Mezzanine funds are getting fresh attention from investors today – and possibly new mandates – after having steadily fallen behind more popular private debt strategies, such as direct lending. But industry experts say this surge in investor interest is likely tied to a greater focus on private debt overall, and may not signal a true comeback for the mezzanine sector.
The signs of a renaissance for mezzanine strategies, which focus especially on junior lien corporate loans, arose in a recent Preqin survey. Close to half of nearly 400 investors polled in June said mezzanine strategies offer the best risk-return opportunity among private debt options, compared to just 27% who picked distressed debt, 23% who are betting on senior debt and 21% each picking special situations and unitranche strategies that blend senior and junior debt.
Furthermore, investors listed mezzanine as the top fund type they are targeting in the next 12 months: 41% of respondents said they are actively seeking to deploy in mezzanine funds, compared to 37% looking to invest in direct lending and 34% seeking distressed debt investments.
The resurgent interest in mezzanine funds is driven in part by their favorable risk-return profile – but also by the "huge interest" in the private credit space overall as yields in traditional fixed income markets stay at historic lows, says Ryan Flanders, head of private debt products at Preqin.
Prior to the financial crisis, mezzanine funds were the main game in town among private debt strategies, but they lost ground in recent years to other types of private debt funds, including real asset lending, senior secured direct lending and private structured credit.
Though mezzanine funds have remained attractive to some investors – with established managers such as Goldman Sachs still reeling in capital, raising $8 billion for its GS Mezzanine Partners VI fund in 2015 – new funds and fundraising activity in mezzanine strategies had been slowing down in recent years. And several large fund shops have gradually shifted focus away from mezzanine strategies, such as Carlyle Group, which recently merged the teams on its two standalone mezzanine funds into its direct lending unit. Despite expanding its credit platform and gearing up for new products in direct lending, Carlyle had no plans for new mezzanine funds last year, as reported.
Preqin’s survey now suggests that investors are circling back to mezzanine funds. The sector had record fundraising last year, pulling in a combined $31 billion in capital. Seven of those funds closed after securing more than $1 billion, according to Preqin. The largest was GSO Capital Opportunities Fund III from Blackstone Group’s GSO Capital Partners unit, which surpassed its $6.5 billion target when it closed in October. HPS Investment Partners’ Mezzanine Partners III fund surpassed its $5 billion goal by $1.6 billion, meanwhile, and Crescent Capital Group’s Mezzanine Partners VII brought in $4.6 billion, exceeding its $3 billion target.
In addition, large mezzanine managers such as GoldPoint Partners and Audax Mezzanine have loyal followings and continue raising substantial funds, according to Jeff Davis, a partner at Eaton Partners in charge of the placement agent firm’s private debt initiatives. GoldPoint’s Mezzanine Partners IV closed at $1.3 billion in April, surpassing its $1.2 billion target, according to Preqin. And Audax surpassed its $1 billion target by $200 million when it closed last July, according to Preqin.
One prime driver of the new interest is likely the substantial amount of dry powder in the private equity buyout space that will eventually need to be invested in deals that require financing, since most mezzanine managers are more focused on such sponsored transactions, according to Raelan Lambert, managing director at Pavilion Alternatives Group. Many of these mezzanine providers are also concentrated on larger deals, she says.
"When there is some sort of economic market or company-specific dislocation event, those larger-cap companies are more stable, are less prone to cyclical downturns, and have exhibited more stable cash flows," Lambert says.
Interest in mezzanine funds is also partially driven by disappointing returns in other strategies, Davis says. Senior direct lending, for example, had a surge of interest in recent years but the 10% gross returns in the strategy may push some limited partners back to mezzanine because of the promise of 18% gross returns, he says.
This year, the future appears bright for the 62 mezzanine funds in the market that collectively are targeting $14 billion. As of July, 16 mezzanine funds closed in 2017 already, meeting their targets and securing $4 billion in capital, according to Preqin. And the last quarter of 2017 will likely see the bulk of the closings, just as they did last year, when about 75% of 2016’s total fundraising occurred in the fourth quarter, according to Preqin – timing that is mostly coincidental, Flanders says.
However, despite the surge in interest in mezzanine funds, direct lending strategies are still overwhelmingly seen as the overall best opportunity in private debt, according to the Preqin survey, cited by 62% of respondents, compared to 40% picking mezzanine strategies. And of the 10 largest private debt funds in the market at the start of this year, all were direct lending or distressed debt strategies, according to Preqin’s January report. Mezzanine didn’t make the list at all.
And the 62 mezzanine funds on the road is actually lower than the 70 a year ago by 11%, and their $14 billion in target capital is 55% lower than last year, according to Preqin. While interest from investors may drive some new mezzanine fund development, thus far most of the activity has come from established fund managers and not new teams, according to Lambert.
The surge in interest in mezzanine funds can be seen as mostly a blip given wider trends, Davis says. While mezzanine funds will continue attracting some investor interest, the strategy comes with too much risk for the promise of mid-teens gross returns, he says.
"[Limited partners] no longer want so much subordination [of lien rights] when there are many other creative credit products out there that come close in returns and have more protections," Davis says.
Seeking safety in credit strategies may become a bigger concern for investors – and could hold back mezzanine managers, Flanders says.
"The potential downside is that you would want to be higher up in the [lien] priority if something goes wrong – and most agree we are pretty late in the credit cycle," he adds.
The likelihood of new mezzanine fund development, therefore, is also slim, Davis says. Instead, he says there’s more activity in distressed debt; specialty debt that includes asset-based lending, litigation finance and royalties; and opportunistic credit, such as unitranche and non-sponsored debt funds.