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Making mezzanine work

The use of mezzanine, once a minority interest financing tool with a niche market, has expanded continuously in recent years, riding to popularity largely on the back of leveraged buyouts. According to the PRICOA Mezzanine Monitor, 2001 was a record year for European mezzanine with EURO4.2 billion invested. However, after several years of increasing levels of mezzanine investment initial indications are that 2002’s figures may not reach the same level.

Although the buyout market is showing signs of regaining some momentum as large deals such as Jefferson Smurfit and Legrand are now reaching completion, the first half of the year was very quiet and all mezzanine providers noticed slower deal flow. “The first six or seven months of the year have been marked by a reduced number of large, high quality deals and fierce competition to do them,” says Paul Piper, investment director of Intermediate Capital Group.

Deal flow has picked up with more deals containing mezzanine, but overall he believes that, excluding one or two mega-deals, this year the volume and number of deals will be down on 2001. “Most deals being done at the moment of any size contain mezzanine. Hence mezzanine could have a better year than expected a few months ago while overall LBO activity is likely to be lower than last year,” he adds. At the other end of the market Graham Sturrock, head of Bank of Scotland’s mezzanine unit, notes: “Mezzanine in smaller deals is harder to find as there are fewer of these types of deals around and so the mezzanine has gone down commensurately.”

The buyout market has suffered as vendors pull back from the low valuations offered. Banks have also been more conservative in the last year, although they are still prepared to fight over the right deal, and senior debt availability has slowed completions. However, to an extent mezzanine lenders are benefiting from tight credit markets and equity sponsors who still need leverage. “If there’s less equity or less senior debt available mezzanine is always the product that takes the strain, whatever the point in the cycle. But there’s such a wall of equity at the moment that there’s not going to be pressure to over-stretch the mezzanine in a deal,” says Bruce McLaren, head of debt ventures at The Royal Bank of Scotland.

Christiian Marriott, a director at Mezzanine Management, agrees that mezzanine is great for weathering cycles: “Mezzanine is not wholly counter-cyclical but it is defensive as it has the downside protection of debt, as well as cash-paying interest and an equity upside.” In the current environment he emphasises the need for good documentation, where mezzanine lenders should be flexible and competitive but sufficiently rigorous to ensure that their interests are protected in the event of refinancings. A combination of factors mean mezzanine is in demand but lenders still need to focus on doing the right deals.

As universal as reports of an initial drop in 2002 deals is the positive feeling that deal flow has now started to pick up again and mezzanine is in demand. Louis Vaillant of Paris-based Euromezzanine says: “Deals may be slow at the moment but the long-term outlook for mezzanine is great. We are seeing more potential deals than a year ago but few are closing at the moment so the number of deals is actually lower than last year.”

Vaillant predicts a flurry of completion activity before year-end. Jim Stevens, managing director of RBS Mezzanine, says: “Mezzanine is expanding across the board, driven by availability. Banks are increasingly willing to underwrite it, institutional investors are happy to take it and CDOs are also keen on mezzanine paper – mezzanine is easier to syndicate than senior debt at the moment.” Sturrock is also optimistic: “There are more bigger deals in the pipeline and there’s plenty of mezzanine available so things look pretty encouraging. There’s been a flourish of deals in the last quarter.”

Positive trends include the increasing size of mezzanine positions. According to PRICOA Capital the average tranche rose to EURO37.5 million last year and as long as the size of buyouts keeps rising this upward drift is likely to continue. Terence Wong, executive director of PRICOA, says although positions of between EURO20 million and EURO40 million are still typical, sizes have increased to EURO50 million or even EURO70 million. Vaillant says the proportion of mezzanine used in deals is also higher, maybe 15 per cent to 17 per cent now rather than 12 per cent or 13 per cent.

The quality of deals is also perceived to be improving, with more conservative deal structures and more sensible pricing. Questions over the quality of deals meant some independent funds chose to lay low in 2001, a decision they say investors understand. Last year was a quiet year for Mezzanine Management: “A lot of the mezzanine invested in private equity deals was, we felt, not structured and priced appropriately in view of where we felt the economic cycle was. It was also very hard to assess prospective earnings during 2001, so we didn’t find it a good time to deploy capital,” says Marriott.

Mezzanine Management cites more conservative structuring and realistic pricing, as well as the current availability of fundamentally good companies that are constrained by inappropriate balance sheets, as a positive feature of the current market. Christopher Howe and Kevin Murphy, both directors of Indigo Capital, say they are looking forward to what they anticipate will be a vintage investing period.

A changing market

Buyouts are still the main source of mezzanine deals, about 85 per cent of the total invested is in buyout situations, and more buyouts than ever are using mezzanine 28 per cent of all European buyouts over EURO10 million last year according to PRICOA. ICG confirms this trend: Piper says in 2001 in the UK 45 per cent of all deals above GBP50 million had a mezzanine tranche. This is in deep contrast to mezzanine lending in the US where the split between buyouts and other deals is closer to 50:50. In the long term growth in non-buyout mezzanine will inevitably become a developing feature of the European market too.

In the meantime mezzanine is happily playing its part in the ever-expanding secondary buyout market. And while buyouts are not likely to be replaced as the bread-and-butter deals of mezzanine lenders many firms are developing a pipeline of self-sponsored transactions. Popular investment situations are acquisitions and development capital where mezzanine has the appeal of being less dilutive for companies that do not want to fully open their equity up to outside investors.

Mezzanine has also emerged as an alternative to senior debt in buy & build situations, which banks are often hesitant in funding, and for small public companies. As well as reducing the reliance on buyouts for deal flow, self-sponsored transactions have other appealing characteristics. The combined roles of equity investor and mezzanine lender give a significant level of control. “If there’s no senior debt in a deal we’re at the top of the balance sheet, which is a good position for us to be in,” says Christopher Howe of Indigo Capital.

In the first two years of investing its 2000 fund, Mezzanine Management has invested in seven self-sponsored deals and only three buyouts led by private equity houses. But Marriott believes the quality of pure mezzanine deals being introduced is better now and that there will be more investments in sponsored deals going forward.

Low M&A levels, a continuing lack of IPOs and a generally weak market for private equity exits mean there is much discussion of recapitalisations of private equity-backed companies. Stevens at RBS says: “I’m not sure how the market for recapitalisations is going to develop, it depends if the IPO market comes back but I expect we’ll continue to see them for the rest of the year and into next year.”

Rory Brooks of Mezzanine Management is surprised not to have seen more recapitalisations and says they are actively looking for this type of deal. “One of the reasons the firm has not seen more of this type of deal is because private equity houses are starting to think exits are picking up, but that perception may change with market conditions,” adds Brooks.

According to Howe both recapitalisations and secondary buyouts need special consideration, as the risks can be higher: “You always have to think about how you’re going to exit and what the motivation of the management is. Recapitalisations may have a shorter maturity date, and if there is no institutional equity provider involved then the mezzanine provider needs to have mechanisms in place to bring about an exit.” Useful tools to encourage a prompt exit include interest escalation, adjusting the warrant percentage and increasing the management’s equity stake.

Increased competition as new players enter the fray has put pressure on mezzanine lenders to provide a range of instruments. A wider choice of mezzanine providers means private equity sponsors can opt for cheaper instruments including those more akin to senior debt, payment in kind (PIK) mezzanine or without equity warrants. “You must have a variety of mezzanine structures in your armoury if you are going to compete now,” says McLaren. “Equity sponsors want the most efficient structure and the very competitive market has helped the process evolve towards bespoke packages.” Although there is general agreement on this point, most firms prefer to stick to their own tried and tested structures. Howe says the market is still fragmented and Indigo tries to avoid competing purely on pricing.

PIK structures appeal to equity sponsors as they do not dilute their stake in the company and they can offer advantages to mezzanine lenders if the equity is not going to be worth a lot at the time of exit. PIK is seen to be appropriate when the company is already heavily geared, as it offers a way of increasing leverage without unnerving the senior debt lenders. It can also be structured to accommodate short term cashflow problems, such as experienced during a down turn, when interest payments can be deferred a factor that is doubtless contributing to PIK’s current appeal.

On the downside investors lack the documentary control of debt or the management control of equity and there is no income if the company fails. Marriott notes that occasionally some of the less attractively priced mezzanine has been hard to syndicate to mezzanine funds.

Mezzanine Management has made only limited use of PIK preferred instruments but Marriott says it does have a place in the portfolio but it must be properly priced, more in line with equity, and should only be one part of a diversified mezzanine portfolio. “PIK is best suited to deals such as platform rollouts where there are real cash constraints but a sensible business plan means there will be cash available in future.” The firm’s strategy is that it will, where appropriate, waive its right for interest payments and roll-up the interest instead, being aware that the equity warrants make it focus on the long-term upside as well: “This is how we’ve earned some of our best returns in the past.”

Louis Vaillant says PIK is a good marketing tool at the moment, he thinks people currently promoting PIK probably get a good reaction from investors but is hesitant about its uses himself. “If we think the purchase price is high or the business plan a little aggressive maybe we’ll use PIK alongside the equity warrant.” In France there are tax and legal issues concerning PIK-only mezzanine structures. If the government perceives that a company could have been financed using cheaper debt it can disallow the deduction of interest expenses. Although this has not yet happened it is a spectre that makes this type of deal less suitable in France.

Another trend, mainly among banks providing mezzanine, is for warrant-less or contractual return mezzanine. “Six months ago I would have said contractual return mezzanine was going to be a feature of the market but it just hasn’t come through,” says Sturrock. He says this type of structure only suits certain deals and has not been in demand as there have not been the right sort of deals around. This variety of mezzanine only appeals to most firms if the credit risk is low and firms such as PRICOA have chosen not to do any warrant-less deals at all.

The use of contractual return instruments enables the equity holder to retain more of the upside but also guarantees the mezzanine provider a more constant return. Murphy points out that warrant-less mezzanine can have drawbacks for the investee company, as there may be less motivation for the lender to work through minor problems, such as a covenant breach, if they have no equity interest. From the perspective of most mezzanine funds it is still important to have the benefit of capital gains from warrants to offset against the occasional losses.

New entrants in the mezzanine market, including leveraged funds and collateralised debt obligation funds, are undeniably making life more difficult for independent funds by putting the emphasis on coupons and rollup, rather than warrants, and doing deals with low-warrants or none at all. Terence Wong says this is the single most important change in the market, and one he hopes will not last too long. A lot rests on whether new vehicles such as AIG MezzVest, GSC Partners and the Hutton Collins fund, which is due to start fund raising in earnest shortly, can make the less equity-orientated forms of mezzanine work for them. These funds are still very young and it will be some time before the market can make an informed judgement.

… but also expanding

As the use and acceptance of mezzanine expands established funds are looking for new, less crowded markets where they can extend their reach. Euromezzanine is currently raising Euromezz 4, like its predecessors it is sponsored by BNP Paribas and Natexis Banques Populaires but it may be Euromezzanine’s first fund to invest outside of France. The fund was launched in May and Vaillant hopes to hold a first close from existing investors by the end of September. He expects to reach EURO212 million, the size of the last fund, with this close but ultimately expects to raise more. Vaillant says it is likely to target the Benelux countries and Spain, but not the UK as it too competitive and not Germany as the market is already tightly controlled by the banks. He also believes that, given time, Italy is a large potential market.

Vaillant says the response from new investors has been positive. “Mezzanine is viewed as a more stable asset class with a more reliable income. New investors are discovering mezzanine but more education is needed.” Howe echoes this: “Investors like the consistency of returns from mezzanine, it’s less volatile and there’s a lot of interest from investors as it generates an income. A lot of investors are still underexposed to private equity and mezzanine is a good way in.”

Last year the UK and Ireland made up half of Europe’s mezzanine investment but fierce competition in these markets and the increasing use of mezzanine on the continent (The Royal Bank of Scotland did more mezzanine deals in Europe last year than in the UK) mean some players are looking further a field.

Mezzanine Management is looking east for new deals. Accession Mezzanine Capital (AMC) recently held its first closing at EURO76 million and is aiming for a final closing of EURO100 million. The fund will invest in the accession countries of Central Europe: Poland, Hungary, the Czech Republic, Slovenia and Slovakia. Mezzanine Management has established offices in Vienna, Warsaw and Budapest. It has not been an easy fund to raise but it will be in a situation where it can cherry-pick the deals and the firm is expecting some good opportunities when it starts investing shortly.

Marriott says that as well as being the only dedicated mezzanine fund present there, Mezzanine Management also has an advantage over banks in the region as it is not under the restraints of banking regulations. With a two-year head start, Marriott says they would welcome some competition in the market eventually.

ICG’s new sweet spot is even further East. Piper says: “ICG is expanding the use of mezzanine, through non-LBO uses and also geographically. We have expanded beyond Western Europe with the Hong Kong office. Private equity houses have been out there for five years or more but there’s no one [mezzanine providers] out there yet – there’s a need for mezzanine.”

Although the UK, France, the Netherlands and Scandinavia are still the most popular mezzanine targets other markets are showing signs of opening up. Germany, the European country where a boom in buyouts has supposedly been just around the corner for several years now, still has a small mezzanine scene with as yet no domestic funds. However, Anthony Tulloch, tax partner in the Frankfurt office of SJ Berwin, has been working on structuring three mezzanine products that will be targeting both individual and institutional investors in Germany. Although they will all invest internationally, he believes they will be the first mezzanine funds to be raised in Germany.

As the UK faces an oversupply of mezzanine, funds scour the continent for better value deals. “Although continental deals do not guaranty lower prices the probability of finding a relative bargain is higher. It’s not so true in Germany as there is a lot of equity chasing deals but it will be a good source once the market has straightened its self out,” says Marriott.

Banks have provided much of the increased competition in the UK mezzanine market, although the withdrawal of ABN AMRO from the sector creates a little breathing space. In the UK banks get a very high market share because of their one-stop-shop approach. It is still difficult for independents to compete with banks that can easily underwrite all of the smaller deals, including the senior debt. In contrast on the continent independent players find it easier to get better deals. “European banks tend to be less aggressive so there isn’t as much competition there. We work with continental banks rather than competing against them,” says Wong.