing real estate portfolios and credit standards that are harder to crack then getting into the wine cellar in the presidential war bunker.   As such, loans for small business remain very hard to come by, and this will continue for some time.  However, debt for large middle market businesses is not only widely available, but the trend has turned silly as banks seek to invest (no loans no loan revenue) as much of their available capital with the highest quality credits.  Eventually, competition will drive these banks to begin moving down the size and quality stack until the lower echelons are again able to access cost effective debt capital.

One prime example of debt market health is the availability of leveraged dividends.  A leveraged dividend involves taking out debt to pay, as you might expect, a dividend.   In short, a significant percentage of capital is not remaining in the business, it’s going in to the pockets of shareholders (often times private equity funds) with the liability remaining at the corporation.   When leveraged dividends are widely available, it is the first sign of debt market excess.   Now consider that over $40 billion of leveraged dividend recaps have been declared in 2010, according to S&P.   These levels exceed 2005 totals and are competitive with 2006/2007 volumes, the base of the last market peak.  The shareholders of HCA, Dunkin’ Brands, Burlington Coat Factories, Ascend Learning, Getty Images, Pelican Products, and Petco have been the chief beneficiaries.   While many of these companies operate in attractive industries that are “recession resistant” (health care, education, pet retail), many of them are not owners of highly predictable recurring revenue streams that would put a lenders credit committee at total ease.

Likely a better measure is what I am seeing in the market as it relates to debt issuance.   Based my purview, the credit market remains bifurcated.  However, as a company’s trailing twelve months (“TTM”) Earnings Before Interest Taxes and Depreciation (“EBITDA”) approaches $10 million, it becomes much more widely available.  Further, in the last 6 months, we have seen a trickle down effect.  In 1Q10 the benchmark was $15 million in TTM EBITDA, while today it is in the +/- $8 million range and goes lower, albeit not much, for companies that are in non-cyclical industries and have predictable recurring revenue streams and performed well throughout the recession.  A caveat is that if EBITDA has spiked materially over the last twelve months, a three or four year average is applied to establish “baseline” EBITDA.   It also helps if the company is backed by a third party equity provider.

What is also notable is that bank hold sizes have gone down considerably.    What this means is I am seeing syndicate deals on transactions that we would traditionally see a lender signal source.    Companies seeking $100 million loans are ending up with 5 – 7 banks in their credit versus 1 – 2 pre-meltdown.  This means it is actually easier for $10+ million TTM EBITDA businesses at the lower end to get credit than at the higher end, as you don’t need to get the entire credit industry on board with your transaction.    I realize this is backwards, but welcome to the current credit market reality.

Finally, availability does not necessarily correlate to volume.    Currently, lenders are seeking a minimum of 40% of enterprise value be in the equity account.   Therefore a company that is valued at 6.0x TTM EBITDA can only get up to 3.5x leverage, and more likely 3.0x.   Thus, no meaningful EBITDA means no meaningful debt.

Net net, we are not in a flush lending environment by any means, due in part to government imposed capital requirements, but debt is available if you fit in the current sandbox.

/bryan

 

 

 

 

allied5In the leveraged buyout run up of the past 5 years, there was a never ending search for debt to finance transactions.  While equity multiples reached into the stratosphere, relative to historical norms, the ability of private equity funds to utilize cheap debt to underwrite deals seemed to provide a justified rationalization for paying significant equity premiums.  Where senior debt and senior stretch ran out, second lien loans were tapped to get deals done with minimum equity contributions.  Second-lien loans, due to their secured nature, were preferred to unsecured or subordinated debt (read — they were cheaper).   Second-lien lenders used to say, “mezzanine is for suckers.”

Second-lien loans made a lot of sense in many deals.  Prior to the credit crunch, private equity sponsors could secure second-lien debt for LIBOR  + 400 – 500 bps.   In the first half of 2007, lenders issued $2.65 billion worth of second-lien loans to finance middle market deals, up significantly from 2006, when $204 million in second-lien debt was issued to finance these same types of transactions.

During all the euphoria, speed to close became a significant differentiator for sponsors, and while second-lien was a great tool to get equity contributions down, it often elongated the process to close, due to the fact that the lender often needed to assess the collateral base at a detailed level so as to ascertain any overflow from the senior secured that would accrue to it in the event of default.  To provide private equity firms a means of overcoming this obstacle, unitranche debt was birthed by Allied Capital, a publicly traded business development corporation (BDC), in 2005.

Unitranche debt combines traditional senior and junior debt terms into a single senior debt facility.  This allowed parties to sign a single loan agreement, involving a single interest rate from a single lender.  The unitranche structure also offers simplified documentation, reduced amortization requirements, and the ease of future add-ons and modifications.  Unitranche was an excellent tool for companies with sub-$15 million EBITDA, whose loan size often did not reach into the syndication market.  Unitranche facilities are floating rate and tend to range in price from LIBOR + 500 – 750 bps.  While this is more costly than parsing the debt structure, the ease of use and speed to close, in many cases, offset the more expensive relative cost.

On the backs of its success in unitranche, Allied began making a name for itself with “one stop buyouts”, providing the equity underneath its simplified debt structure.  As an agent, Allied and its chief competitor American Capital Strategies became first calls for those seeking a stalking horse in a competitive bid process.  Both Allied and American Capital were perceived to have the ability to pay higher equity multiples due to their inputted IRR from providing the debt financing.

As deal velocity increased so did Allied’s stock price.  Offering investors a handsome dividend yield of ~ 8% which it funded using a combination of current interest and asset sales.  Allied raised new pools of capital by issuing new equity through secondary offerings.  In December 2007, the unitranche movement peaked when Allied Capital and GE Commercial Finance raised $3.6 billion for Unitranche Fund, LLC.   Prior to the financial meltdown, Unitranche Fund closed two deals, backing Carousel Capital’s acquisition of Brasseler USA and The Riverside Company’s acquisition of Central Power Products.

Despite its simplicity, unitranche and one stop buyouts have their detractors.  In a one stop, the lender splits the loan between secured and unsecured tranches.  Often times these tranches are funded from different vehicles and commingled pursuant to an inter creditor agreement that is negotiated by the funding entities without consultation of the borrower or sponsor.   This can create some adgeda when it comes time to do additional add-ons.  However, may people state that the speed and simplicity to close over come this obstacle in spades.

The other common criticism of one stop buyouts, is that it puts the lending organization directly in competition with the equity community.  In effect Allied and American Capital, an others of that ilk, drive up equity multiples for other bidders, who are also their customers.  Allied is careful to disclaim this notion by being very cognizant not to compete as a standalone bidder in a multiparty auction process.   In my experience they have always toed this line gracefully.  I’ve never heard a sponsor make a substantive complaint, thought I am sure it has happened.

So if unitranche/one stop buyout makes so much sense, why is Allied stock yielding ~ 87.5%, American Capital ~ 66.4% and Gladstone Capital (a smaller version of the two) ~ 20.4%?  The answer to that is the perception that the model is clearly broken, for now (for the purposes of this discussion we will leave aside Allied’s tussle with David Einhorn, which you can read about here).

Long short, Allied and its ilk face liquidity challenges caused by the current market turmoil.  Remember, these funds fill their coffiers through secondaries, but at their current valuations such issuances would be highly dilutive.  Their other option for liquidty is through asset sales of companies that it own equity in through one stop buyout transactions.  Yet, selling assets in this environment is surely to be disadvantageous given the prevailing multiples.  Sort of a dammed if you do, dammed if you don’t scenario. Further, if these unitranche players had captive liquidity, the option of buying fully collateralized senior debt on the open market at 60% of face value or repurchasing their own stock, seems like a much better use of capital than issuing new debt at par.

That all being said, I don’t see unitranche or one stop buyouts going the way of the dodo bird.  There are several reasons to support this assert.  First, unlike the investment banks, publicly traded BDC are largely underleveraged.  Allied’s current debt to equity ratio is less than 1.0x.  Further, due to the nature of regulations in their business,  Allied and other BDC’s cannot count preferred equity investments in their equity base, so their real leverage is, to an extent, over stated.  While Allied is going to have issue with its tangible net worth covenant related to its current third party indebtedness, lenders are likely to work with Allied given its current position in the industry.  Additionally, Allied will likely cut its dividend in order to preserve capital.  The stock is currently trading in anticipation of such an event.  While this would be a downer for investors, it is in the best interest of long term equity value.  Third buying senior debt on the open market appears to be a realitvely good risk reward tradeoff for capital, with the potential to create real returns for shareholders.  Finally, I think BDC play a significant and valuable role in the middle market for both companies and private equity firms alike.  This ability to deliver long term value will likely be their saving grace.

/bryan

The term debtor-in-possession, refers to a company that has filed for bankruptcy, but continues to operate, controlling its assets for the benefit of creditors and shareholders.  The current borrowing environment is the “un-debtor-in-possession”.  Borrowers, despite strong balance sheets, healthy collateral, and even strong cash flow are being left high and dry by the lending community.  Their assets are at the mercy of the banks, not management.

I guess $750 billion in bailouts, including $250 million of direct investment, does not bridge the gap between debtors and creditors.   How bad is it?  The White House went on the offensive today, chiding banks receiving financial aid for not lending.  The harsh reality, until the lending environment improves, and companies and consumers starved for cash can get some assistance, economic expansion will not occur.

I don’t blame the banks for their actions.   If I had money, I’m not sure I would lend it either.  Sure lending at LIBOR + 1466, last weeks all in yield in B/B2 credits, seems juicy, but not relative to buying back your own stock, or purchasing senior paper at 70 cents on the dollar in the secondary market and holding it to maturity.  After all, if I am a bank officer, I’m probably incented using options on my underlying equity, not my good Samaritan IQ.

In light of the above, I thought I would go in search of some answers in the debt markets about what is going on and what will be going on over the next 60 – 90 days.  What I found was is summarized it below.  We will work from the bottom of the capital to the top.  Let’s leave out mezzanine as I think I have flogged that concept for now.

Unitranche Debt

Unitranche debt is a fandango instrument invented by the publicly traded business development corporations (BDOs) (Allied Capital, American Capital, Gladstone, etc.).  Unitranche debt combines the terms of senior and junior debt into one single debt facility.  BDOs have the ability to provide a one-stop-shop for all your capital needs.  Historically, unitranche was very attractive for sub-$15 million EBITDA companies.  Issuers targeted a 12% – 14% total return, making them an attractive alternative to mezzanine debt.

Unfortunately, the unitranche model is broken.  Very.  Consider the following yields on the equities of publicly traded BDCs (after a day when the market climbed 10%): a) ALD ~ 43.8%, b) ACAS ~ 39.4% and c) GLAD ~ 17.3%.   These stocks are trading under the assumption that their dividends are going to be slashed.  The BDC model relies on their ability to issue new stock in the equity markets to raise capital,  lend that captial at attractive rates and get equity kickers, pay your dividend with return from equity kickers.  Small problem — equity returns are in the tank, new issuance’s are at a standstill and these companies can’t issue equity to fund forward commitments.   The model is broken.   The best use of capital for these companies is to buyback their own stock or, as previously noted, purchase senior loans on the secondary market.  Unitranche debt is an endangered species until yields on corporates come down to reasonable levels.

Cash Flow Loans

We can keep the section on cash flow loans quite short.  There are more Do-Do birds than cash flow loans right now.  However, unlike our extinct friend friends, cash flow loans will eventually return.  I would not wait around however.

Other Senior Debt

On the senior debt front, I spent some time with a Senior Vice President from GE Financial Services.   He told me, that contrary to popular belief, and potentially only viable for this week (since things are so fluid), they remains open for business.  However, what he said was stunting their business was their ability to syndicate deals.  In fact, the entire GE syndication team was working on only a small handful of deals at this time.  Here is what else he told me:

> Equity contributions in private equity deals had reached 50% – 60% as collateral rates of asset based financing’s (ABL) had contracted 10% – 15% from historical norms.

> Syndications are near impossible right now.  The commitment terms on deals are not firm or even best efforts but rather “might fly” with partners.  The market flex language is bigger than a material adverse change clause in a traditional leverage buyout.

> When asked about equipment loans I was met with the following response, “I’m not sure who is going to take those.”  Enough said.

> Strong deals are going for LIBOR + 650 with upfront fees 4% – 5%.  That’s expensive money for a solid operating business.  Businesses are bypassing deals because the cost of funds takes them from accretive to dilutive.

> Facility extensions for add-on acquisitions are resulting in a full renegotiation of facility terms and conditions.  Given the cost of funds that issuers are now facing, this a market reality.

Net, net the debt market is on life support.  Despite the best efforts of the government, the velocity of money through the system has not increased.  The reality is most lenders are trying to gauge how deep and how long the current recession is going to be.  No one wants to be caught on the wrong side of a credit decision in the near term.  As a result, grid lock will prevail until the equity markets show signs of life.  While today was a step in the right direction, after hours trading shows profit takers are selling off.

Anyone want to loan me any money?  I’m good for it.  I swear.

/bryan