“Everybody is more nervous about the economic climate yet that can be quite good for mezzanine investing because it makes the banks more nervous plus it’s good generally to be more cautious about companies that you invest in,” says Christopher Howe of London-based Indigo Capital. His colleague Kevin Murphy goes on to say: “The problem at the moment is completing deals. People are more pessimistic and the attrition rate on deals is getting higher.”
Howe’s distinction between the banks and players like Indigo Capital is in one part the size of deal that interests each party and on the other the structure of the deals each is prepared to undertake. “We don’t see the global mezzanine funds doing much in our market place in Europe. Those funds are competing more for larger deals and with high yield.
Their size criterion puts them in the same league as the high yield market,” says Murphy. For their part, some of the independents, like Indigo Capital (which was until 1999 Kleinwort Benson’s captive mezzanine operation), would be hard pressed to do a deal that did not have a sufficient equity upside obtained via warrants.
Equity warrants still appear on the bigger deals done by banks but they tend not to be a significant part of the motivation for doing a deal, the predominant motivator being underwriting fees and interest payments. Regis Mitjavile, of Paris-based IFE Conseil says: “When the PIK coupon was introduced it was the fruit of the greed of equity sponsors who didn’t want to dilute their equity. But when you don’t see the same rosy picture as the equity sponsor does for a deal, [PIK] can be of interest.” PIK, or payment-in-kind, or roll-up, which better sums up its character, acts like equity with a fixed return. A higher coupon is attached to the PIK element of a deal structure than to the mezzanine loan but the coupon is not paid until a specified year in the future, such as upon the investor’s exit of the business. Mitjavile notes that he was not seeing much PIK as little as two years ago.
All mezzanine players have their reservations about PIK. Howe sums up those concerns: “We are not usually attracted to deal structures with a significant amount of roll up or where the warrant percentage is very small. Whilst it’s not completely unattractive to lock in some of the return through PIK, you don’t want the PIK to be too big in relation to the total anticipated return.” The PIK decision is all to do with risk assessment, something mezzanine players with equity interests continually face. Howe goes on to explain: “You have to ask yourself how much value is in the business and how much down side protection there is. The danger is that you take equity risk and get mezzanine pricing. So you need the mind set of being a lender and being risk averse, and being an investor and getting the equity upside.”
As the structuring of mezzanine has come under pressure from the private equity investors it appears at the same time that mezzanine players are becoming less dependent on buyout opportunities presented by those same players. While mezzanine players still source deals from private equity houses as well as banks and advisory firms deals can come from the company itself such is the awareness of mezzanine as a financing tool today. Mitjavile notes that IFE Conseil invested in the mezzanine tranche of the Center Parcs financing late last year because the firm knew Pierre & Vacances, not the equity sponsor, DB Capital Partners.
Mezzanine players are noting an increase in their presence in a deal as a sole investor, rather than as part of a wider buyout funding package. At the time of writing, Indigo Capital was working on a deal where an equity investor had been in the company for a number of years and was looking for an exit as a result of its fund being in its wind-down phase. Boutique advisory and accountancy firms are generally recommended as an interesting source of deals because the nature of these boutiques means the people working there can be more entrepreneurial in the way that they approach their mandates. “We think deal flow will be good because the banks are being more cautious, equity investors are seeking to enhance their returns and there are comparatively few dedicated mezzanine investors in the market place,” says Howe.
Mezzanine opportunities are by their nature not sector specific although it’s likely that in this more cautious investing environment players will avoid sectors that will be hit by the knock on effect of the events of September 11 and the US response to it. As things stand the UK, France, and the Netherlands and Scandinavia will continue to offer the most frequent mezzanine finance opportunities. Germany is also expected to become more interesting in this respect, but Spain and Italy are generally not considered that important. This is in part due to the fact that those markets simply haven’t seen enough buyouts of a sufficient size for the introduction of mezzanine or at least it being under consideration for us to be common place.
Another area where the buyout has yet to make it onto the scene is Central Europe. This has not stopped Mezzanine Management taking the bull by the horns and raising a E150 million fund, called Accession Mezzanine Capital, to invest in the area. Likely much of this will be expansion capital since one of the main inhibitors of the buyout in this region is the lack of debt finance. While bank loans are available they tend to be project finance loans since banking regulation in response to across the board irresponsible lending in the early 1990s makes it extremely difficult for banks in the region to support a leveraged deal. And currency and infrastructure (mainly legal) issues make lending by non-domestic banks into the region not particularly attractive. All of this aside there are problems with inter-creditor agreements in parts of Central Europe, placing a further constraint on the possibility of mezzanine in buyouts.
Mezzanine Management is in the midst of raising its Accession Mezzanine Capital fund and the first closing is expected this autumn. See the run down, which starts on page 48, of funds and what phase of their life cycle they are in. Mezzanine investors face the same changes as their private equity counterparts. “It’s completely clear that conditions are quite difficult. First, US investors’ allocations have reduced and the percentage of allocations has gone down as the public markets have fallen. Secondly, there’s the fall out suffered by telecoms and Internet investments. And thirdly, some investors took the for every GBP1 committed only 60 pence is drawn at any one time’ argument fully on board and therefore over committed to the asset class,” says Howe.
This is certainly not the time to be raising a first fund, but that’s not to say it’s a walk in the park for those that have. Mezzanine players who may have found their more modest, but steady, returns off the radar screen of many investors who, 18 to 24 months ago, were fixated on high tech, high growth venture funds, now get a hearing. Those looking to expand their investor base, however, may find themselves facing an education exercise, especially given the hybrid nature of many of the mezzanine/ equity funds.
Certainly those with a good track record will be able to point to the IRR figures published by CalPERS (California Public Employees’ Retirement System) this summer. CalPERS is a major investor in private equity funds with commitments to several funds of 1990 vintage onwards. If CalPERS’ experience is used as a benchmark, the figures posted place several mezzanine players in the top quartile of performance. What also may attract institutional investors many of which are looking at some pretty dismal write-downs on their private equity portfolios is that there is a quicker return on mezzanine since the repayments on the debt element of the investment mean the negative side of the J curve is less steep than for pure equity investors.