A new audience for mezzanine

With the dramatic growth in mezzanine, new investors and providers have entered the market and it has become increasingly common in large buyout transactions.

“One of the more remarkable facts about the European mezzanine market is how quickly the market has grown in the last couple of years,” says Fenton Burgin, director of the debt advisory group at Close Brothers, adding that some €5bn was issued in Europe in the first half of this year – roughly the same amount as the whole of 2004.

As well as the growth in issuance, mezzanine is also making up a higher proportion of the capital structure of deals, on average, up from about 8% in 2005 to 12% this year. Spreads are under pressure, says Burgin, with below 8% a common starting point especially in larger deals. “We’ve also seen the use of mezzanine in increasingly large LBOs,” says Burgin: “In 2005 the largest European mezz deal was the €683m in Gala’s acquisition of Coral, but that was eclipsed this year by the €1bn Casema transaction.”

Carola Babcock, head of Germany for mezzanine provider ICG, says: “It’s clear that primary issuance of mezzanine has increased a lot. Will that continue? Yes, because it’s being driven by the twin factors of private equity fund raising and investor appetite and neither of those show any signs of declining. On private equity fund raising, for example, last year was a record and the first half of 2006 was very strong.”

The high level of mezzanine raised for Dutch cable company Casema last month [Oct] was an indication of just how much liquidity there is in the mezzanine market, says Babcock. “The fact that €1bn was raised through mezzanine and that it was oversubscribed says a lot about demand from investors.”

Fenton Burgin agrees: “Knowing that a deal the size of Casema can be closed so quickly is very attractive for investors.”

He adds that the CVC-Permira recap of the AA LBO facility in the first half of this year was another good example of the use of mezzanine in today’s environment: “They reduced the margins by taking advantage of market liquidity and that would not have been possible in the high-yield market where there would be expensive prepayment penalties.”

The increasing importance of mezzanine is confirmed by James Stirling of Investec’s growth and acquisition finance division, which does not run a mezzanine fund but invests off its own balance sheet. He says: “We are seeing more and more mezzanine syndication opportunities in increasingly highly leveraged deals.”

Nathalie Faure Beaulieu heads the mezzanine team at European Capital, a buyout and mezzanine fund that has invested €655m in 19 companies since mid-2005. She also points to an increase in the number of mezzanine transactions, particularly of very large deals.

The nature of the market has also evolved in terms of the major players. Three or four years ago the market was largely confined to independent providers such as Mezzanine Management and ICG or some of the investment banks like Goldman Sachs and Lehman.

This relatively small pool of players generally underwrote the tranche that they were providing to deal sponsors. That remains largely true for the mid-market, says Beaulieu, where the same group of mezzanine providers, plus European Capital, still work directly with sponsors.

But what has changed more dramatically is the large deals market, which now accounts for the vast majority of mezzanine in terms of financial volumes. In this market the debt is underwritten by an investment bank or large commercial bank, such as RBS or HBOS, and then syndicated. They usually reduce their mezzanine exposure to zero but perhaps hold onto some of the senior debt. This large deals market has attracted a lot of money from hedge funds and CDO/CLO funds.

“The market has therefore developed, with new investor types and an expansion in deal size because sponsors have raised bigger buyout funds,” says Beaulieu.

Carola Babcock of ICG says the arrival of CDO/CLO funds and hedge funds is having a significant effect on the market. These new investors and particularly the CDO/CLO funds now account for 50% of the market. “There are a lot of new CDO/CLO funds being raised in the US and within about six months there have been estimates that up to US$10bn of US CDO/CLO money could be coming to Europe looking for deals,” she says.

But she adds that it is not entirely understandable why so much CDO/CLO money is coming to Europe, given that the increase in this investor demand is simply driving down returns. “I wouldn’t be surprised to see pricing of below 800 basis points on a transaction coming to market in the future,” she says, adding that despite the high level of liquidity there are not that many deals.

“Some CDOs are only getting allocations of €2m to €3m, and some even as low as €500,000. If you’re a €500m CDO fund, I don’t know where you’re going to find enough deals to make a return on equity.”

Transactions have become more structured because each type of mezzanine is attracting a slightly different type of investor, says Babcock, adding that there has also been the development of a second lien market that did not exist a few years ago. She describes second lien as the least senior of the senior debt or the most senior of the junior debt. It is the same product but is sometimes sold with senior debt, sometimes with mezzanine, and sometimes just sold to institutional investors looking for yield.

“Like mezzanine, the second lien market has grown rapidly,” says Beaulieu at European Capital. “It has not taken over mezzanine, but developed alongside it.”

As well as an evolution in investor types, there have been changes in product, triggered by the trend for larger transactions and the increasing sums of money available. Originally, mezzanine investments were debt products with an associated warrant, which gave the investor access to a capital gain. In recent times mezzanine has become a purely fixed-income product, says Beaulieu.

Pricing has also changed. Eighteen months to two years ago mezzanine was paying Libor plus a maximum of 10%, while today that is lower. The reason for that is increasing demand from investors and the fact that sponsors must pay more for companies, as well as the fact that because those companies tend to be larger they have better ratings. “Pricing for everyone has gone down and for mezzanine it’s now Libor plus 8.50% to 9.25%, which means a drop of 75bp to 100bp compared with a couple of years ago,” says Beaulieu.

Babcock points out that there is a gap between pricing for large and smaller deals: “Larger deals are more finely priced but because of investor interest some people have been trying to apply a big-deal structure to smaller transactions, even though with the smaller deals the investor is taking on more risk.”

There has also been the development of a secondary market, although this is still fairly limited at the moment because although hedge funds and CDOs/CLOs will trade, many of the other investors do not. The hedge funds and CDOs/CLOs have a much smaller exposure per deal than the dedicated mezzanine providers like ICG and European Capital, which can take more than €100m each.

“Increasing demand for mezzanine has led to the secondary market developing in the last two years, although it is still at an early stage,” says ICG’s Babcock. She adds that the emergence of this market enables investors to manage risk: “If a deal isn’t doing that well you can find a buyer for it.”

It is clear that the private equity houses are in a strong position, thanks to the high levels of liquidity in the debt market and the appetite for product. “The banks try to reduce the pricing and still fill their book, so they’ll offer a certain price and then come back and ask if we’d accept a lower one,” says one fund director. “The sponsors are able, to a certain extent, to reduce pricing and we know we can still make money on a reduced price but obviously we’d prefer to keep it higher.”

As to whether there is a demand and supply imbalance, Beaulieu says: “We’ve invested over €600m in the last 15 months, so we don’t feel there’s not enough of a market for us. But it’s clear that there are a lot of investors trying to buy the same paper but sponsors have different requirements and don’t always want to see too much held by one class of investor, unless it’s a mezzanine provider because they know how we operate.”

She adds that a CDO/CLO fund might be trading paper and that sponsors who are used to knowing the people that the debt is going to are not always happy to have the majority of the mezzanine paper going to institutions that will trade it.

According to ICG’s Babcock, this concern among some sponsors could work in favour of the more traditional mezzanine players. She argues that independent mezzanine providers such as ICG take a longer-term investment approach than some of the new entrants like CDOs/CLOs and hedge funds and they are also known by transaction sponsors.

She says: “The influx of unknown players means some sponsors are starting to take more care about who they allow in to primary issuance and in some cases they are restricting the participants in order to avoid the trading out of mezz paper.”

This is being achieved by changes to the documentation, so that those participating in the mezzanine must agree not to sell it to certain categories of investor, or even certain named institutions. “The sponsors increasingly want to know who they are in bed with when it comes to mezzanine,” says Babcock.

Adam Eifion-Jones, who co-heads the mezzanine team at Babson Capital, a multi-debt fund manager, says the makeup of investors syndicates varies from deal to deal. He says that it is easier in mid-market transactions for sponsors to limit the syndicate to long-term relationship investors.

Eifion-Jones says: “But in larger transactions sponsors tend to trade off getting the best deal possible with the composition of long-term investors and those who may seek to trade the asset.”

He adds that in larger transactions the arranging bank will be likely to resist attempts by a sponsor to limit too much the pool of investors for mezzanine: “The arranging bank will not want to be restricted too much.”

Babcock says that there is growing recognition in the market that high levels of leverage and an uncertain economic scenario are making problems in leveraged transactions more likely in the future: “Something is likely to happen and we don’t know how these new players will behave if a company runs into problems.”

According to James Stirling of Investec, a number of lenders are willing to provide increasing multiples of EBITDA. “At the moment private equity houses are still able to negotiate attractive packages in the acquisition finance market, where debt is being marketed increasingly aggressively.”

He adds that providers such as Investec are facing competitive pressure “from the bottom up”, with senior lenders prepared to stretch further into what was traditionally regarded as mezzanine space.

“Some senior debt providers are competing aggressively to win work and it seems they’re stretching the amount of senior debt they’re willing to put into a transaction,” he says. Broadly, senior priced leverage at only three times EBITDA would now be considered very conservative. This is principally being driven by the continuing low interest rate environment, the availability of CDO-type instruments as a way of mitigating balance sheet risk, and the fact that ‘default’ seems to be a word no longer in people’s vocabulary! We have had to be flexible in reacting to this, and move our offering higher up the risk structure, to play a ‘senior equity’ role.”

But ICG’s Carola Babcock argues that, more generally, it is second lien that is moving into the mezzanine space rather than senior debt. It depends on the size of the transaction, she says. In smaller deals of under €100m enterprise value the senior debt provider may simply regard the €10m to €15m allocated to mezzanine as just part of the debt package and prefer just to make it all senior debt. In some of the larger deals, however, the investment bank involved may prefer to include second lien and that can eat into the mezzanine tranche.

“But overall, mezzanine is holding up well as a proportion of the overall capital structure of deals,” she says.

Most in the mezzanine market expect high levels of activity to continue in the coming 12 months. “We don’t see demand for mezzanine slowing down and, with the high level of fund raising by buyout houses, there will still be strong demand for deals,” believes Babson Capital’s Eifion-Jones.

But high levels of leverage and the possibility of default are a reality, and one that could negatively affect the mezzanine market. “That’s why we are very selective in our deals,” says Eifion-Jones. “We carefully assess which businesses have the right level of stable earnings that can sustain the financial structures being placed on them. Even though there is a lot of competition for investment opportunities in today’s market, the selectivity of assets is critical.”


Mezzanine in emerging markets

The mezzanine market in Central and Eastern Europe is attracting increasing interest, thanks to strong GDP growth in the region and growing demand from businesses for risk capital.

“In the CEE region leverage only really became available two years ago but today there is increasing availability of leverage and the development of a true LBO market,” says Bob Graffam, global head of mezzanine at Darby Overseas Investments.

He adds that the LBO market has developed more rapidly in the CEE than in Asia or Latin America, two other emerging markets where Darby has raised mezzanine funds.

Darby is expecting to reach a final close of €300m on its CEE fund by early 2007. The other main fund in the region is Mezzanine Management’s Accession Mezzanine Capital, which was the first fund specifically targeting the region, raising €115m in 2003.

The fund focuses on investments of €6m to €15m. It has made six investments so far, the most recent of which were in Bulgarian telecom networks company Telelink and Bulgarian financial services company Jet Finance, which is controlled by AIG’s Central European Private Equity Fund.

Franz Horhager, Mezzanine Management’s executive director in Central Europe, says there is “friendly competition” between the two firms but that Darby focuses more on infrastructure transactions than Mezzanine Management.

As well as these dedicated CEE funds there is increasing interest from Western European mezzanine funds in the bigger deals in the region, following the growing focus of some of their private equity clients on CEE deals.

Horhager says: “What is driving the growth of mezzanine here is that corporate finance products are becoming more sophisticated in the region, as well as the fact that mezzanine providers are looking for new markets, in which they can make better returns than Western Europe, where it’s got much harder to make a decent return.”

A new entrant to the CEE market is Syntaxis Capital, set up in early 2006 by former Mezzanine Management staff, with mezzanine firm Indigo Capital taking a minority stake.

“The CEE region is an attractive place to be, perhaps similar to how Western Europe was 15 years ago in terms of business opportunities,” says co-founder Ben Edwards.

Among the main investment areas, Edwards identifies Poland and the Czech Republic as obvious locations, given their membership of the EU and economic size and development, but also countries on the verge of EU membership such as Bulgaria and Romania.

A number of private equity firms active in the region, such as Advent, Argus, Enterprise Investors and Mid Europa Partners, have had some highly successful investments. Mezzanine providers such as Syntaxis are keen to tailor their products to these funds’ needs, says Edwards: “We think they’ll want to think about structuring their deals and including mezzanine from ‘buy to hold’ investors like us and the other dedicated CEE players.”

While returns from mezzanine investment in the region may, on average, be higher than in Western Europe, this is not a given, says Bob Graffam of Darby, noting that much depends on the country, the size of deal and the sector. He says that because there is much lower political risk in countries that have already joined the EU, such as Poland and the Czech Republic, pricing for deals in those countries can be pretty close to Western European levels.

He says: “Similarly, for larger deals in attractive sectors like cable TV or telecoms returns are in the mid-teens, similar to Western Europe. But for smaller deals there is a different risk-return equation.”

Similarly, while leverage levels may often be lower than for deals in Western Europe, for the larger deals or those in attractive sectors that is not the case: “There have been cable auctions in Poland or the Czech Republic where leverage levels have reached a multiple of seven.”

Graffam says that the best opportunities are in countries that are not yet part of the EU. “In those countries you can still get warrants and other forms of equity optionality on mezzanine investment.”

He adds that the region is attractive because of economic growth rates that are two or three times higher than Western Europe, and declining sovereign risk even in countries like Turkey.

As for the particular attraction of mezzanine in the region, he says: “It offers an attractive risk-return profile and, whereas there is a lot of buyout money, mezzanine is not over-supplied in the CEE region.”

The main barrier for Darby in the region, says Graffam, is the lack of understanding of mezzanine products among company owners. “The buyout firms understand mezzanine, of course. But we want to also identify non-sponsored deals, as they offer the best pricing and the possibility of equity uptake, and in those situations there is often a lack of knowledge.”