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Mezzanine lending can be high returning - and today in the blue chip space there is a lot of opportunity.
Key Takeaways
- Mark Rubenstein, managing director of HPS's mezzanine credit strategy (SIP), describes the basics of mezzanine lending and the opportunity in the space.
- Mezzanine lending is lending at the junior part of the capital stack (with secondary claims to assets in the event of bankruptcy) and can be fixed or floating loans.
- These strategies typically have net returns in the low teens with some equity-like upside. If you lend to blue-chip companies, the downside is more protected - and there is a lot of demand from companies with few credit suppliers.
- Mezzanine lending is attractive to companies seeking creative and flexible long-term capital partners, which could drive growth in the asset class.
Transcript
Mark Rubenstein, I joined HPS in 2008. I oversee the junior capital investing strategy at HPS, which is called Strategic Investment Partners, or SIP. In terms of structuring, the instruments are typically set up as either second lien, unsecured, subordinated, Holdco, debt, or preferred equity with debt-like covenants. Typically the instruments will have a fixed coupon which will be fixed or floating; in our more recent vintages have been more geared towards floating. They'll be issued with some fees on the front end, and they'll be prepayment penalties associated with prepaying them. The risk-return profile is characterized by a net return that we see in the teens, and there is some convexity, some call option to the upside on the more junior portion of the portfolio that in some vintages will drive the returns higher towards the mid-teens.
So most of the companies at this scale will have access to fairly inexpensive dollar one or first-lien financing. So if you think about a business worth 12 to 15 times EBITA, the first zero to four, four and a half turns will be accessible through a private or public solution on pretty efficient terms. I think the junior capital strategy attaches typically beyond that layer of capital. So it could be a debt instrument right behind that first lien, or it could be structured as preferred equity. But in all cases, the equity cushion in those transactions will be significant and typically north of 40%. In a capital structure, first-lien debt will have a priority claim on the assets of a company. So in a bankruptcy scenario, those first-lien investments will be repaid first. So the junior capital sits between the first lien debt and the common equity of the company. What we found over time is that by selecting these very large companies, which, you know, on average north of 400 million of EBITDA, but in more recent transactions we've been investing in companies even over a billion dollars of EBITDA is that when you invest in these very stable businesses that are recession resilient and generate a lot of cash flow, but we haven't seen those enter periods of distress as extreme as would require bankruptcy filing. There are some strategies that are focused on more stress and distress investing where you know the bankruptcy risk is higher, and that's acceptable to those strategies.
The market in terms of first-lien that is fairly mature in terms of the attachment and detachment levels of the capital and the pricing associated with it. So I think issuers will typically seek to put that layer of capital in; it's very efficient. We've seen on the junior capital side that the universe of issuers, whether they be private equity-backed transactions or non-sponsor management-owned companies, that universe of large companies that are seeking long-term partners that can provide these creative junior capital solutions, we've seen that universe growing. I think the creativity, the flexibility, the ability to move quickly in certain situations. I think all of that resonates with issuers today. And I think as people think about strategies to drive equity, value creation, having a sophisticated partner like HPS in that seat as a partner, people see a lot of value in that. So we see that opportunity set continuing to grow.
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