Mezzanine has really taken off in the EU accession countries in the last three years. Previously, although banks such as Erste, HVB, ING and KBC had been providing some debt with mezzanine-type risk alongside senior debt since the late 1990s, volumes were low and traditional mezzanine, with both a cash coupon and warrants, was almost unheard of.
However, all that changed in 2002, when the first fund dedicated to providing mezzanine to the accession countries, Mezzanine Management’s Accession Mezzanine Capital (AMC), had its first close. Since then, several other independent mezzanine providers have emerged, including the Vienna-based Darby, the Balkan Accession Fund and Investkredit Bank’s Invest Mezzanine. In addition, local banks such as OTP in Hungary have now joined existing bank lenders such as KBC and Erste to offer the product.
The sudden increase in mezzanine providers is being driven by a sharp rise in demand; from private equity houses looking to expand in or enter the region for the first time, and also within the region, from Eastern Europe’s own rapidly growing corporates.
Since 2002, the volume and number of buyouts in Eastern Europe has picked up dramatically, with private equity interest in the 10 new member states; the Czech Republic, Cyprus, Estonia, Hungary, Latvia, Lithuania, Malta, Poland, the Slovak Republic and Slovenia, significantly boosted by accession on May 1, 2004.
Although some buyouts were seen in countries such as the Czech Republic as far back as 1997, such as the 1997 LBO of leading CD and DVD producer Gramofonové závody by Winslow Partners, backed with senior debt from Erste Bank, not only were they few and far between, but also mostly backed by senior debt only, rather than mezzanine.
However, buyout volumes in the region have risen significantly in the past two years, to US$1.621bn in 2004 from US$475m in 2002 and US$195.3m in 2000, according to Thomson Financial. Individual deal sizes have also soared, culminating in the €1.2bn buyout of Bulgarian mobile phone company MobilTel in 2004. “The private equity market has taken off in the accession countries in the last two years. Although the market is still very small compared to Western Europe, volume and deal sizes have more than doubled in that time,” says David Marek, senior manager with acquisition finance at Erste Bank.
Notable buyouts with mezzanine tranches include Advent International’s €230m LBO of Bulgaria’s telecom incumbent BTC in 2004 (which included a €40m mezzanine tranche, the biggest yet seen in the region), Verizon’s sale of its yellow pages business to 3i in 2003, Advent’s buyout of Hungarian radio station Danubius in June 2003, the secondary buyout of leading Polish cable TV operator AstraCity Cable and the LBO of Czech hard coal mining and metal trading group Karbon Invest.
With accession, the external perception of the region as an emerging market changed for good. With aligned legal systems and rapidly growing economies, Eastern Europe represents a hub of buyout opportunities, albeit with deals mostly still on the small side, and, with the arrival of mezzanine, financing options for buyouts have greatly improved.
To date, Advent International and 3i are the only major international buyout firms frequently active in the region. Volume has been driven by these two groups and by regional and local private equity firms such as Baring Corilius Private Equity, EMP Europe, Enterprise Investors, Innova Capital and Vienna Capital Partners. Not only have most deals have been too small to interest many big Western private equity firms, but the due diligence and local expertise required means the transaction costs for sponsors not physically established in the region can be high. “Apart from the truly large buyouts, most deals still fall below the radar of the big international sponsors,” says Erste Bank’s Marek.
Yet despite this, some big sponsors are recognising the region’s potential and are considering entering the market in the next year or two. Although initially interest has focused on certain industries, such as telecoms and pharmaceuticals, international sponsors are now starting to consider a far broader range of industries. “Although many deals are still small, the region is growing so fast and there are so many opportunities that some big international sponsors are now looking at entering the market,” says Wolfgang Lafite, partner at DLA Piper.
Growth driving volumes
Buyouts are not the only thing driving mezzanine volumes in the region, however. With Eastern Europe’s economies growing rapidly and GDP rising much faster than in the West, the region is undergoing a huge wave of consolidation and development and corporates’ financing requirements are soaring.
As a result, there is an unprecedented need for mezzanine as expansion capital, to help fund acquisitions, the launch and development of new products, the buyout of minority shareholders and other strategic goals. One notable deal was the expansion financing that AMC provided for Polish healthcare group Lux-Med last year to fund acquisitions, which exceeded €5m.
Mezzanine can fill the gap when bank loans are in short supply. Although more banks are gradually willing to extend longer-tenor senior bank loans to young or growing companies in the region, there is still a perception of risk that makes bank financing hard to come by, or at least very finite, for many corporates. “The whole region is crying out for capital. Mezz is a solution if companies cannot gain access to sufficient bank loans, plus it is longer-dated and has less covenants,” says DLA Piper’s Lafite.
For mezzanine providers looking to get into the region, broadly speaking, there is no difference between the various accession countries’ legal systems, as they have been aligned with those of the EU. Yet although superficially the accession country laws are similar, in practice there are still some differences mezzanine lenders need to negotiate.
For example, country-specific distinctions are apparent in the pledging of security or the acceleration of a loan, which varies from country to country. In some accession countries, just as in some Western European countries such as Germany and Austria, there are tougher restrictions on the ability to distribute the equity of a target company.
Given the relative paucity of precedents in this fledgling buyout market, it is still unclear which case law for taking security over assets some accession countries will follow; the more restrictive German practice or the more flexible UK system. “There are still big questions over case law in leveraged buyouts; whether the lender can enforce its security over assets of the target. Poland has followed the more liberal UK practice, but countries such as the Czech Republic and Slovakia could still follow the German standard, where taking security is far harder,” says DLA Piper’s Lafite.
Culturally too, there are certain differences between the various countries. Often, cultural divides between local entrepreneurs and lenders need to be bridged. For example, for company owners, the notion of having to share control with mezzanine lenders in certain situations can be a sticking point.
While happy to let management run the show, mezzanine lenders keep a tight grip on their control mechanisms and their powers in certain situations can be difficult for some company owners to accept. Although expansion capital also involves the mezzanine provider taking equity through warrants and having certain powers, these issues arise more often in a buyout situation. Company owners can be more amenable to the concept of taking out what can just be viewed as an expensive loan, than to the concept of giving away far more equity and control to a private equity firm.
According to mezzanine specialists, negotiating these clauses can take far longer in countries such as the Czech Republic, which has traditionally been more industry-based, than in Hungary, which has more of a history of financial engineering and negotiation. “It can be easier to negotiate mezz lenders’ control mechanisms in countries such Hungary, where there is a more flexible financial deal-making culture, than in countries such as the Czech Republic,” says Lafite.
Meanwhile, although mezzanine has been imported from Western Europe and largely follows the same blueprint, there are some differences between the two regions in both the strategy of the mezzanine provider and the structure of the product.
Firstly, although some Western European mezzanine providers assume private equity positions and take controlling or meaningful equity stakes in the companies they finance, their counterparts in Eastern Europe mostly harbour no such ambitions. “Although you see some mezz firms acting as sponsors in Western Europe and taking control of companies, this has not happened in the EU accession countries. It is certainly not our policy, we have no interest in playing a management role,” says Franz Hoerhager, head of Mezzanine Management’s Accession Mezzanine Capital (AMC).
Getting into sponsor territory requires significant management resources and expertise, something that most mezzanine specialists in Eastern Europe are not set up for. Also, the potential threat to their relationships with their private equity firm clients means few are considering this path. Most mezzanine players say that, even if a company were to approach them to ask them to take a large equity stake, they would introduce them to a private equity firm instead. “Most mezz firms in the region are not equipped to play the role of sponsor, with all the corporate managing that entails. Also, we don’t want to set ourselves up in competition with our private equity clients. We are their partners, not their competitors,” says AMC’s Hoerhager.
There are also regional differences in the structure of the asset class. Although similar in tenor, structural and contractual subordination, nearly all Eastern European deals offer warrants. In contrast, warrants are fast dying out in Western Europe, where more sponsor-friendly structures reign due to intense competition for debt among investors. The growth in warrantless mezzanine in Western Europe is also due to the rising influence of institutional investors such as CDOs, which prefer contractual only spreads.
In Eastern Europe, however, given the relative paucity of mezzanine providers and that most of these insist on an equity upside, warranted deals will be the norm for the foreseeable future. “In Central Europe we always do deals with warrants, which is how it should be. Mezzanine is risk capital and you need the chance to outperform that warrants offer, to make up for the underperformers,” says AMC’s Hoerhager.
Another regional difference is that mezzanine in the accession countries carries higher pricing, at roughly 16% all-in, compared to 12%, or substantially below for the bigger deals, in Western Europe. Also, with the exception of the odd jumbo deal such as BTC’s €40m tranche, average deal sizes are far smaller in Eastern Europe. Tranches typically do not exceed €10m and are often as small as €2m, compared to the average Western European mezzanine deal of €80m to €100m.
Lastly, the leverage multiples lenders are willing to countenance are far lower in Eastern Europe. Western Europe’s much-documented spiralling multiples have not spread to Eastern Europe, where about 4x total debt to EBITDA is the limit, compared to 7x to 8x for some deals in Western Europe at present.
Looking forward, mezzanine firms are extremely bullish about the future of their product in the accession countries. The region is growing at an exceptional rate and a huge level of consolidation is underway. More specialised mezzanine funds are expected to emerge in the coming years to meet the rising demand for the product, a development that is broadly welcomed by the existing funds, given the syndication possibilities on bigger deals this will bring.
Yet although buyouts have come to dominate mezzanine volumes since 2002, over the next two years it is expansion capital that is expected to be the major source of business for most mezzanine firms. Buyouts will continue to flourish, but most players currently see most activity in expansion capital, to meet the growing wave of M&A that is engulfing the region.
Mezzanine players estimate this will remain the case until large international sponsors enter the region in earnest, which is not expected to occur before late 2007. “Since we started in 2002, buyouts have been our main source of business. But in 2005 this has changed: our current pipeline is two-thirds growth capital. There is a huge amount of consolidation among Central European corporates now and we see the biggest opportunities in financing this,” says AMC’s Hoerhager.