Mezz lender feels the squeeze

Mezzanine investor Intermediate Capital Group (ICG) recently reported preliminary pretax profits of £224m for the year ended March 31, up from £190m for the 14 months to the same date 2006 and a core income rise of 23% to £112m. The results were followed by a 10% plunge in share prices over the following days.

The share price fall came thanks to the company’s warning on conditions for mezzanine lenders. In a statement outlining the results the company said it expects to be affected as prices and structures “get worse before they get better” as the debt market is squeezed by excess liquidity. ICG CEO Tom Attwood said he was unshaken by the share price plunge.

“We’re not especially focused on short-term share price fluctuations and remain on course for our stated objective to double the size of the business every five years,” he said.

He pointed out that the past year or so has been remarkable for private equity and for ICG.

“The year from 2006 to 2007 generated record returns. It was an exceptional year for the private equity business as a whole. There has been a step change in the private equity market, which has had two fabulous years and as an investor we are very much part of that market.”

The volume of mezzanine finance issued in Europe rose from US$11.5bn in 2004 to US$25.7bn in 2006, with a doubling in the number of deals. But after sustained growth the mezzanine market has been squeezed in 2007.

The asset has come under pressure from deeply liquid lenders desperate to invest in senior loan tranches, on the one hand, and PIK loans and notes, on the other. Mezzanine traditionally traded off the private disclosure advantage over high-yield notes but has no advantage over available senior debt from a borrower perspective.

Typical of pressure the asset class is under, was bookrunners Goldman Sachs and RBS structural and pricing flex on the €2.74bn LBO financing of French retailer Vivarte.

The flex included scrapping €245m of mezzanine debt which had paid a comparatively heady 825bp over Euribor by increasing the senior B and C tranches (at the same time as margins were cut to 200bp and 250bp over Euribor respectively) and increasing a second-lien tranche (while cuttings its margin to 75bp from 425bp over Euribor to 350bp).

Such a flex is now entirely predictable on any large financing initially syndicated with a mezzanine tranche. Deals where investors would have expected to see a substantial mezzanine tranche routinely come to the market with little or none.

Attwood acknowledges that the asset class faces a challenge but disagrees that the trend is across the market.

“What we are seeing is a polarisation between the big deals and the mid-market,” he said. “On big deals mezzanine has been squeezed by the appetite for senior debt which has driven pricing to a level which does not reflect the risk, and is reliant on the macro environment staying benign and default levels remaining at the current low levels.”

Attwood said his firm is increasingly rejecting the upper part of the market to focus on areas where traditional mezzanine can still find a role: “Our response is to extend and expand into global mid-market deals. In 2006 we did our first deals in Australia, New Zealand and this year our first deal in Taiwan.”

As well as being squeezed by pricing, Attwood pointed to the complexity of relationships and structures on some major deals as another reason to focus away from the top of the market.

“The difficulty of recovery on Focus or Eurotunnel highlights the desirability of the kind of secure syndicates the mid-market offers. On a mid-market deal we would expect to see one lead bank, one equity investor and one mezzanine investor and an intercreditor agreement which ensures we are in the room when negotiations start.”

Indeed, as a relationship-focused mezzanine investor he queries how the current wave of LBO financings will deal with any upset. “Borrowers have done fantastically well out of the liquidity and the new structures available, but it throws up the issue of who can they speak to in the event things start to go wrong?”

The ICG chief sees other factors which could dampen the current investor appetite, including overconfidence in the ability to trade out of difficulties in the event of a downturn and the creep up of interest rates. “A rise in defaults has historically tended to follow rate rises,” he said.

Despite the current difficulties Attwood is still upbeat about ICG’s future prospects.

“Even if net interest income is squeezed there will be growth in assets under management, and the regional business is strong. For now we have little interest in the bigger deals and will continue to turn them down on a risk/return basis.”