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oaktree insightsmay 2016strategy primer:investing in mezzanine debt3 3 3 s . g r a n d a v e 2 8 t h f l o o r , l o s a n g e l e s , c a 9 0 0 7 1 ( 2 1 3 ) 8 3 0 - 6 3 0 0 w w w. o a k t r e e c a p i t a l . c o m
bill caspersonManaging Director and Co-Portfolio ManagerMr. Casperson joined Oaktree in 2001. He has been with the Middle-Market Finance Group sinceits inception, and currently serves as co‐portfolio manager. Prior to joining, Mr. Casperson workedin the Leveraged Finance and Global Syndicated Finance Groups at J.P. Morgan Chase where he wasresponsible for leading high yield deal teams in all phases of due diligence and “one‐stop” financingsincluding senior credit facilities, high yield bonds and bridge loans. Prior thereto, Mr. Casperson wasa member of Chase Manhattan’s Financial Sponsor Group, where he was responsible for managingrelationships with a variety of buyout funds. From 1989 to 1998, Mr. Casperson worked at NationsBankN.A., most recently as a Principal in the High Yield Finance Group. Prior to NationsBank, he wasan auditor at Touche Ross & Co. Mr. Casperson holds a B.A. degree in accounting from RutgersUniversity and an M.B.A. from the University of Michigan School of Business Administration with aconcentration in finance.“Mezzanine capital plays an important role in growth- and acquisition-related financings in theNorth American middle-market. Private lending in the middle-market is relatively inefficient; andwith banks and other traditional lenders exiting the market, there remains a unique opportunity forseasoned mezzanine capital providers to find attractive investments.”“This paper intends to discuss the mezzanine debt asset class, the opportunityset and our perspectives at Oaktree. We hope you will enjoy it.”raj makamManaging Director and Co-Portfolio ManagerMr. Makam joined Oaktree in 2001. He has been with the Middle-Market Finance Group since itsinception, and currently serves as co‐portfolio manager. Prior to joining, Mr. Makam worked at Bancof America Securities LLC (previously NationsBanc Montgomery Securities LLC) for four years intheir Leveraged Finance/High Yield Group. During that period he specialized in bridge and mezzaninefinance, with responsibility for deal origination, market analysis, structuring, due diligence and legaldocumentation. Prior to joining Banc of America Securities in 1997, he worked for five years as asenior software engineer at Montage Group Ltd. and Dantec Electronics Inc. Mr. Makam received aB.S. degree with distinction in engineering from the Bangalore Institute of Technology, India. He thenwent on to receive an M.S. degree in engineering from the University of Akron, Ohio and an M.B.A.in finance from Yale University.
investing in mezzanine debtobjectiveIn this paper we seek to provide information on investing in mezzanine debt. Any reference to mezzaninedebt should only be considered with regard to investing in the North American middle-market, as some of theinformation discussed may not be applicable to other markets. We will also only briefly mention preferred equity,which can sometimes be considered mezzanine capital. We will explore the following six topics in order to providea foundation for investing in mezzanine debt.1.2.3.4.5.6.What is mezzanine debt?What are the characteristics of the middle-market in North America?What are the potential benefits and risks of investing in mezzanine debt?What are the different ways to invest in mezzanine debt?What is the current opportunity in mezzanine debt?How does Oaktree approach investing in mezzanine debt?what is mezzanine debt?As its name implies, mezzanine debt is situatedbetween the senior secured bank debt and theequity in an issuer or borrower’s capital structure.Mezzanine debt is typically used to finance leveragedbuyouts, recapitalizations and corporate acquisitions.It is also an alternative to public or private equity forcompanies seeking growth capital. Typically junior incredit standing, mezzanine debt provides additionalcapital beyond senior secured debt. As shown in figure1, mezzanine debt typically takes the form of seniorFigure 1: Sample Capital StructureSenior Debt: 30-40% Security: First Lien Asset-based loans First lien cash flow-based loans Return Range: 5.25% /-unsecured or subordinated notes, or second lien debt.From an issuer’s perspective, mezzanine debt canreduce overall capital costs by providing additionaldebt financing that can enhance equity returns.For middle-market businesses, mezzanine debttypically takes the place of the high yield bonds usedby larger companies. As highlighted in figure 2, theminimum issuance size for a company to access today’shigh yield bond market is generally 200 million ormore. In other words, most middle-market businessesdo not have the financing need or the ability toaccess the high yield bond market. By creating acapital structure with a ‘‘right-sized’’ combination ofmezzanine debt and bank borrowings, middle-marketcompanies can leverage their equity capital to generateattractive returns for their owners.Figure 2: Debut High Yield Bond Issuance of 200million or Less as a % of Total High Yield Bond Issuance Upside: None5% Security: Usually unsecured butcan sometimes have a second lien Return Range: 14% /-4 Upside: Highest potential0Source: S&P Capital IQ-2-2015 Common equity201412013 Return Range: 25% /-2012 Preferred equity2011 Security: None2010Equity: 30-50%200922008co-investment20073 Upside: Through equity2006 Second lien debt Senior unsecured notes Subordinated notes2005Mezzanine Debt: 10-20%
what are the characteristics of the middlemarket in north america?Middle-market companies account for the vastmajority of businesses in the United States andrepresent approximately 33% of private sector GDP,48 million jobs and, on a standalone basis, wouldbe the world’s fifth largest economy.1 According tothe U.S. Census Bureau’s 2012 economic census,there were approximately 41,100 middle-marketcompanies in the United States with annual revenuesbetween 50 million and 1 billion. This compares tojust 1,450 companies with annual revenues above 1billion.2 Most middle-market businesses that employmezzanine debt have earnings before interest, tax,depreciation and amortization (“EBITDA”) rangingfrom 10 million to 50 million.Middle-market companies are usually closely heldby their founders, families or by private equityfirms. The majority of middle-market companiesare privately held due to their limited resources andthe costs associated with being a public company.Middle-market companies can be found in almostevery industry sector.what are the potential benefits and risks ofinvesting in mezzanine debt?Some of the potential benefits of investing in mezzaninedebt include the opportunity for attractive totalreturn, downside risk management through privatelynegotiated transactions, and less-volatile performancethrough a high current coupon component.Potentially Attractive Total ReturnDue to their subordinated or junior position in anissuer’s capital structure, mezzanine debt investorsgenerally demand higher prospective returns comparedto senior secured debt investors. As shown in figure3, total returns on mezzanine debt typically comefrom (1) high current coupons (typically fixed-rateand paid quarterly, mostly in cash), (2) commitmentor arrangement fees (often paid in the form oforiginal issue discounts) and (3) call protection (i.e.,premium payments if the mezzanine debt is repaidearly). Mezzanine debt, in contrast to senior secureddebt, will most often come with an “equity kicker”in the form of the opportunity to purchase equity inthe underlying borrower. This results in the potentialfor additional returns beyond those contracted forby the junior debt investment by itself. Mezzanineinvestors have historically targeted blended grossannualized returns in the mid-teens. Similar to other-3-Figure 3: Sample Mezzanine Debt TermsCurrent Fixed Coupon 11-12.5% (11% cash, 0-1.5% PIK)Ranking Subordinated unsecuredMaturity 6-7 year debt instrumentEquity Participation Purchased equityCommitment Fees 2-3 points up-front (or via OID)Call Protection 1-2 years non-call; premium prepaymentschedule thereafterdebt investments, we feel the avoidance of defaultsand subsequent losses, sometimes referred to as the“negative art of bond investing,” can be the mostimportant aspect for mezzanine investors striving toachieve attractive total returns.Private Structures Provide Downside Risk ManagementIn the middle-market, mezzanine debt is typicallyissued through privately negotiated transactions.A mezzanine lender’s decision to extend credit to aborrower is usually based on the issuer’s ability togenerate free cash flow (as opposed to being based onasset backing) and on the growth prospects for thebusiness and industry. Compared to what is often lessthan a week of limited, public-side due diligence forbroadly syndicated loans, mezzanine debt investorstypically are able to perform extensive private-sidedue diligence over a four- to six-week period. Aspart of this due diligence, mezzanine lenders receivegreater access to company information, such ashistorical financial statements, earnings and auditreports, and environmental or other expert analyses.This gives mezzanine debt investors the ability tobetter understand the borrower, negotiate terms andstructure loans in ways that are appropriate for theunderlying business. In addition, mezzanine debtinvestors also have the opportunity to interact withthe company’s management several times before aninvestment is made.After making an investment, mezzanine debt investorsusually receive monthly or quarterly financialstatements. In addition, many mezzanine lendersnegotiate board observation rights as part of the terms
of their investment. Receiving board of directormaterials and attending the meetings, alongside whatis often frequent dialogue with company owners andmanagement, gives mezzanine lenders the ability toclosely monitor their investments and stay ahead ofpotential business issues. It also helps the investorkeep up to speed with company performance andknowledgeable should amendments to the creditdocuments be necessary.Potential Risks of Investing in Mezzanine DebtFirst and foremost, mezzanine debt is junior in thecapital structure and typically in a first-loss positionafter the value of the company drops by more than theamount of its equity. Second, since mezzanine debtis provided through privately negotiated transactions,it is far less liquid than more public securities if itneeds to be sold. Lastly, middle-market businessesoften face greater idiosyncratic risks compared tolarger companies. For example, due to their smallersize, loss of a customer or increases in the cost of rawmaterials may have a larger impact on the borrower’sEBITDA than it would on a larger company. Incertain instances, due to their size and ownershipstructure, middle-market companies may also haveless professional or less seasoned management teams.Lastly, although debt financing to large corporateissuers has increasingly become covenant-lite with nomaintenance financial covenants (e.g., a maximumleverage ratio), loans to middle-market businessescontinue to carry both incurrence and maintenancecovenants. These covenants give mezzanine lendersadditional tools should the business underperform.Mezzanine lenders often work with owners to takeproactive steps to upgrade the borrower’s operatingwhat are the different ways to invest inperformance and maximize liquidity. These proactivemezzanine debt?steps may include cost reductions, divestitures ofless productive assets, and changes to operationsThe two main ways to invest in mezzanine debt are:or management.Additional steps to address(1) through directly negotiated transactions withunderperformance may even include voluntarilya company or its owners, or (2) by investing in adeferring the cashpooled, private-fundportion of intereststructure that targetsdue on the mezzanineinvestmentsin“Potential benefits of investing in mezzanine debt:debt in order to helpmezzanine debt.1) attractive risk-adjusted return,the company avoid2) downside protection of private structures,defaulting on itsDirectmezzaninesenior secured debt.debtinvestmentsare3) reduced volatility from high current coupon.”Senior secured debttypicallyreservedfor larger issuersonly for investorsis more likely to be syndicated and may includewith large amounts of capital. Direct investmentslenders who are less willing to work through cyclicalcan be sourced through relationships with familydownturns.owners, investment banks or private equity firms.They are often purchased by large institutionalHigh Current Coupon Reduces Volatilityinvestors or by smaller investors with relationshipswith the underlying borrower. Most mezzanine debtMore often than not, mezzanine debt is structuredinvestments, whether directly made by an individualwith a fixed coupon that is paid quarterly (mostlyor made on behalf of a pooled fund, typically takein cash). This coupon compensates lenders forseveral weeks to a few months to negotiate and close.subordinating their position in the capital structure.In today’s market, coupon rates are running fromPrivate limited partnerships are the most common way11.0% to 12.5%, on the low end of the historicalfor investors to access the mezzanine debt market. Thisrange. Still, for investors targeting mid-teen grossis typically done through capital commitments thatreturns in a low-yield environment, mezzanine debtare aggregated with the express purpose of investingis an attractive alternative to other debt instruments.in mezzanine debt. Asset management firms typicallyFurthermore, since mezzanine debt coupons areorganize these funds and act as the general partner.usually paid quarterly, the high current couponThe general partner seeks attractive risk-adjustedcomponent reduces the overall volatility of returns toreturns for the partnership, while maintaining ainvestors.diversified portfolio of investments.Collateralized loan obligations (“CLOs”) and businessdevelopment companies (“BDCs”) also invest in-4-
second lien loans, an asset class that is a competitivereplacement for mezzanine debt. BDCs also investdirectly in mezzanine debt. CLOs are securitizedvehicles where payments from multiple loans (mostlyfirst lien) are pooled together and passed on todifferent classes of owners in various tranches. BDCsare closed-end investment companies that raisecapital by selling equity shares to investors, often inthe public markets. Recently, however, fewer CLOshave been created due to regulatory rulings and amore expensive funding environment. BDCs arealso undergoing structural issues that largely impedethem from making new investments. At this time, itis difficult to forecast the full impact of these issuesand the extent to which they will affect the marketpresence of CLOs and BDCs.what is the currentmezzanine debt?opportunityFollowing the end of the financial crisis, competitiveconditions in the mezzanine debt market intensifiedas investors searched for yield in a low-interest-rateenvironment. CLOs, BDCs, commercial lendersand private funds all participated in driving downreturns and loosening financing terms. That beingsaid, as shown in figure 4, the pool of uninvestedprivate equity capital available for leveraged buyoutsremained large, helping maintain the demand formezzanine debt. As shown in figure 5, private equityfirms’ equity contributions to buyout transactionsalso remained high (particularly compared to precrisis levels), mitigating risk to lenders. With suchsubstantial equity capital invested, the enterpriseFigure 4: Total North American Dry Powder in Buyout Funds( in billions) 300 255250 268 265 237 235 262 247 213 209 186200150 147 128 31/1412/31/15Source: PreqinFigure 5: Average Equity Contribution for Middle-Market LBOs (EBITDA 50 02200320042005in2006Source: S&P Capital IQ-5-2007200820092010201320142015
value of a borrower can decrease up to 40% to 45%before the mezzanine debt becomes impaired.CLOs and BDCs facing the aforementioned issues,private funds with long-term capital and the ability tohold the full amount of a loan (or a large portion aspart of a “club” deal) should continue to see attractiveinvestment opportunities. While the middle-markettypically lags larger market credit cycles, the recentnegative shift in outlook for corporate credit didimpact the volume of new middle-market transactions.This is highlighted by figure 7, which shows thatLBO volume in the middle-market dropped from 83 billion in 2014 to 54 billion in 2015. Oaktreebelieves this was due to reduced confidence in theoverall economic environment and the impact of theoil and gas industry dislocation on businesses withexposure to the sector. The owners of middle-marketcompanies will often hold off commencing a saleprocess until weakness in the underlying businessabates or buyer financing becomes more attractive.Since the start of the oil and gas market downturnin mid-2014, credit markets have become less frothy,and certain providers of debt capital have, at times,retrenched. As shown in figure 6, over a number ofyears, banks have also gradually exited the middlemarket leveraged loan business in order to focuson larger issuers with facilities that are more easilysyndicated. According to Standard & Poor’s, domesticand foreign banks have been steadily reducing theamount of leveraged loan new issuance they retain,from over 70% of primary issuance in the 1990s toless than 20% in recent years.With traditional lenders having significantly reducedtheir middle-market debt holdings and, more recently,Figure 6: % of Leveraged Loan New Issuance Retained by Domestic and Foreign %19% 20%2032%29%29%23%21%17%14%14%18%1001994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015Source: S&P Capital IQFigure 7: Total Volume of North American Middle-Market Buyouts (Enterprise Value 1 billion)( in billions) 90 83 8080 73 69706050 73 70 59 54 50 4240 303020100200520062007200820092010Source: Preqin-6-20112012201320142015
While it is hard to predict where middle-marketM&A and financing markets will go from here, it isclear that the competitive landscape for mezzaninedebt investing has changed since 2014. Oaktree isoptimistic that these changes will provide additionalopportunity for risk-focused junior debt investorswith capital to lend.how does oaktree approach investing inmezzanine debt?Oaktree targets mezzanine capital investments inNorth American middle-market businesses, providingloans to borrowers being purchased by privateequity firms in leveraged buyouts. Due to the risksassociated with both mezzanine debt and middlemarket businesses, Oaktree believes it is prudent tonot use leverage in this strategy, and to conservativelystructure the investments it makes.Many mezzanine funds buy preferred or commonequity alongside their debt investments. AlthoughOaktree typically invests 10% to 15% in equity inconnection with its mezzanine debt investments, thisis limited in order to conservatively participate inthe upside potential of each business, with a goal ofadding 100 to 200 basis points to potential returns.Mezzanine debt investments can be approachedin two different ways: (1) with a credit emphasis,where a substantial portion of the return is in theform of a debt coupon supplemented by some equityupside, or (2) with an equity emphasis, where thereturn is primarily driven by equity investments. AtOaktree, we follow a credit-focused strategy with aheavy emphasis on safer, less-risky companies, andwe structure our investments as extensions of
investing in mezzanine debt objective In this paper we seek to provide information on investing in mezzanine debt. Any reference to mezzanine debt should only be considered with regard to investing in the North American middle-market, as some of the information discussed may not be applicable to other markets.
real estate in the private markets. Direct real estate in - vestments include the outright purchase of real estate. This requires established and often costly infrastruc-ture with on-the-ground personnel in target markets, an in-depth understanding of the local markets and regulations, and access to market intelligence, deal flow and capital.
Excludes closed -end Senior Loan funds, CLOs, Oaktree Asia Special Situations Fund, Asia Principal Opportunities Fund, certain separate accounts and co investments 4Represents annualized time-weighted return since October 1988 1 History of Exceptional Investment Performance s) e ¹ Sharpe ra
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