Investing in Mezzanine Debt

“Mezzanine capital plays an important role in growth- and acquisition-related financings in the North American middle-market. Private lending in the middle-market is relatively inefficient; and with banks and other traditional lenders exiting the market, there remains a unique opportunity for seasoned mezzanine capital providers to find attractive investments.”

- Bill Casperson

“This paper intends to discuss the mezzanine debt asset class, the opportunity set and our perspectives at Oaktree. We hope you will enjoy it.”

- Raj Makam

In this paper we seek to provide information on investing in mezzanine debt. Any reference to mezzanine debt should only be considered with regard to investing in the North American middle-market, as some of the information discussed may not be applicable to other markets. We will also only briefly mention preferred equity, which can sometimes be considered mezzanine capital. We will explore the following six topics in order to provide a foundation for investing in mezzanine debt.

• What is mezzanine debt?
• What are the characteristics of the middle-market in North America?
• What are the potential benefits and risks of investing in mezzanine debt?
• What are the different ways to invest in mezzanine debt?
• What is the current opportunity in mezzanine debt?
• How does Oaktree approach investing in mezzanine debt?

what is mezzanine debt?

As its name implies, mezzanine debt is situated between the senior secured bank debt and the equity in an issuer or borrower’s capital structure. Mezzanine debt is typically used to finance leveraged buyouts, recapitalizations and corporate acquisitions. It is also an alternative to public or private equity for companies seeking growth capital. Typically junior in credit standing, mezzanine debt provides additional  capital beyond senior secured debt. As shown in Figure 1, mezzanine debt typically takes the form of senior unsecured or subordinated notes, or second lien debt. From an issuer’s perspective, mezzanine debt can reduce overall capital costs by providing additional debt financing that can enhance equity returns.

For middle-market businesses, mezzanine debt typically takes the place of the high yield bonds used by larger companies. As highlighted in Figure 2, the minimum issuance size for a company to access today’s high yield bond market is generally $200 million or more. In other words, most middle-market businesses do not have the financing need or the ability to access the high yield bond market. By creating a capital structure with a ‘‘right-sized’’ combination of mezzanine debt and bank borrowings, middle-market companies can leverage their equity capital to generate attractive returns for their owners.

what are the characteristics of the middle- market in north america?

Middle-market companies account for the vast majority of businesses in the United States and represent approximately 33% of private sector GDP, 48 million jobs and, on a standalone basis, would be the world’s fifth largest economy.1 According to the U.S. Census Bureau’s 2012 economic census, there were approximately 41,100 middle-market companies in the United States with annual revenues between $50 million and $1 billion. This compares to just 1,450 companies with annual revenues above $1 billion.2 Most middle-market businesses that employ mezzanine debt have earnings before interest, tax, depreciation and amortization (“EBITDA”) ranging from $10 million to $50 million.

Middle-market companies are usually closely held by their founders, families or by private equity firms. The majority of middle-market companies are privately held due to their limited resources and  the costs associated with being a public company. Middle-market companies can be found in almost every industry sector.

what are the potential benefits and risks of investing in mezzanine debt?

Some of the potential benefits of investing in mezzanine debt include the opportunity for attractive total return, downside risk management through privately negotiated transactions, and less-volatile performance through a high current coupon component.

Potentially Attractive Total Return

Due to their subordinated or junior position in an issuer’s capital structure, mezzanine debt investors generally demand higher prospective returns compared to senior secured debt investors. As shown in Figure 3, total returns on mezzanine debt typically come from (1) high current coupons (typically fixed-rate and paid quarterly, mostly in cash), (2) commitment or arrangement fees (often paid in the form of original issue discounts) and (3) call protection (i.e., premium payments if the mezzanine debt is repaid early). Mezzanine debt, in contrast to senior secured debt, will most often come with an “equity kicker” in the form of the opportunity to purchase equity in the underlying borrower. This results in the potential for additional returns beyond those contracted for by the junior debt investment by itself. Mezzanine investors have historically targeted blended gross annualized returns in the mid-teens. Similar to other debt investments, we feel the avoidance of defaults and subsequent losses, sometimes referred to as the “negative art of bond investing,” can be the most important aspect for mezzanine investors striving to achieve attractive total returns.

Private Structures Provide Downside Risk Management

In the middle-market, mezzanine debt is typically issued through privately negotiated transactions. A mezzanine lender’s decision to extend credit to a borrower is usually based on the issuer’s ability to generate free cash flow (as opposed to being based on asset backing) and on the growth prospects for the business and industry. Compared to what is often less than a week of limited, public-side due diligence for broadly syndicated loans, mezzanine debt investors typically are able to perform extensive private-side due diligence over a four- to six-week period. As part of this due diligence, mezzanine lenders receive greater access to company information, such as historical financial statements, earnings and audit reports, and environmental or other expert analyses. This gives mezzanine debt investors the ability to better understand the borrower, negotiate terms and structure loans in ways that are appropriate for the underlying business. In addition, mezzanine debt investors also have the opportunity to interact with the company’s management several times before an investment is made.

After making an investment, mezzanine debt investors usually receive monthly or quarterly financial statements. In addition, many mezzanine lenders negotiate board observation rights as part of the terms of their investment. Receiving board of director materials and attending the meetings, alongside what is often frequent dialogue with company owners and management, gives mezzanine lenders the ability to closely monitor their investments and stay ahead of potential business issues. It also helps the investor keep up to speed with company performance and knowledgeable should amendments to the credit documents be necessary.

Lastly, although debt financing to large corporate issuers has increasingly become covenant-lite with no maintenance financial covenants (e.g., a maximum leverage ratio), loans to middle-market businesses continue to carry both incurrence and maintenance covenants. These covenants give mezzanine lenders additional tools should the business underperform. Mezzanine lenders often work with owners to take proactive steps to upgrade the borrower’s operating performance and maximize liquidity. These proactive steps may include cost reductions, divestitures of less productive assets, and changes to operations or management. Additional steps to address underperformance may even include voluntarily deferring the cash portion of interest due on the mezzanine debt in order to help the company avoid defaulting on its senior secured debt. Senior secured debt for larger issuers is more likely to be syndicated and may include lenders who are less willing to work through cyclical downturns.

High Current Coupon Reduces Volatility

More often than not, mezzanine debt is structured with a fixed coupon that is paid quarterly (mostly in cash). This coupon compensates lenders for subordinating their position in the capital structure. In today’s market, coupon rates are running from 11.0% to 12.5%, on the low end of the historical range. Still, for investors targeting mid-teen gross returns in a low-yield environment, mezzanine debt is an attractive alternative to other debt instruments. Furthermore, since mezzanine debt coupons are usually paid quarterly, the high current coupon component reduces the overall volatility of returns to investors.

Potential Risks of Investing in Mezzanine Debt

First and foremost, mezzanine debt is junior in the capital structure and typically in a first-loss position after the value of the company drops by more than the amount of its equity. Second, since mezzanine debt is provided through privately negotiated transactions, it is far less liquid than more public securities if it needs to be sold. Lastly, middle-market businesses often face greater idiosyncratic risks compared to larger companies. For example, due to their smaller size, loss of a customer or increases in the cost of raw materials may have a larger impact on the borrower’s EBITDA than it would on a larger company. In certain instances, due to their size and ownership structure, middle-market companies may also have less professional or less seasoned management teams.

what are the different ways to invest in mezzanine debt?

The two main ways to invest in mezzanine debt are: (1) through directly negotiated transactions with a company or its owners, or (2) by investing in a pooled, private-fund structure that targets investments in mezzanine debt.

Direct mezzanine debt investments are typically reserved only for investors with large amounts of capital. Direct investments can be sourced through relationships with family owners, investment banks or private equity firms. They are often purchased by large institutional investors or by smaller investors with relationships with the underlying borrower. Most mezzanine debt investments, whether directly made by an individual or made on behalf of a pooled fund, typically take several weeks to a few months to negotiate and close.

Private limited partnerships are the most common way for investors to access the mezzanine debt market. This is typically done through capital commitments that are aggregated with the express purpose of investing in mezzanine debt. Asset management firms typically organize these funds and act as the general partner. The general partner seeks attractive risk-adjusted returns for the partnership, while maintaining a diversified portfolio of investments.

Collateralized loan obligations (“CLOs”) and business development companies (“BDCs”) also invest in second lien loans, an asset class that is a competitive replacement for mezzanine debt. BDCs also invest directly in mezzanine debt. CLOs are securitized vehicles where payments from multiple loans (mostly first lien) are pooled together and passed on to different classes of owners in various tranches. BDCs are closed-end investment companies that raise capital by selling equity shares to investors, often in the public markets. Recently, however, fewer CLOs have been created due to regulatory rulings and a more expensive funding environment. BDCs are also undergoing structural issues that largely impede them from making new investments. At this time, it is difficult to forecast the full impact of these issues and the extent to which they will affect the market presence of CLOs and BDCs.

what is the current opportunity in mezzanine debt?

Following the end of the financial crisis, competitive conditions in the mezzanine debt market intensified as investors searched for yield in a low-interest-rate environment. CLOs, BDCs, commercial lenders and private funds all participated in driving down returns and loosening financing terms. That being said, as shown in Figure 4, the pool of uninvested private equity capital available for leveraged buyouts remained large, helping maintain the demand for mezzanine debt. As shown in Figure 5, private equity firms’ equity contributions to buyout transactions also remained high (particularly compared to pre- crisis levels), mitigating risk to lenders. With such substantial equity capital invested, the enterprise value of a borrower can decrease up to 40% to 45% before the mezzanine debt becomes impaired.

Since the start of the oil and gas market downturn in mid-2014, credit markets have become less frothy, and certain providers of debt capital have, at times, retrenched. As shown in Figure 6, over a number of years, banks have also gradually exited the middle- market leveraged loan business in order to focus on larger issuers with facilities that are more easily syndicated. According to Standard & Poor’s, domestic and foreign banks have been steadily reducing the amount of leveraged loan new issuance they retain, from over 70% of primary issuance in the 1990s to less than 20% in recent years.

With traditional lenders having significantly reduced their middle-market debt holdings and, more recently, CLOs and BDCs facing the a forementioned issues, private funds with long-term capital and the ability to hold the full amount of a loan (or a large portion as part of a “club” deal) should continue to see attractive investment opportunities. While the middle-market typically lags larger market credit cycles, the recent negative shift in outlook for corporate credit did impact the volume of new middle-market transactions. This is highlighted by Figure 7, which shows that LBO volume in the middle-market dropped from $83 billion in 2014 to $54 billion in 2015. Oaktree believes this was due to reduced confidence in the overall economic environment and the impact of the oil and gas industry dislocation on businesses with exposure to the sector. The owners of middle-market companies will often hold off commencing a sale process until weakness in the underlying business abates or buyer financing becomes more attractive.

While it is hard to predict where middle-market M&A and financing markets will go from here, it is clear that the competitive landscape for mezzanine debt investing has changed since 2014. Oaktree is optimistic that these changes will provide additional opportunity for risk-focused junior debt investors with capital to lend.

how does oaktree approach investing in mezzanine debt?

Oaktree targets mezzanine capital investments in North American middle-market businesses, providing loans to borrowers being purchased by private equity firms in leveraged buyouts. Due to the risks associated with both mezzanine debt and middle market businesses, Oaktree believes it is prudent to not use leverage in this strategy, and to conservatively structure the investments it makes.

Many mezzanine funds buy preferred or common equity alongside their debt investments. Although Oaktree typically invests 10% to 15% in equity in connection with its mezzanine debt investments, this is limited in order to conservatively participate in the upside potential of each business, with a goal of adding 100 to 200 basis points to potential returns.

Mezzanine debt investments can be approached in two different ways: (1) with a credit emphasis, where a substantial portion of the return is in the form of a debt coupon supplemented by some equity upside, or (2) with an equity emphasis, where the return is primarily driven by equity investments. At Oaktree, we follow a credit-focused strategy with a heavy emphasis on safer, less-risky companies, and we structure our investments as extensions of credit with small equity kickers. As shown in Figure 8, when structuring investments, we expect the majority of the return to come from the quarterly cash coupons.

When making mezzanine debt investments, Oaktree targets companies with sustainable cash flows, proven management teams, strong market positions, and diversified, well-developed businesses. As previously discussed, we have a conservative bias and employ a loss-avoidance approach. Oaktree works closely with private equity sponsors in conducting thorough and complete private-side due diligence, acting as the sole, lead or co-lead investor in most of its mezzanine debt transactions. We believe it is important to retain control over the terms of our investments, and we typically request board observation rights that allow us to continuously monitor each investment. We try to keep total debt multiples between 4.0x and 6.0x EBITDA or less and interest coverage ratios at 2.0x or greater.

Oaktree tries to be opportunistic with respect to deal flow and to select those transactions that provide the best risk-adjusted returns. Oaktree has a proprietary private equity deal-sourcing network, which has been built across market cycles since the inception of the strategy in 2001. We are exceptionally proud of the fact that over 15 years, more than 70% of our investments have been with repeat sponsors, a statistic that highlights our relationship-oriented approach.

Conclusion

As with most credit strategies, the mezzanine debt market has been very competitive since the end of the financial crisis. However, Oaktree believes there have been, and will continue to be, opportunities for attractive risk-adjusted returns in mezzanine debt. Furthermore, the recent cooling in the credit markets reminds us that investors with durable capital and market experience should be able to take advantage of dislocations to find attractive opportunities and enhanced returns. Oaktree has a 15-year track record of investing in the debt of middle-market companies. Regardless of credit and economic cycles, we expect there will always be middle-market companies and owners in need of a relationship-oriented junior lender.

Endnotes

¹ The National Center for the Middle Market (in collaboration with The Ohio State University Fisher College of Business) as of March 31, 2016.

² United States Census Bureau, Statistics of U.S. Businesses (2012).

³ Includes transactions for Oaktree Mezzanine Funds, as well as Oaktree's middle-market CLO warehouse and BDC seed vehicles.

notes and disclaimers

This document and the information contained herein are for educational and informational purposes only and do not constitute, and should not be construed as, an offer to sell, or a solicitation of an offer to buy, any securities or related financial instruments. Responses to any inquiry that may involve the rendering of personalized investment advice or effecting or attempting to effect transactions in securities will not be made absent compliance with applicable laws or regulations (including broker dealer, investment adviser or applicable agent or representative registration requirements), or applicable exemptions or exclusions therefrom.

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An investment in any fund or the establishment of an account within Oaktree’s U.S. Private Debt strategy is speculative and involves a high degree of risk. There can be no assurance that investments targeted by any strategy will increase in value, that significant losses will not be incurred or that the objectives of the strategy will be achieved. Moreover, a portfolio within a strategy may not be diversified among a wide range of issuers, industries and countries, making the portfolio subject to more rapid changes in value than would be the case if the portfolio was more diversified.

Investments in debt instruments entail normal credit risks (i.e., the risk of non-payment of interest and principal) and market risks (i.e., the risk that certain market factors will cause the value of the instrument to decline). A default on a loan or a sudden and extreme increase in prevailing interest rates may cause a decline in a portfolio holding such investments.

Fixed income securities may be subject to redemption at the option of the issuer. If a fixed income security is called for redemption, the holder may be required to permit the issuer to redeem the security, which could have an adverse effect on the holder’s ability to achieve its investment objectives.

Mezzanine debt and equity investments will typically be subordinated. Subordinated investments may be characterized by greater credit risks than those associated with the senior obligations of the same issuer.

Investments in mezzanine debt are expected to include companies whose capital structures may have significant leverage. Such investments are inherently more sensitive than others to declines in revenues and to increases in expenses and interest rates.

This document contains information and views as of the date indicated and such information and views are subject to change without notice. Oaktree has no duty or obligation to update the information contained herein. Further, Oaktree makes no representation, and it should not be assumed, that past investment performance is an indication of future results. Moreover, wherever there is the potential for profit there is also the possibility of loss.

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