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Rosa O'Hara

9Questions is our Q&A series featuring key decision-makers in the corporate credit markets — get in touch if you know who we should be talking to!

Rising rates means higher costs of debt: but there may be a solution in mezzanine financings. 

We talked to Joshua Liebow and Matt Szwarc, co-heads of junior credit at Manulife Investment Management, about why many private-equity backed companies are choosing the certainty of mezzanine debt in an uncertain macro environment.

1. What is the attraction of mezzanine financing in the current environment?

Mezzanine debt is a fixed-rate security that provides flexible payment options to the borrower. Borrowers that believe interest rates will continue to rise prefer fixed rate securities over other alternatives that are floating rate and are subject to increase. Additionally, mezzanine debt interest is typically structured through a combination of cash-pay and PIK (paid-in-kind). 

While the overall mezzanine interest rate may be higher than alternative financing, the cash component may be lower than more senior securities in the capital structure. The balance of the rate, which is PIK, is not paid in cash and accrues throughout the duration of the mezzanine loan and is ultimately repaid at maturity (or upon a refinancing, if prior to maturity). 

In the current environment, mezzanine is attractive due to its fixed coupon structure and general flexibility. As we head towards a potential economic downturn, private equity sponsors are focused on certainty and having like-minded partners in their capital structures.

2. Is there a concern that taking on mezzanine debt increases the interest burden on companies, as rates remain high?

In today’s market environment, mezzanine debt can be more attractive than senior debt from a cash burden perspective. While mezzanine debt has a higher all-in contractual rate than senior debt, a portion of it is in the form of PIK. This feature provides a borrower more flexibility from a cash/liquidity perspective.

3. PIK and preferred equity instruments are appearing as an attractive option today. Does that popularity come at the expense of mezzanine debt?

Not necessarily. PIK and preferred equity are currently dominating the refinancing market as borrowers look to refinance existing floating rate all-cash debt, which has become more expensive over the last year, with non-cash pay securities, including PIK and preferred equity instruments. 

The majority of mezzanine providers are focused on new platform investments (change of control transactions) where they can also buy equity alongside their debt investment. The majority of refinancings do not provide that exposure. 

PIK and preferred equity are more expensive than mezzanine debt, so while they may be used in conjunction with mezzanine debt to finance a new platform investment, it is not at the expense of mezzanine debt.

4. Have you seen better terms and pricing on mezzanine debt in the last 12 months?

The increase in interest rates has led to lower leverage and higher pricing for mezzanine financings, resulting in strong risk-adjusted returns for the mezzanine asset class. Generally speaking, leverage has declined by one to two turns and pricing has increased by 200bps to 400bps. 

We’ve also seen stronger call protection, tighter financial covenants, and, in certain circumstances, higher minimum return thresholds. All of this has led to the most attractive mezzanine debt environment in over a decade.

5. What sectors are offering the best opportunities for mezzanine financing?

Our focus has always been to build a diversified portfolio, which can be viewed in several ways. For us, diversification not only includes the number of portfolio companies in each fund but also sponsor and sector diversification. 

We’ve historically shied away from highly-cyclical sectors like retail and oil and gas, and businesses with high fixed costs, such as restaurants. When we do decide to make an investment in a more cyclical industry, like automotive or building products, we focus on two key factors: assessing where we are in that specific sector cycle, and backing durable, capex-light business models that can generate free cash flow during economic downturns. This has served us well through various economic cycles. 

Today, mezzanine financing is prevalent across various sectors and we continue to focus on the best opportunities across each one. That said, we are generally ‘risk-off’ on cyclical industries and seeking more recurring-revenue business models.

6. Mezzanine funds are raising large sums this year. What is driving investor interest in the strategy?

Historically speaking, mezzanine as an asset class has outperformed other asset classes on a relative basis during periods of volatility. Based on our market observations, mezzanine debt is currently priced at a double-digit fixed rate. 

Mezzanine investment strategies also invest 10%-20% in equity alongside their debt investments. This type of strategy provides an attractive risk-adjusted return with potential upside. Returns generated by mezzanine funds during the great financial crisis support investor interest in the strategy.

7. While concerns about a recession have tempered lately, is there still concern about recovery rates on loans — especially considering you're positioned further down the capital stack?

New investments are stress-tested for a potential recession. During underwriting, we focus on businesses that have an ability to weather a potential downturn. 

This translates to highly diversified businesses (in terms of customers, suppliers, etc), strong free cash flow generators (such as companies with limited capex costs), and multiple opportunities to win (such as professionalization, pricing opportunities, new products and markets, cost savings, etc). 

We also focus on well capitalized balance sheets with strong owners that we know well. We believe this strategy positions us best for a strong recovery if a company faces any headwinds.

8. Mezzanine financing is fashionable today, but in the long term could it suffer from borrowers turning back towards unitranche structures?

Rates would need to materially decline for unitranche to be as popular as it was in the prior several years. Mezzanine debt offers predictability (fixed-rate) and flexibility (cash vs PIK) to borrowers. 

During periods of volatility, borrowers also like two-handed structures (senior and mezzanine) as opposed to unitranche due to the partnership approach (for example, decreasing cash interest and increasing PIK) employed by many mezzanine providers.

9. What book has most influenced your life?

While it’s difficult to find the time for leisure reading between our kids’ activities, work, and travel, we both like to read about a variety of topics, from finance to history. 

For me (Matt), having been born and raised in Poland under communist rule, “The Long Walk” is a tremendous story of human perseverance. 

Based on true events during World War II, the author and six other prisoners escaped a Soviet labor camp in Siberia — a camp where enduring hunger, cold, and illness, and avoiding daily executions were everyday feats. 

Their march — over thousands of miles by foot — out of Siberia, through China, the Gobi Desert, Tibet, and over the Himalayan mountains to India is a remarkable statement about the human desire to be free. 

A bit of a heavy read at times, this story truly encapsulates what we are capable of under the most dire situations. It reminds me of how lucky we are to live in a place of freedom and where your hard work is often rewarded.

9Questions — Joshua Liebow and Matt Szwarc, Manulife — Doin’ the mezz around

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