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Mezzanine: Pastures new

As larger cap LBO mezzanine pricing falls and leverage levels rise in a market awash with new investors, the risk-reward ratio of conventional European mezzanine is becoming less appealing to traditional investors. Alternative investments are being explored, such as smaller buyouts, sponsorless deals, general corporate financing and development capital. Joanna Hickey reports.

The rapid growth of the investor base for European mezzanine is one of 2004’s major leveraged finance trends. While just five years ago traditional mezzanine investors enjoyed a relatively uncompetitive, club-style market inhabited by a handful of major mezzanine funds and some banks, over the last two years, a plethora of new lenders have piled into the asset class. The attractions of mezzanine for these new investors are clear: low default rates and a significantly higher yield than today’s alternative asset classes, amid plunging high yield bond, senior debt and second lien pricing in both the US and Europe.

With such unprecedented liquidity flooding the asset class, jumbo deals have emerged this year, such as the AA’s £400m (€570m) deal in August – Europe’s largest ever mezzanine facility – and Saga’s £325m facility in November. Both deals were substantially larger than the previous record – Telediffusion de France’s €300m facility in 2003. The extent to which the mezzanine investor base has ballooned is illustrated by the unprecedented uptake of the AA, where £700m was raised from over 20 investors.

Traditional investors (as defined by their preference for an equity component through warrants) such as ICG, Indigo and Mezzanine Management now have to jostle for mid-to-large buyout mezzanine paper with up to seven other investor groups.

Major mezzanine banks such as Barclays, HBOS, HSBC, HVB and RBS have substantially increased the amount of mezzanine that they can hold on balance sheet. Other banks, such as HVB and Mizuho, have created mezzanine capability in the last few years. “Banks that have appetite to hold mezzanine on balance sheet have doubled or tripled their exposure in the last two years,” says Kirk Harrison, head of mezzanine finance at Barclays Capital.

Some CDOs are also increasing their exposure, with new vehicles now stipulating minimum mezzanine targets.

Meanwhile, several new groups of investors have entered the market in the last two years. The number of US banks with specialised, third-party mezzanine funds is growing. As well as Goldman Sachs and Lehmans, Citigroup is believed to be in the process of launching a European mezzanine fund. New specialist funds are emerging, such as Park Square Capital, which closed a €1bn mezzanine fund in October, and Hutton Collins, which closed its debut mezzanine fund in July. In addition, this year private equity houses’ limited partners started to gain direct access to debt arrangers and break into mezzanine syndicates, as with the AA.

Finally, amid plunging high yield pricing in both the US and Europe and lower US senior debt spreads, opportunistic investors such as hedge funds, high yield investors and other US institutional investors are swarming over European mezzanine. These more speculative institutions are aggressively chasing both senior debt and mezzanine in Europe, in search of the favourable relative value and arbitrage currently on offer.

As their market is gradually being taken away, the role of the traditional mezzanine investor at the helm of the market for mid-to-large buyouts is changing. Whereas five years ago a mandated bank would have approached a firm such as ICG to help structure, price and arrange the mezzanine component of the LBO financing, today this process is becoming rare. Traditional investors, which want to structure and lead deals, rather than just participate, are increasingly frustrated. Not only are they often side-stepped in the mezzanine structuring process, but, in general syndication they are often locked out of deals.

Also, as deal sizes swell, smaller traditional investors are encountering capacity issues in a market where competitors such as Goldman Sachs, Lehmans and Park Square can write €100m+ tickets. “The role of the traditional mezz player is changing. With so much liquidity around, their pricing and structuring input is no longer the pre-requisite it once was for arranging banks and even today’s biggest jumbos can be done without specific funds. This was inconceivable just two years ago,” says Harrison of Barclays.

With so much liquidity in the market competing for assets, demand is outstripping deal supply. LBO volumes may have hit an all-time high this year and 2004 may have yielded some jumbo mezzanine deals, but total volume is not much higher than in 2003, as the rebounding high yield market and flourishing second lien market have taken volume away from mezzanine. According to Standard & Poor’s LCD, January to September 2004 saw a total of €3.37bn in mezzanine volume from 41 deals, compared to €3.33bn from 49 deals in 2003.

In addition, the deals that do emerge are increasingly unattractive to many traditional mezzanine investors. In a market awash with liquidity, sponsors are firmly in the driving seat when negotiating terms and are successfully negotiating away warrants on most mid to-large-cap deals. S&P’s LCD stats show that, in the quarter ended September 30th, 66.47% of mezzanine volume and 63.4% of mezzanine deals were warrantless, compared to 51.3% volume and 44.9% number of deals in 2003. Although banks and CDOs are happy to buy warrantless mezz, it is anathema to many traditional houses, which rely on the few really big hits that successful warranted deals generate to deliver promised returns to investors. IRRs are getting a further hit from falling contractual pricing. According to S&P’s LCD, average warrantless mezz pricing slid to 1058.3bp in Q3 of 2004 from 1107.5bp in 2003.

Pricing is falling at a time when credit quality is deteriorating and leverage levels are rising alarmingly. S&P’s LCD shows that 73.1% of rated deals had a single-B rating in the first three quarters, compared to 58.5% in 2003 and just 43.6% in 2002. Meanwhile, 29% of European buyouts in the year to date have had leverage multiples of more than 5x total debt to EBITDA earnings, compared to just 16% of deals in 2002. Compounding the problem, the advent of second lien has often pushed mezz investors into a third lien position, forcing them to lend through more leverage.

Alternative investments sought

Today’s highly competitive market, aggressive structures and dearth of warrants has made the larger buyout space unappealing to most traditional mezzanine investors. Most have stricter return and credit quality hurdles than many of today’s newer mezzanine investors and cannot accept lower pricing.

As a result, although most traditional investors still appear in some larger deals, all are pulling back a bit and some have even retreated entirely from the market. “We have not done syndicated mezz in a large LBO for over a year. We feel that there is too much risk for too little reward in large-cap mezz today,” says Christiian Marriott, investor relations director at Mezzanine Management.

So they are backing away from the syndicated market and are being forced to look elsewhere for quality, high yielding investments. “Traditional mezz houses are being forced to look beyond conventional syndicated mezzanine to meet their return hurdles,” says Haseeb Aziz, investment director at Hutton Collins.

Most firms have always done some deals away from the standard mid to-large-cap sponsor-backed buyout market. However, such alternative investments are becoming a far greater focus today. There are four main areas of non-conventional mezzanine that investors are now exploring. The first alternative is to retreat down the deal size curve to the smaller buyout space. Given the illiquidity of the debt paper and perceived higher risk of smaller companies, there is significantly less competition for assets in this part of the market. As a result, there has been far less pricing erosion and, crucially, these deals also still tend to offer warrants.

Secondly, some firms are turning to new countries, where competition is also lower. For the most part, this means entering markets such as Italy, Portugal, Spain and the Nordic regions. For example, ICG opened a Madrid office earlier this year. Some firms are also increasing their buckets for the nascent Central & Eastern Europe market, although for now most are unlikely to raise dedicated funds for this region.

A third way of diversifying deal flow is sponsorless mezzanine: funding an acquisition that does not involve a private equity house.

Although sponsorless mezzanine is nothing new for some traditional investors and banks like RBS and HBOS, they are concentrating far more on this aspect of their business now. “We have always done sponsorless deals and historically almost half of our capital has gone into sponsorless deals. But in the current fund it’s over 60%, and that is to some extent due to today’s aggressive LBO market conditions,” says Marriott.

Newer mezzanine firms like EQT Mezzanine and Hutton Collins are also increasingly active in this field. In addition, local firms targeting this growing niche are being created such as Buchanan Group and M Cap in Germany. “Several new mezz firms have been set up in Germany in the last year, with more in the pipeline to serve the growing market for sponsorless mezz,” says Jeremy Golding, founder of German based advisor Golding Capital Partners, which recently launched Europe’s first dedicated mezzanine fund-of-funds.

Thus although sponsorless mezzanine is still a very small part of the mezzanine market (by volume, well over 95% of deals are conventional buyouts) it has grown noticeably over the last year. Industry experts estimate that, while only one or two deals per year were done before 2003, this year about a dozen deals have been done, spanning the UK, Germany, Holland, France and the Nordic region. “We have definitely put more focus on sponsorless mezz this year. We are actively marketing the concept to corporate advisers to try and originate deals,” says James Davis at ICG.

Sponsorless deals range from helping management or the major shareholder take a company private via an MBO to gearing up the owner or shareholder’s stake in a private or public company to create cash for an acquisition. “Where management have a significant stake in the firm but can’t inject any cash equity, sponsorless mezz can be a way of gearing up the value of the business to enable them to take control,” says Davis.

Although the mezzanine firm is not attempting to buy out the company itself and management retain control, sponsorless mezzanine usually involves a far higher minority equity stake than the usual 2%-3% in LBOs. An equity stake, either direct or through warrants, of up to 20% is quite normal. Even so, for corporates, the advantages over selling out to a private equity house are clear. “Mezzanine can be the solution if a company owner needs money to buy another business or to go private, but doesn’t want to relinquish control to a private equity firm or dilute its equity too much,” says Kevin Murphy, director at Indigo Capital.

One recent example is the take-private MBO of UK dental chain Integrated Dental Holdings. The £12.1m take-private was done without an equity sponsor, with management injecting a £3m equity stake. Mezzanine Management provided £9.5m of mezzanine, alongside £9m of senior debt, with total leverage a conservative 4x EBITDA, far lower than today’s big buyouts. Also this year, UK pest control firm Sorex obtained £9.5m of mezzanine from Indigo and £20m of bank debt from RBS to finance a US acquisition. “Sorex was an unleveraged family-owned business looking to make a US acquisition. There was no cash equity – we provided mezz on the basis of the value of the business,” says Murphy.

Meanwhile, last year, ICG provided £14m in mezzanine to support the acquisition by UK greeting card firm Card Fair of Card Warehouse. “Card Fair was wholly owned by an entrepreneur and all his wealth was tied up in the business. We looked at the value of the business and treated that as the equity value beneath us,” says Davis.

Sponsorless mezzanine is not an easy market to play in, however. It is generally held to be riskier than traditional sponsor-backed buyouts. Not only is the small size of the company an inherent risk, but exits can be a problem, as the mezzanine firm has only a minority stake. “Sponsorless and expansion mezzanine deals can be riskier, as the majority of the equity is with the management. Careful structuring can help mitigate the risks and you have to be able to protect your position in the event that the management don’t perform or their motivations to seek an exit change,” says Christian Marriott.

Some market specialists point out that, although smaller companies usually imply greater risk, they also carry lower leverage and higher pricing, usually delivering 20%-22% IRRs compared with 14%-15% now on conventional buyouts and can make these deals more attractive than conventional buyouts. “There is a risks trade-off between a large stable company with high leverage and a small but growing company with low leverage,” says Aziz of Hutton Collins.

Another risk is that, as the mezzanine firm is often the front-line funder, it cannot look to a private equity house to inject equity if the business starts to under-perform. “You are the deepest pocket at the table. If the company struggles, there is no private equity house to inject further capital – it is down to you to sort it out,” says Murphy.

The mezzanine house also has to assume the usual private equity house roles, such as running board meetings and due diligence. Firms may not only lack sufficient management skills, but such involvement is also labour-intensive and requires far more resources. If mezzanine houses start doing many more sponsorless deals, they will need more people – a resource investment that could make their models less attractive. “The primary responsibility for running the management shifts to you, which is time-consuming and demanding. We don’t have the resources to do a lot of sponsorless deals each year, although we would like to do more as they are more lucrative than many of today’s sponsor-backed deals,” says Murphy.

Away from resources and risk issues, a major problem for mezzanine houses looking to build their sponsorless mezzanine activities is that the deals are relatively hard to come by. “The volume of sponsorless deals is restricted by the number of opportunities. You can only do it if management have a large stake in the business and the volume of deals that fits this profile is limited,” says Davis.

One or two mezzanine houses have gone one step further down the sponsorless path, acting in the place of a private equity house to actually taking control of the firm.

In general, however, this is not deemed an advisable business model and most firms will only end up with a majority stake if the business runs into trouble. Taking control of firms requires even more hands-on involvement and expertise, plus a minefield of conflicted interests. “Taking majority stakes in companies and acting like a private equity house makes no sense and very few mezzanine firms will do it. You are competing with the very people that you normally market yourself to,” says Murphy.

Expansion capital opportunities

In addition to smaller buyouts, new countries and sponsorless deals, a fourth avenue for traditional investors looking to boost returns is expansion capital and refinancing.

According to Mezzanine Management, the use of mezzanine in refinancing and expansion capital deals rose by 60% in the first half of 2004, with €116m invested compared to €72.4m in the second half of 2003. “Traditional mezz houses are also doing more general corporate lending. For example, we provided Hawkpoint with mezzanine for refinancing and expansion capital,” says Marriott.

Another example is the Triumph Adlers financing in Germany in November, where alongside the restructuring of the company’s existing senior debt, a consortium led by Dresdner Anschutz Mezzinvest provided fresh capital in the form of a €30m mezzanine piece.

The supply of such deals is growing, especially in countries such as Germany and France. Although traditionally, most small to mid-market corporates have accessed cheaper senior debt from banks and have regarded mezzanine with something approaching disdain, with Basel II approaching, bank loans are becoming less accessible. As a result, corporates are coming round to the fact that they will have to pay more for their funding and mezzanine is losing its stigma. “There is increasing demand for financing with mezzanine from the Mittelstand. Traditional sources of capital are disappearing as banks are reducing their lending ahead of Basel II. Mid-market companies are finding it tough to obtain senior debt on attractive terms,” says Thomas Warnholtz, partner at Augusta & Co.

Looking forward, with smaller buyouts, sponsorless deals and expansion capital providing good investment alternatives for traditional mezzanine investors, many appear optimistic about meeting their return hurdles over the next few years. However, it is unclear how long the need to do non-conventional mezzanine will endure.

With leverage levels rising alarmingly and credit quality plunging in the sponsor-backed buyout arena, the likelihood of a big LBO syndication failure or default is growing. Meanwhile, sooner or later a wider financial market event will cause bond pricing and US leveraged loan pricing to rise again. These factors will serve to dampen liquidity across Europe’s leveraged finance markets. Not only will some of the fast money then drain out of the mezzanine market, but banks will stop structuring stretched senior pieces and holding such large tickets.

At some stage in the next few years, the market will turn once again. Structures will become more conservative and liquidity will fall, opening the window for traditional investors again. “The need to find alternative investments is only short-term. It will only take one or two high profile LBO casualties for the debt markets to cool and banks to stop providing tranches lower down the capital structure. Then, the need for traditional mezz investors will return,” says Philip Butler, leveraged finance partner at law firm DLA.