SPECIAL REPORT:<br/>THE US MID-MARKET(2)

The credit crunch isn't bad news for everyone. This summer turmoil in the subprime mortgage market spread to the larger credit markets, ultimately making debt for LBOs scarcer and more expensive. But one group stands to gain from the moribund credit markets: the rising cost of debt could actually be a boon for mezzanine lenders.

“When debt becomes more expensive, you can either bring in more equity, bring in mezzanine debt, restructure the deal, or walk away,” says Jim Upchurch, president and chief executive officer of Caltius Mezzanine.

Mezzanine was once the main source of bridge financing for deals if senior debt was exhausted or unavailable. Mezzanine lenders were willing to accept much greater risk and far less restrictive covenants than senior lenders, albeit for higher rates. But mezzanine providers got squeezed out during the rise of second lien financing, explains Scott Zimmerman, an attorney in the corporate and securities practice group of Dechert.

“Mezzanine used to be the middle class of the debt structure, beyond first lien,” said Zimmerman. “But as second lien became more prevalent, mezzanine suffered.”

Second lien became the middle ground between senior and mezzanine debt. Second lien lenders provide loans at higher rates than senior lenders, and take on more risk. But unlike mezzanine lenders, second lien lenders have a subordinated claim on the underlying collateral.

The rise of second lien had a direct and negative impact on mezzanine, which found itself competing with second lien more and more, Zimmerman said.

“Mezzanine used to look for returns in the high teens or the low twenties,” he said. “As more capital moved into second lien, mezzanine lenders had to lower their overall return expectations.”

But second lien is priced off the London Interbank Offered Rates index, which has risen over the past three years. And as second lien has become more expensive, mezzanine has begun to regain some of its appeal. The recent credit crunch only exacerbated this trend; senior and second lien debt is not only more expensive, but in some cases completely unavailable, making mezzanine debt more important than it has been in years. “You need to look at the economics of mezzanine versus second lien,” says Neil Wessan, a managing director and co-head of leveraged loan capital markets and syndications for investment bank Jefferies & Co.

“If you have a second lien priced at Libor plus 750 [basis points], and Libor is at 5.75 [percent], you're talking about a 13 percent plus piece of paper. And mezzanine has a lot of interesting advantages over second lien – it has much fewer rights, and from a psychological standpoint, mezzanine investors often like to align themselves with the sponsor.”

Wessan notes another cultural fit between mezzanine and private equity that appeals to sponsors: “A lot of the mezzanine players have been around for quite a while. They have tremendous amounts of capacity and they aren't going to be overly concerned by technical fluctuations in the marketplace.”

By contrast, says Wessan, “A lot of hedge funds that participated in the loan market were opportunistic, which is what they're supposed to be. But it's not necessarily a long-term commitment. A number of funds who were using leverage are finding it is not available and that is lessening their appetite.”

As the market appears to be on the edge of a cyclical downturn, senior lenders will prefer to have a mezzanine tranche below them over a second lien tranche, as uncertainty in the markets make defaults more likely, and mezzanine lenders have no contractual claim on collateral, Zimmerman notes.

With demand for mezzanine expected to rise, mezzanine specialists are wasting no time in raising fresh pools of capital to deploy. Probitas Partners, a placement agent, counts 18 mezzanine funds on the road or planning to fundraise within the next year.

Littenberg, Wessan, Upchurch and Zimmerman all say they have noticed a slight uptick in interest in mezzanine debt, and expect that opportunities for mezzanine lenders will increase, at least in the immediate future.

“Certainly there are some funds that I'm working with that are starting to approach mezzanine lenders for new deals,” Littenberg says. “And it wouldn't surprise me if there are people who have existing mezzanine funds that are structured more as hedge funds rather than private equity funds who are starting to see more money flowing into their funds. Certainly there is interest in the sector.”

Increasing demand for mezzanine debt is already starting to affect pricing, Upchurch said. “Senior debt rates have gone up 100 to 200 basis points,” he said. “I would think mezzanine will probably go up 100 to 300 basis points. That's already starting.”