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Private lenders in the United States are seeking alternative ways to maintain their lending activity as traditional bank financing slows down. Direct lending, which involves non-bank creditors providing funding for leveraged buyouts, has been on the rise in recent years, surpassing traditional Wall Street banks in terms of the volume of buyout loans. However, with a slowdown in deal activity and rising interest rates, private lenders are looking for new strategies to continue their lending spree. This shift in strategy could have potential risks and consequences for both lenders and borrowers.

Direct lending has experienced significant growth, with private credit assets reaching over $1.4 trillion by the end of 2022, a 460% increase since 2010, according to Preqin. However, the recent rise in interest rates, exacerbated by a Treasury selloff, has dampened the direct lending market. Private equity-led acquisitions in 2023 have decreased by 41% compared to the previous year, as reported by LSEG. Consequently, private credit players, such as HPS Investment Partners and Blue Owl Capital, are exploring new avenues to sustain their lending activities.

One emerging trend is the rise of “mezzanine” lending, also known as “capital solutions” or “opportunistic credit.” Mezzanine lending involves offering loans that rank below traditional senior debt and may allow borrowers to defer interest payments. Preqin data indicates that mezzanine funds have raised $41 billion in assets so far in 2023, a 54% increase compared to the entire year of 2022. Lenders like HPS have successfully raised billions of dollars for mezzanine funds to support this growing lending segment.

Mezzanine lending offers several benefits. It enables private credit players to source new deals and provides flexibility for borrowers with stretched balance sheets. However, it also comes with risks. Companies that accumulate too much debt face challenges in managing their financial obligations. The surge in mezzanine lending also raises concerns for regulators, as it contributes to the rapid build-up of credit risk outside the traditional banking sector.

The need for mezzanine lending is driven by the impending $7 trillion of loans and bonds that will mature over the next three years, as highlighted by S&P Global. With floating interest rates, rising central bank rates result in higher interest payments for borrowers. This change in circumstances can strain companies that were previously able to cover their interest expenses comfortably. To mitigate this risk, lenders like HPS offer “payment-in-kind” loans, which replace a portion of the debt with additional borrowing that does not charge interest. This arrangement allows the company to cover interest payments on the remaining debt and reassure other lenders.

There is no evidence to suggest that major private equity-direct lending firms are utilizing exotic debt to support their own portfolio companies. However, they may be employing such lending products to lend to other cash-constrained firms. For instance, plastics company Trinseo refinanced a portion of its debt through a $1 billion loan from Angelo Gordon and Oaktree, with half of the interest paid in kind. Similarly, Centerbridge’s financing deal with Sabre allowed the travel software developer to pay off debt with a high interest rate and improve its cash flow in the short term.

Although mezzanine lending presents opportunities, it also involves certain drawbacks. The increasing competition in this space has compressed the extra return that investors expect from mezzanine loans over traditional senior-ranking private debt. Bankers suggest that the additional return can be as little as 3 percentage points, compared to the historically higher spread of 5 percentage points. To compensate for this, mezzanine lenders introduce innovative features such as equity upside through warrants or convertible notes that trigger at specific valuation levels.

The use of equity upside introduces uncertainties, as equity gains are less guaranteed than contractual interest payments. Mezzanine lenders attempt to secure minimum returns through various mechanisms, but in the event of bankruptcy, mezzanine loans are repaid after senior lenders. Despite the potential drawbacks, private credit players like HPS, Oaktree, and Blue Owl continue to explore mezzanine lending opportunities. While this sector remains relatively niche, the expansion of private credit allows lenders to target larger and healthier borrowers compared to the mid-market companies they traditionally served.

However, the rush to dominate the mezzanine lending space could have unintended consequences. Increased competition among lenders may result in private loans becoming cheaper than liquid, tradable loans, contradicting established financial norms. If this scenario unfolds, lenders could be left with substantial amounts of risky debt. Combined with misguided expectations of falling interest rates or easier refinancing, corporate borrowers might find themselves trapped in a leverage prison. The euphoria of the lending party could ultimately lead to a messy hangover.

It is important for private credit players to approach mezzanine lending with caution and carefully assess the potential risks involved. As the market becomes more competitive, lenders must strike a balance between seeking higher returns and ensuring the long-term sustainability of their lending strategies.

More detail via Reuters here… ( Image via Reuters )

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