Mezzanine funds in vogue during debt drought

MIDDLE-market companies are facing a refinancing gap unprecedented in modern times as they struggle to raise much-needed capital for expansion. With banks currently unwilling to lend following the global financial crisis, companies and private equity firms are being forced to explore alternatives and mezzanine debt is shifting up the pecking order.

This hybrid between debt and equity is typically used by companies that are too small to access traditional high yield corporate bond markets. The debt is junior to traditional bank financing but senior to equity financing in a capital structure. It is offered by specialist funds, meaning there are opportunities aplenty for canny investors. It is particularly attractive when you consider that, due to the fact this type of financing is aggressively priced because it is non-public and unsecured, lenders frequently seek returns of 20 to 30 per cent.

In a new report, consultancy Mercer outlines an investment case for mezzanine debt funds it believes is supported by analysis of the demand side.

It reckons there is around $500bn of capital still to be deployed for future private equity investing – and thus potentially requires some mezzanine support – along with the refinancing of around $1trillion in high yield and leveraged loans maturing between now and 2015.

The supply side of mezzanine debt has been impacted by the recent global financial crisis with banks’ ability to lend having declined significantly. Taking these factors together, Mercer believes investors could expect a near doubling of returns from mezzanine debt compared with previous market cycles.

Paul Cavalier, global head of Mercer’s Bond Boutique, says: “Mezzanine debt is currently a strategy that we believe investors should be considering as part of their future alternative or opportunistic fixed income portfolios. As with most investments there are risks attached and active portfolio management and credit analysis skills will be required to ensure default risk is minimised. To address this, when investing we believe careful investment manager selection should be undertaken and we have applied our global resources in identifying high quality firms.”

The Mercer report highlights the greater equity allocations to be found in capital structures, providing an additional cushion for debt investors. These changes combined with better terms, high coupons and potential equity participation make for an interesting opportunity for patient investors with risk capital, it adds.