April 4, 2005 - Just a few years ago, many mezzanine lenders wouldn’t even think of providing debt financing for lower middle market companies - such deals were often too labor-intensive and risky to be worth their while. However, many mezzanine players have changed their tune lately, in light of the current market’s ultracompetitive conditions and relatively tight pricing spreads. Now, mezzanine players are looking for more returns in the formerly overlooked lower middle market. The lower middle market, in the view of many market participants, comprises companies with about $20 million or less in EBITDA, and in many cases, lower than $10 million.

The decision for mezzanine players to move down the corporate EBITDA ladder is, in part, due to their being squeezed out of business by hedge funds. “With all that competition [from hedge funds and second lien loans], we’ve seen some of the traditional [lenders] starting to move down-market,” said Stephen Boyko, a partner at Proskauer Rose LLP. This trend started roughly a year-and-a-half ago, he said, as the mezzanine market began adjusting to the influx of secon4 lien loans, which hedge funds often provide.

In addition to facing competition from hedge funds, Boyko also noted that the mezzanine market itself has become more crowded, as there were about 50 to 70 mezzanine funds in the 1990s, compared with over 200 now.

The lower middle market, however, does not get as much attention from lenders, offering more opportunities for asset hungry mezzanine players. “The competitive environment is reduced [in the lower middle market] because a lot of the major players [and] recent entrants are playing in larger size transactions [instead],” said Elliott Jones a managing partner at Gleacher Mezzanine LLC. “There are a number of mezzanine players that will play in this space, but the number of senior lenders is smaller in this universe,” he said. Jones said at a recent conference on mezzanine financing that his firm has moved into the lower middle market to complete a few deals for companies with $10 million in EBITDA.

In a time of extremely tight credit spreads, mezzanine players also find the lower middle market’s deal pricing to be attractive. That’s because the return on mezzanine deals for companies with EBITDA lower than $10 million tends to be a bit higher than that of the traditional middle market. Returns for the lower middle market range on average from 13% to 17%, noted Steven Ellis, also a partner at Proskauer. Returns for the wider middle market are a bit lower in the 12% to 14% range, he said.

“People are looking for the yield, and there is certainly a lot of yield to be had south of $5 [million] to $7 million in EBITDA,” Boyko added. The downside of dealing with lower middle market issuers, however, is that they do carry higher risk. “There’s also some risk - you’ve got to do your homework,” noted Boyko.

The higher level of risk is attributed, in part, to the fact that lower middle market companies tend to have less traditional management structures - this usually requires more due diligence from the lender, noted Michael Hermsen, a managing director in the mezzanine and private equities group at Babson Capital Management LLC. “You need to be a little more tolerant of the warts’ of the deal,” he said. “You have to.. .have a higher risk appetite.” One way Babson’s mezzanine group, which has long provided debt financing to companies with about $10 million to $20 million in EBITDA, shields itself from risk is by getting involved with companies that have sponsors, Hermsen noted.

To be sure, more firms specifically focused on providing financing to the lower middle market have been popping up in the market lately. For example, former Fifth Third Bank executives, Joseph Gaffigan and Chris Randall, teamed up with Ed Ryczek, formerly of One Mezzanine Capital Corp., last month to form MFC Capital Funding, Inc. The trio formed the firm to serve a market they believe is underserved. Companies with EBITDA of about $2 million to $7 million ‘just don’t get as much coverage from the larger leveraged lenders,” Gaffigan said. “You’ve seen a ton of consolidation amongst the banks, and you’ve seen people naturally migrating up-market and looking for deals that are going to enable them to grow.” Roughly 90% of MFC’s business will be split between cash flow and asset-based lending, and the other 10% will be mezzanine and equity, he said.

“Everything is getting more competitive,” Gaffigan said. “There are people looking for where they can get an appropriate risk/return, and you do see some of the [mezzanine] players coming down to the lower middle market,” he noted.

But how long will such interest in the lower middle market continue? Proskauer’s Ellis said he expects interest to continue at a steady pace, but it could taper off after the next default cycle. “I think some people in the lower middle market will have some interest in going back to the middle middle market,” he said.

Still, this is not to say that all lenders will migrate back up to larger companies once market conditions shift. “[Lenders] are finding some gems down there,” Ellis said.

Copyright 2005 Thomson Media Inc. All Rights Reserved.