German institutions favour mezz

Munich based fund groups Golding Capital Partners and VCM have completed the final closing of the first European fund-of-funds dedicated to mezzanine. The fund VCM Golding Mezzanine has closed at E200m, above its original E150m target and after just over 12 months of fund raising. The vehicle is the first of its kind to offer European investors access to a diversified portfolio of mezzanine transactions throughout Europe and the US.

A unique aspect of the fund is that its investor base is primarily German institutions, which historically have been cautious of investing in the alternative asset class, in particular private equity. Since many German institutional investors still have concerns about the J-curve typical of private equity, the inherent structural advantages of mezzanine currently make it a more attractive option. Mezzanine may be categorized as an alternative asset, but can also be positioned as a fixed income offering to provide diversity to a traditional bond portfolio.

Whilst fund raising itself took around a year, the team spent almost as long structuring the fund and researching the complex legal and tax requirements of German institutional investors beforehand. The fund was customized to meet the diverse regulatory needs of different types of institutions such as insurance groups, pension funds, endowments and family offices. This entailed structuring the fund around a Luxembourg SICAV as the main investment vehicle with a German limited partnership as an alternative vehicle.

Jeremy Golding, Managing Partner of Golding Capital Partners, says: “German institutional investors are generally still quite risk-averse. Most have to show an annual yield and so it is currently difficult for them to defend the J-curve and get approval from their board for investments in private equity. That’s why the mezzanine fund-of-funds appealed to German investors. They can expect the first returns within six months of the fund closing. We positioned the product as a competitor to a corporate bond portfolio.”

The successful fund raising demonstrates the appetite for a lower-risk alternative to private equity among German institutions and also highlights the fact German institutions may be getting ready to reconsider investments in alternative assets after being hardly present in the market over the last four years. “Mezzanine is the first step, due to its attractive risk-return profile and current yield. There is every reason to believe that buyouts and venture will follow in time,” says Jeremy Golding.

Investors were attracted to the mezz fund by four key advantages. The first is its attractive return profile – the fund aims to generate a net return of around 10%; the second is its limited risk profile; the third is the low correlation between mezzanine and other asset classes, which is extremely attractive to asset managers who need to diversify their portfolio; and the fourth is the interest coupon, which starts paying out early and will deliver stable, predictable returns on a quarterly basis.

The strategy of the fund-of-funds is to invest approximately 50% of the capital in Europe and 50% in the US to achieve broad geographic diversification. “Investors will also gain exposure to a diverse group of experienced regional US mezzanine funds, which tend to demand a higher coupon than in Europe” says Linda Behnke, Partner with Golding Capital Partners, who manages the San Francisco office. “This is what makes mezzanine so attractive relative to private equity for our conservative investor base.”

The fund has already committed about 50% of its capital to twelve European and US-based mezzanine funds, resulting in an initial portfolio of some 80 mezzanine loans. The prompt deployment of capital will facilitate the expected early returns which have attracted investors to the product. Golding adds: “We were able to deploy capital quicker than normally would be expected since we were able to warehouse the initial investments prior to the first closing. This proved to be an additional incentive to institutional investors because they appreciated the fact that it would reduce the investment period and generate initial returns from the fund quicker than expected.”

Investors can expect a net return of approximately 10% IRR from the fund. The basis for this expected return is an extensive empirical database encompassing more than 1,500 complete mezzanine transactions from Europe and the US. The database was created by CEPRES, a joint venture between VCM and the University of Frankfurt. With the database, the team was able to calculate key statistics such as portfolio risk, likelihood of default and correlation of the product with other asset classes, which, according to Golding was an extremely useful tool in winning over skeptical first-time investors. After running extensive simulation models the data confirmed that an investment in a mezzanine fund-of-funds offers an average return of around 10%, low default risk and limited correlation with other asset classes such as quoted equities, corporate bonds and high yield bonds.