Warrantless mezzanine is increasing in buyout financings, reducing dilution of equity returns for sponsors and LPs. A greater proportion of mezzanine is warrantless due to the entry of new classes of investor with different return requirements, according to Greg Lomas, head of loan underwriting and distribution at CIBC World Markets.
Speaking at Mezzanine Finance 2005, Lomas said that 58.6% of mezzanine transactions had no warrants last year. That compared with just 46.4% of warrantless deals in 2000. Traditional mezzanine investors favour warranted deals because the structure allows them to share in operational value creation over the life of the deal. However, newer mezzanine investors, most notably CDOs, do not receive credit for warrants and therefore prefer the contractual yield offered by warrantless facilities.
“Warrantless mezzanine is attractive from a yield point of view. Mezzanine buckets are running between 20% and 25%, but with so many investors in the market, CDOs are getting less paper,” said a CDO official managing US$3bn in assets.
Increased liquidity also means that mezzanine pre-payment fees are reducing, improving exit scenarios for private equity sponsors. Average year-one pre-payment fees fell to 206bp in 2004 from 246bp in 2000. Other sponsor-friendly trends include an increasing appearance of LPs in mezzanine facilities. This brings some welcome familiarity amid ever more complex and diverse mezzanine syndicates.
Conference delegates expect the mezzanine market to continue to grow this year, with higher volumes of mezzanine debt in aggressively structured transactions. That scenario points to the wider use of supply and demand features, most notably reverse flex and credit-specific pricing. Leverage is also expected to increase as the tranches themselves get larger, and sponsors will take a more active role in the syndication process.
Increased use of multi-tranche options is on the cards, too. Combinations will include warranted/warrantless mezzanine, second-lien loans, mezz notes, FRNS and PIK/PIYC facilities. BC Partners’ €270m mezz tranche, for example, included warranted, warrantless and PIK tranches. Pricing ranged from a ceiling of 3.5% cash pay for warrants up to 7% on the PIK notes.