Mezzanine funds broaden offerings as borrowers seek customisation and flexibility

“Mezzanine strategies have evolved into a broader capital solution approach,” said Constantine Braswell, vice president in the alternatives consulting group at Callan. “Like many aspects of private credit, the distinctions and definitions of underlying private credit strategies have become blurred.”

The mezzanine fund strategy is becoming a catch-all term for anything that does not quite fit the traditional first lien, senior direct lending or private equity strategy, said Adrian Rae Leipsic, partner at Cleary Gottlieb.

Some funds allow the manager to participate in direct lending as the lead lender, or in syndicated debt deals in a passive role, as well as in ‘funkier’ investments that start to look more like structured equity.

“The long-term trend has been one in which distinctions between the senior and mezzanine space have become less bifurcated,” said Reed Harmon, RVK manager research consultant and principal.

Harmon has observed cases where some mezzanine teams have been combined into more conventional first lien direct lending teams. The idea is that by combining the capabilities, private credit firms can offer dedicated junior debt positions alongside unitranche solutions to borrowers, he said. It allows the private equity sponsor or corporate management team to decide what solution they like best, and the manager can then match the risk to an LP vehicle.

Mezzanine funds are benefiting from the rise in companies seeking customised financing when they are unable to tap the IPO market or raise capital from traditional VC funds. “These companies need alternative capital that regular private equity firms or senior direct lenders cannot provide,” Leipsic said.

In Europe, the opportunity for junior debt has opened with the uptick in activity in the broadly syndicated market, Park Square Capital founder and managing partner Robin Doumar previously told Creditflux. Borrowers can combine a low-cost BSL with second lien, PIK, preferred equity and the like to create an attractive financing solution.

With private equity firms under pressure to return capital to LPs, there is also room for private credit managers to provide junior debt for a dividend recap, Doumar said. Finally, there are companies seeking PIK to reduce the cash burden of senior debt after experiencing a rise in base rates.

Managers might also be more interested in raising mezzanine funds because they anticipate M&A activity to significantly improve this year.

“We see there is a large amount of private equity dry powder, and that’s going to require some junior debt financing,” Callan’s Braswell said.

However, the firm has yet to see a lot of mezzanine funds targeting the upper middle market and large cap borrowers. Many of the junior capital funds are focused on the lower to mid-market space.

The broadening mezzanine debt strategy could also be a response to a change in LP demands. Many institutional investors are seeking a risk-return different from their existing direct lending investments.

“[LPs], rather than having a dedicated subordinated or mezzanine bucket, are able to put these funds into an opportunistic bucket in their private credit allocation,” Braswell said.

There is also an argument that institutional investors are becoming more sophisticated, and want to be as specific as possible with the risk-return of each asset class, Leipsic said. As a result, managers are building products with specific return profiles.