Thomas H. Lee Co. is preparing to launch a mezzanine fund with a target of about $1 billion to invest alongside the firm’s buyout fund.
The launch will come a year after the firm settled four lawsuits filed by L.P.s alleging breach of fiduciary duty in the group’s two prior mezzanine funds, which raised a total of about $700 million in 1987 and 1989. The defendants-which included Thomas H. Lee Co., co-sponsor Merrill Lynch & Co., lawyers, a placement agent and general partners-settled those suits for approximately $20 million, said a source close to one of the plaintiffs.
“Those were in effect leveraged junk bond funds and the junk market collapsed and we took strike suits. Fortunately, we persevered and the fund came back and performed well,” said Thomas Lee, founder of the Boston-based firm.
A source close to Thomas H. Lee Co. said the as-yet-unnamed fund, unlike ML-Lee Acquisition Fund I, L.P. and ML-Lee Acquisition Fund II, L.P., will invest alongside the firm in its buyouts and not provide financing for other companies. This stipulation is meant to avoid many of the alleged conflicts of interest that occurred in the prior vehicles.
The suits, which were settled for a combination of cash and a buy-back agreement, alleged that the fund violated the Investment Security Act of 1940. The Act requires sponsors to offer fair and full disclosure in their offerings. The suit, however, alleged the mezzanine fund bought the securities of several companies-including Hills Department Stores-in which Thomas H. Lee Co. had a pre-existing position, and, in effect, insinuated that the mezzanine investment was made primarily to shore up the earlier equity investment.
In the new effort, the mezzanine fund will invest flexible percentages of capital alongside Thomas H. Lee Co. in buyouts at the same time the equity investment is made. The partnership will then receive equity or warrant kickers that give it the right to obtain shares of the company at a pre-determined rate based on the level of its investment compared to the buyout fund’s equity investment.
Deals Show a Need for Mezzanine …
Thomas H. Lee Co.’s most recent investments-including $300 million in Metris Cos. (BUYOUTS Dec. 21, 1998, p. 6), $125 million in Affordable Residential Communities (BUYOUTS Oct. 12, 1998, p. 14) and $110 million in Cott Corp. (BUYOUTS June 22, 1998, p. 10)-were all-equity deals, and a source close to the firm said the group would have used a mezzanine tranche in two of those deals if it were readily available.
Thomas H. Lee Co. is raising the fund to drive more favorable financing structures and better rates of return.
Several L.P.s said Thomas Lee had sworn off raising a new mezzanine fund only a few years ago, but they believe he changed his mind to remain competitive with other shops that also target growth investments. “The competitive environment has forced him to change his stance. What he sees is he needs to be a one-stop shop for growth investments. Summit Partners and Welsh, Carson, Anderson & Stowe have stepped into his zone, and he needs to defend his spot,” a fund-of-funds manager said.
Partners at the firm, who manage the $3.45 billion Thomas H. Lee Co. Equity Fund IV, L.P., will also invest the mezzanine fund.
The group expects the fund to generate a gross IRR of close to 20%; its first mezzanine fund generated a gross IRR of 17% and the second fund generated a 25% gross IRR, Mr. Lee said.
… But History Points to Problems
The mezzanine funds lost more than $60 million when they were invested alongside Thomas H. Lee Co.’s buyout of American Health Cos. American Health operated the Diet Center, and declared bankruptcy.
The mezzanine fund also was unable to refinance a bridge loan it made in its investment in BeefAmerica, due to the falling price of beef in the early 1990s.
However, the funds also generated high returns investing alongside Thomas H. Lee Co. in Snapple, General Nutrition Cos. and EquiCredit.
At the time of the first two mezzanine funds, the firm arranged a credit line with several banks secured against the mezzanine funds to give it more flexibility in its investments. Mr. Lee said there are no plans to leverage the mezzanine fund this time.
Mr. Lee said he has learned from some of his experiences in the prior mezzanine efforts.
“In a deal we found for someone else, one of our new analysts said right before the closing that management had just backed off from buying its stock in the company. I didn’t listen to him, and it turned out to be very bad omen and a bad deal,” he said, when speaking this month at the New York Capital Roundtable breakfast. Mr. Lee did not name the investment.
Thomas H. Lee Co. is expected to charge a 0.5% management fee for the new fund and to take 20% of all income, which includes coupons, Mr. Lee said.