Rising interest rates and tightening credit conditions have jarred many investors who have not experienced either in a while, but there is one corner of the market where the current environment may offer opportunity: mezzanine debt.
Mezzanine lenders are well positioned to “bridge the gap” in the capital structure between senior debt and equity contributions made by private equity sponsors or management teams during times of economic turmoil. Particularly in periods of economic uncertainty and tighter liquidity – when many senior lenders seek lower levels of risk – this gap in the capital structure may widen, creating an opportunity for the mezzanine product category.
Mezzanine financing provides institutional investors with an alternative to investments in traditional forms of senior debt or equity capital. There’s potential for higher contractual yield relative to traditional senior debt investments and greater stability relative to traditional private equity investments. As a result, many institutional investors view mezzanine funds as having an attractive risk/return profile, offering downside protection and current income as well as equity upside potential.
“The reduction of capacity in the private credit markets on a senior basis, and the narrowing in the gap of cost between mezzanine financing and senior financing, may lead to a favorable environment for mezzanine,” said Eric Seward, Partner at PGIM Private Capital. “The PE community has largely bypassed mezzanine for several years because they could do almost anything they wanted to on a senior or unitranche basis. Now they’re coming back to the mezzanine product because it’s a viable part of the capital structure.”
The mezzanine category provides investors with diversification from private equity investment return characteristics; unlike PE funds, mezzanine is not solely reliant on leveraged buyout transactions to deploy capital. In addition to financing change-of-control transactions, mezzanine financing can also be used for refinancing, recapitalization, growth financing, and acquisitions.
Back in Favor
Fundraising for mezzanine lending grew to $46 billion last year, reaching its highest total ever, according to research from McKinsey & Co. The management consulting firm noted that investors may view mezzanine as being well positioned in the current credit cycle, with banks and direct lenders taking a more conservative stance on risk. McKinsey pointed out that in percentage growth terms, mezzanine strategies have enjoyed some of their best fundraising years—2008, 2016, and 2022—during periods of rising risk premiums.
“The senior leverage available in both sponsored and non-sponsored deals is lower than where valuation expectations have been reset to at this point,” said Steve Szejner, also a Partner at PGIM Private Capital. “So there is a bit of a disconnect between senior leverage coming down, yet valuation multiple expectations haven’t come down by as much, so that’s where mezzanine can be particularly useful in helping to bridge that gap.”
To strive to achieve strong and consistent returns, PGIM Private Capital places emphasis on companies with strong value-added businesses and management teams with demonstrated track records and who have a meaningful economic stake in the company’s success. The firm is not dependent on leveraged buyout and M&A market conditions alone, through its experience with a variety of transaction types including investing in and managing non-sponsored investments. Its distinctive access to a wide range of origination sourcing channels provides increased diversification and closer relationships with key decision-makers among borrowers, enhancing investment returns and improving downside protection.
“On top of the market fundamentals we’ve talked about, the fact that we have a close working relationship with our direct lending colleagues here at PGIM Private Capital is really distinctive in the marketplace,” Szejner said. “To be able to team up and provide a one-stop financing solution is a combination not a lot of firms in the market can offer.”
That can be especially valuable in times of market strife. PGIM Private Capital has the capacity and resources to grow as a financial partner to its portfolio companies. A decades-long history of successfully investing in mezzanine for middle-market companies demonstrates the firm has the knowledge and experience to act as a trusted advisor and help portfolio companies navigate through different kinds of challenging times.
“Uncertainty doesn’t have to be a bad thing for new capital deployment on the mezzanine side, and it can be an opportunity for new companies that haven’t thought of mezzanine as a viable option for their capital needs,” Seward said. “Ultimately, we want to execute good deals with good companies, and in that our approach is very consistent.”