Investec Growth & Acquisition Finance’s Ed Cottrell talks about the recent resurgence of mezzanine, albeit in new forms adapted to suit the changing needs of business.
Recent visits to the cinema have convinced me that the 1980s are coming back into fashion. Richard Gere – who had his heyday in that decade – has been starring in a film called Arbitrage, named after a financial term that also had its zenith back then.
I've been pondering another 1980s financial phenomenon – mezzanine debt. When it first emerged, this form of unsecured debt was seen as a high-risk product that sat between senior debt and equity (as the term suggests) and was used greatly in leveraged buyouts. "Mezz" has been in and out of fashion a fair bit in the last couple of decades, tending to follow the risk appetite of investors and deal-makers, but a recent study from Partners Group going back 21 years found that mezzanine funds have enjoyed good returns and low defaults.
Since the financial fallout of 2007, you'd have thought that mezzanine was definitely out of fashion. However, like Richard Gere, it has shown some resilience and has both made a return to deals in the last couple of years and morphed to reflect recent financial realities.
You don't have to spend too much time reading the financial pages or talking to business people to find out that finance for business is tight at the moment. This is due to most banks still recovering from the losses they incurred in the last decade and being under regulatory pressure to hold more capital. The resultant liquidity squeeze is in turn causing a squeeze on lending, and when banks do lend, they tend to be quite risk averse – both in terms of the sectors they consider and the multiples of profitability they will lend at.
This has created a gap in the market for well-structured higher-risk, higher-return lending, with more focus on sectors less loved by the high street banks and the ability to lend on higher multiples of EBITDA than is available in the senior debt market. This helps both fast-growing companies, which might have a need for more finance to fund growth, as well as private equity firms looking for a deal structure with the appropriate levels of gearing to get them the returns they are looking for.
This debt is mezzanine, and while it has returned to some extent, it has also morphed into a number of different structures, which the market draws together under the umbrella term "unitranche".
In a sense it is quite similar to high-yield bonds – which have also made a comeback recently – though the key differences are that it is not tradable debt, the amounts raised tend to be smaller and it is held by the originator or one or two banks or funds. Unitranche tends not to be syndicated. However, it can (often in conjunction with "super-senior" from traditional lenders) fill the gap left by the leveraged senior and mezzanine structures of yesteryear.
Demand has been driven by the requirement to achieve appropriate leverage. However, supply has often come from providers of finance unencumbered by the legacy of the financial crisis and therefore responding to the liquidity gap – in particular debt funds whose fundraising models drive them to seek higher returns than the traditional senior market. That same model encourages them to put increasingly large numbers (in total and per deal) out the door so they can achieve the scale of funds they need. This has quickly pushed debt funds to the upper end of the mid-market.
But what about the lower mid-market – companies that want to borrow between £5-50m? This is where the liquidity gap has hit hardest. They have the same needs as the larger businesses but they haven't been served well by either their traditional banks or debt funds. Furthermore, they are the likely engine room of growth to get our current moribund economy moving.
As one of those unencumbered by the excesses of the past, the Investec Growth & Acquisition Finance team has found quite a demand for both mezzanine and unitranche facilities at this sort of level and has recently completed four deals with growing companies looking for the flexibility and headroom that unitranche and mezzanine give them.
Giving business the finance that they need to grow is essential in the current economic climate. Mezzanine may not be the answer to every financing issue, just as Richard Gere isn't ideal for every movie. But for some companies, modern mezzanine – or unitranche – is as popular today as it was in in the 1980s.
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