Current State of the Corporate Mezzanine Market
Between 2010 and 2020, the availability of capital for middle-market companies increased to record levels, driven by the emergence of non-bank institutional sources of credit (such as direct lending funds and BDCs) following the 2008 financial crisis and a ramp-up in private equity fundraising across North America and Europe. This, in turn, resulted in the high availability of credit financing for private equity transactions, which drove private equity deal activity to record levels throughout the prior decade. Over this period, enterprise values and leverage levels on completed LBO transactions rose to pre-2008 peaks, indicating a loosening of terms and underwriting standards as lenders competed to deploy capital to middle-market borrowers. As a product that sits in between senior debt and equity in the capital structure, the need for mezzanine financing was reduced in many transactions (particularly in private equity sponsored transactions) due to excess availability of senior debt and equity capital over this period.
While private equity deal volume is inherently cyclical, and thus the demand for private debt and mezzanine capital also changes with economic conditions, mezzanine lenders are well placed to “bridge the gap” in the capital structure between senior debt and equity contributions made by PE sponsors or management teams during times of economic turmoil. Particularly in periods of economic uncertainty, as senior lenders seek lower levels of risk (and leverage), this gap in the capital structure may increase, creating a larger opportunity for the mezzanine product category.
Through PGIM Private Capital’s regional office network we have a long track record of successfully deploying capital through market cycles. Even in shifting markets, our capabilities to support both sponsored and non-sponsored transactions and flexibility to participate across the capital stack, enable PGIM to maintain both deployment pace and investment discipline.
Overview of a Corporate Mezzanine Fund & a Mezzanine Investment
A mezzanine investment fund is a pool of capital that invests in mezzanine securities issued to companies within an identified target universe, such as the middle market, a particular sector, or in support of a particular transaction type (such as sponsored buyouts). Mezzanine financing “fills the gap” between senior debt and common equity in the capital structure of a company. This financing can take many forms, but most often consists of subordinated debt and/or preferred stock.
As a result of their capital structure position, mezzanine investors require returns that are typically closer to returns demanded by private equity investors than traditional private debt. The return on mezzanine investments is earned through a combination of economic features:
- Cash Interest: a contractual, periodic payment of cash interest based on a percentage of the outstanding balance of mezzanine financing.
- Payable in kind (PIK) Interest: a contractual form of interest payment where the interest is not paid in cash but is instead added to the principal amount of the security each period (thus increasing the principal and overall interest payment amounts over time).
- Equity Ownership: mezzanine investments often provide investors the right to an equity stake in the form of a warrant, preferred equity, or a common equity co-investment.
- Fees & Other Economic Features: mezzanine investors often receive an upfront structuring fee and may also benefit from call protection and other fees, such as an exit fee under certain circumstances.
Mezzanine financing is a patient form of capital, typically featuring a longer-term maturity than senior debt and no required principal amortization before its final maturity. Traditionally, mezzanine capital is a buy and hold product that is not publicly traded on an exchange. As a result, mezzanine funds (and the investments made by them) have limited liquidity relative to publicly traded securities and are often organized as closed-end investment funds. Managers of a mezzanine fund take the non-transferability of these securities into account when managing their portfolio, its liquidity, and the timing of maturities.
Alternatives to Investing in Corporate Mezzanine
Mezzanine financing provides institutional investors with an alternative to investments in traditional forms of senior debt or equity capital. Many institutional investors are enthusiastic about mezzanine financing due to the 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 a very attractive risk/return profile.
Mezzanine funds generally target investments in securities that are structured as debt instruments. In this regard, mezzanine funds are similar to direct lending funds because they both invest in debt that is not syndicated and that tends to be held to maturity. The key difference is that direct lenders focus on investing in first-lien, senior-secured, floating-rate loans, while mezzanine funds invest in junior, fixed-rate securities. As a result, mezzanine funds assume higher risk but expect to achieve greater returns than direct lenders.
Unlike the common equity investments made by a private equity sponsor in a typical leveraged buyout, mezzanine funds generally make passive investments and do not take a management role in the operations of the company after the close of a transaction. Rather, mezzanine lenders seek to partner with strong management teams or sponsors, who are capable of successfully executing on the business’s growth plan and strategy.
While mezzanine investors may take some equity-like risks due to their subordinated position in the capital structure, they receive significant current income through contractually mandated coupons, which increase the stability of returns relative to common equity. Additionally, mezzanine lenders typically benefit from financial covenants and other debt rights, providing additional downside protections relative to equity in the event of underperformance.
Mezzanine securities often receive some form of equity enhancement in the form of warrants or co-investment rights, which allow the investor to share in the upside when a business performs well. However, equity investors will typically benefit from a greater upside in the event of business outperformance.
Benefits of Investing in Corporate Mezzanine Funds
There are several features of the mezzanine product category that make it highly attractive relative to other forms of debt or equity:
Most mezzanine investments are privately negotiated transactions. The transactions can be customized so that the terms meet the company’s growth and cash flow characteristics while providing protections to the holder of the mezzanine security.
- Comprehensive upfront due diligence and structuring of the mezzanine investment, which enable the investor to gain a thorough understanding of the business and tailor the mezzanine security to protect against perceived risks.
- Financial covenants and consent rights, which allow the mezzanine investor a “seat at the table” if performance begins to deteriorate or management seeks to take certain actions.
- Structural Priority to Equity, which provides contractual downside protection in the event of underperformance or business valuation declines.
- Alignment of interests between equity holders and management, which ensures significant shareholder “skin in the game” and proper management actions.
- Board representation, through obtaining Board seat rights or observer status, which provides the mezzanine investor access to the management team and shareholders.
- Close tracking of the company’s performance, including through monthly reporting of financial and board materials, and discussions with management and shareholders.
Significant Current Income
Unlike equity investors who are not guaranteed dividends or specific payments on a regular basis, a mezzanine investor is contractually entitled to interest payments each month, quarter, or year, which increases consistency of returns. Further, mezzanine investments often benefit from call protection features, which provide certainty of contractual coupon rates through a specified time horizon (barring a bankruptcy or liquidation) and ensure the capital is not simply used as bridge financing.
Diversification from Private Equity and Direct Lending
Mezzanine provides investors with significant diversification from private equity investment return characteristics, as the mezzanine market, unlike private equity and direct lending funds, 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. These non-buyout transactions often pose less risk than an LBO as leverage levels are typically lower and there is less pressure for rapid growth or change of business strategy in pursuit of value creation. While many mezzanine funds do not have the breadth of resources or direct calling network to pursue non-sponsored deal flow, we differentiate ourselves through a history of executing and managing non-sponsored transactions, where we partner directly with management teams to deploy capital.
Additionally, mezzanine returns can match or exceed those of private equity returns in a challenging environment. The priority position of mezzanine debt in a capital structure allows for the possibility of a restructuring where the mezzanine holder receives substantial value while existing equity is meaningfully diluted.
Finally, unlike many private equity investments, mezzanine investments are typically not as dependent upon exits to generate liquidity. This is particularly attractive given the volatility of the M&A and IPO markets and a greater sensitivity to valuations in equity investment. Mezzanine investments can be monetized via refinancing, recapitalizations, sales, merger events, or public offerings.
Potential for High Total Returns
Since mezzanine debt is subordinated to senior debt, mezzanine investors demand higher returns, often in the mid- to high-teen IRR range. In addition to a significant contractual coupon, the total return achieved often includes an equity component. Equity features enable mezzanine investments to share in the upside from a well-performing investment. Mezzanine investors can benefit from equity returns of warrants, participating or convertible preferred equity, and/or equity co-investments.
PGIM Capital Partners’ Approach
PGIM Capital Partners (“PCP”) fully leverages PGIM Private Capital’s (“PPC’s”) strong and proprietary middle-market investment capability through our 14-office global network and experience in managing a private capital portfolio of $100.6 billion as of December 31, 2020. We have a wide range of deal flow sourced through PGIM Private Capital’s direct prospect calling efforts, strong agent and equity fund relationships, and financing relationships with more than 1,000 companies. This global network allows us to capture inefficiencies in the middle market and generate premium returns.
While the mezzanine product category demands an intensive due diligence process and a significant amount of resources to manage the investment post-close, PPC has a strong track record of investing in subordinated debt and structured equity of middle-market companies since 1995. We have generated consistently strong returns on our six mezzanine funds, which have been invested and managed across multiple economic cycles. The most recent fund, Prudential Capital Partners Fund VI, raised $2.23 billion in institutional investor commitments and was closed in 2020.
To achieve strong and consistent returns, PPC 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. We seek to avoid the cyclicality of leveraged buyout auctions through experience with a variety of transaction types and are capable of managing non-sponsored investments. Through our nearly 30 global deal teams, we have the significant resources required to fully understand and diligence a proposed company and structure the financing in a manner that best fits the unique needs and goals of the business and its stakeholders, as well as meet the return and risk expectations of our institutional investor base. We ensure that the transaction opportunity fits within our investment mandate, such as investment size, business profile, and investment horizon, and that we are aligned with the business owners on supporting the direction and objectives of the business.
Further, we believe our predominantly single-investor transactions permit a more intensive due diligence process, more favorable terms and pricing, and more control of our investment post-closing.
Why Mezzanine is an Attractive Investment
Considering an investment in mezzanine debt versus equity is ultimately about an investor’s risk appetite and return expectations. Equity offers a higher risk profile and a higher potential return (20%+); mezzanine debt offers a lower risk profile and targets a lower return than equity (15% - 20%), yet a significantly higher return than traditional senior debt (<10%).
With a 5-8-year maturity, mezzanine is patient capital – meaning that it supports long-term growth. PPC has the capacity and resources to grow as a financial partner to its portfolio companies. Our 20+ year history of successfully investing in mezzanine for middle-market companies demonstrates that we have the knowledge and experience to act as a trusted advisor and help our portfolio companies navigate through challenging times.
PGIM Capital Partner’s unique access to a wide range of origination sourcing channels, focus on strong value-added businesses, and active portfolio manager role provide increased diversification and closer relationships with key decision-makers among borrowers, enhancing investment returns and improving downside protection.
If you are interested in investing in a corporate mezzanine fund, PGIM Capital Partners is here to help. Please visit PGIMPrivateCapital.com for more information.
About the Author
Steve Szejner is a Dedicated Partner of PGIM Capital Partners, the middle-market mezzanine debt and structured equity fund management business sponsored by PGIM Private Capital. Prior to this role, he led a team responsible for marketing, originating, and underwriting mezzanine and structured equity investments, managing the portfolio, and supporting the firm's fundraising efforts. He joined PGIM in 1999. Mr. Szejner received a BS from Boston College and an MBA from Northwestern University Kellogg School of Management. He holds the Chartered Financial Analyst® designation.