Private-equity firms fill void as senior lenders

Private-equity firms, never ones to sit on the sidelines for long, are seeing dollar signs in the seized-up credit markets and are taking on the role of senior lenders in M&A transactions.

Industry experts see the trend as a temporary — but lucrative — move for private-equity firms that will allow deals to get done despite the financial turmoil and let the firms pocket handsome returns for their trouble.

“We’re able to make the kind of returns now in senior positions that we were making in mezzanine-like positions [in the past],” said Kjerstin Hatch, principal and portfolio director at Madison Capital Management LLC, an investment management firm in Greenwood Village, Colo. Yet, the risk is far lower, she said.

And demand for senior lenders is escalating. “It’s up dramatically — 200% — in the past year,” said Ms. Hatch, whose firm manages more than $550 million in assets. “Without a doubt, we’ve been doing more of it, and we’ve had more requests to do it.”

She said many companies are itching to do deals to take advantage of another company’s distress in this shaky economic environment, and yet they can’t get senior financing to do it. Ms. Hatch estimates senior lending currently accounts for about 30% of her firm’s business, up from 15% in 2006.

Private-equity firms are filling a void left by banks, which have all but abandoned the deal market over the past year, with few issuing new loans during the upheaval in the credit markets. Most are preoccupied with getting rid of their existing debt rather than adding new loans to their books.

“There’s certainly a gap that has to be filled,” said Alan Madian, an economist with LECG LLC, an Emeryville, Calif., advisory firm. As a result, some savvy private-equity firms that had traditionally focused on equity injections and pricier mezzanine financing are stepping up to fill the vacuum.

“They’ve come up with an interesting product to allow some of these deals to happen in a market where they wouldn’t otherwise happen,” said John Babala, a partner at Dreier Stein Kahan Browne Woods George LLP, a law firm in Santa Monica, Calif.

He first noticed the trend a few months ago when working on the leveraged buyout of SM&A, a management consulting firm in Newport Beach, Calif. Basically, Odyssey Investment Partners LLC, a private-equity firm in New York, planned to acquire SM&A for $6.25 a share, or $119.6 million, but couldn’t find senior financing.

“They just couldn’t find any senior lender willing to write a check,” said Mr. Babala. As a result, another private-equity firm, Caltius Mezzanine in Los Angeles, offered to provide the senior financing. But Caltius got creative: It agreed to cough up financing for the senior piece at a high single-digit interest rate on the condition the firm refinances the loan within 21 months. If the loan isn’t repaid in that period, the borrower will face traditional mezzanine pricing, which is typically almost twice as expensive as senior debt financing.

“They essentially structured it as a bridge loan,” with Odyssey betting that the credit markets would turn around in the next 21 months, Mr. Babala said.

Caltius is currently looking at offering similar financing deals to other firms. “We’ve always done the mezz tranche of the capital structure, but recently with senior lending drying up, we’ve moved up to fill that hole,” said Greg Howorth, a managing director at the firm.

Demand for senior loans is surging, but Ms. Hatch cautions that it’s important to be selective when choosing deals to finance. Ten to 15 mergers-and-acquisitions deals cross her desk each week, she said, and her firm pulls the trigger on only 5% to 10% of all such deals.

SWEET REWARDS

For private-equity firms, the rewards are sweet: Rates on senior financing have climbed to the high teens from the low teens over the past two years while mezzanine financing rates have jumped to the low 20s from the mid-teens, according to Ms. Hatch.

“They’re able to do senior lending right now at the same rates that you could do mezzanine lending a few years ago,” said Monte Brem, chief executive of StepStone Group, a private-equity asset management, coinvestment and advisory services firm in San Diego.

Although there’s plenty of money to be made in this niche, Ms. Hatch cautions cash-hungry investors not to jump randomly into funds that invest in this niche.

“One of the reasons that we’re still around lending today is because we’ve always had incredibly rigorous underwriting standards,” she said. “This space is rife with dead bodies — there have been many high-profile bankruptcies of companies that took money from individual investors, lent money in this space, and then completely blew up.”

E-mail Janet Morrissey at [email protected].