Mezzanine returns

In the first half of 2007, traditional providers of mezzanine finance faced a troubling environment. They had been squeezed out of many transactions by second lien finance, while the arrival of CDO/CLO funds and hedge funds into the market also affected business.

These factors had already been in place in 2006 and that led a number of the traditional mezzanine providers to sit on the sidelines in the first half of 2007 as they just didn’t see a market that was profitable enough to take part in.

“Six months ago it was a very difficult market for traditional mezzanine providers to get decent finance out of the door but since then there’s been a repricing of risk, which has allowed them to re-enter the market,” says Ed Cottrell of Investec Growth and Acquisition Finance.

Last year, the traditional mezzanine players had been hit by a major evolution of the debt market. Three or four years ago it was much simpler – there were a handful of major independent mezzanine providers, such as ICG and Mezzanine Management, as well as a few investment banks like Goldman Sachs and Lehman. This group generally underwrote the mezzanine tranches they provided to deal sponsors.

But, particularly in the larger deals, where debt was being underwritten and syndicated by the investment or commercial bank, mezzanine was being sold on to specialist hedge funds or CDO/CLO funds. By late 2006 these funds were accounting for around half the mezzanine market and billions of dollars were raised for new CDO/CLO funds.

One of the impacts of this new competition, however, was a driving down of mezzanine returns. At the same time, there was the emergence of a second lien market, a new product that could be described as the least senior of the senior debt or the most senior of the junior debt. It was sometimes sold with senior debt, at other times with mezzanine and in some cases offered on its own to institutional investors seeking yield.

“What was happening was that there was an excess of senior debt and so mezzanine became squeezed, while at the intermediate level cheaper second lien came into play,” says Cottrell. “Second lien was on offer at base plus 4% to 5% and with no warrants, so it was effectively another slice of senior debt.”

Since July, the situation has changed dramatically, says Erik Thyssen, managing partner at mezzanine provider AlpInvest: “The cost of capital for CLOs has gone up and it’s becoming clear that it’s got a lot harder to place second lien.”

Christophe Evain, managing director at mezzanine and investment firm ICG, says: “Since July a lot of the players that were active in the mezzanine space have had a shortage of liquidity, notably CDOs which found themselves unable to raise more funds and because of their outstanding commitments unable to fund new deals.”

He adds that the buyout market has also slowed considerably since the summer. “To the extent that deals are being done at all, there is much lower leverage and different pricing conditions.”

The larger deals market has all but closed, although the mid-market remains open. Some in the market believe any deal with an enterprise value over €500m to €600m is difficult to do in today’s climate.

Thomas Warnholtz, a partner at merchant bank Augusta & Co, says: “Leverage levels have come down and often up-front fees for mezzanine have improved, as well as spreads.”

Warrants are back

Another change the traditional mezzanine providers didn’t like was around warrants. Historically, mezzanine investments were debt products that came with a warrant giving the investor the possibility of a capital gain. With the growing competition in the market last year it became much more difficult to provide mezzanine with an associated warrant and the product became, in many cases, a fixed-income investment.

With the current changes in the market, warrants are making a comeback. “One of the key points for us has always been warrants, which we’ve always insisted on in deals, and we see warrants becoming increasingly part of mezzanine more generally,” says Cottrell.

Simon Tilley, a managing director in Close Brothers Financial Sponsors Group, says 2007 was “a game of two halves” with the first half representing the peak of the debt market in terms of liquidity, as well as on pricing and structuring. In the second half, there has been a return to more normal levels of financing, in historical terms. “Some of the long-term mezzanine players baulked at the situation in 2006 and so stayed out of the market in the first half of this year as pricing dropped to 7% or even lower. Some of those players that have returned to doing business since the credit squeeze could understandably say to the market, ‘I told you so!’” says Tilley.

ICG’s Evain says the firm did not actually withdraw from the market last year and in the first half of 2007, although like other independent mezzanine providers it felt the increased pressure: “Because we have a network of offices across Europe we’ve been able to access deals off the beaten track.”

But he adds ICG did decide not to participate in any of the very large deals in the last 12 to 18 months because the return on assets was extremely tight and there were more interesting opportunities in the mid-market. “We had to reject certain deals because they were too highly leveraged or the return was not satisfactory,” he says.

One of the problems for mezzanine providers until this summer, says Evain, was that the pace of repayment had accelerated. “If you’re getting the debt repaid after 12 months that’s fine from an IRR point of view but not from a money multiple, which is much more important,” he says.

Nathalie Faure Bealieu, managing director at European Capital, distinguishes between the larger transactions and the mid-market, when it comes to mezzanine. In the past three years, there has been a segmentation between the €1bn to €2bn-plus transactions and the mid-market deals. “Historically, it was the larger deals that drove the market and which led to increasing leverage and declining spreads for financing, including mezzanine. That spread to the mid-market, which also saw leverage increasing and margins declining.”

She says that, as a result of the credit crunch, it has become difficult for the larger sponsors to pull together deals because investment banks are no longer willing to underwrite senior or mezzanine debt. “In the mid-market, it’s more positive because the investment banks were never really active in that market, as deals were smaller and fees less.”

The banks active in the mid-market have been less affected by the overhang of unsyndicated debt and are still open for business. But they are more cautious on the amount of leverage they are comfortable with and less willing to underwrite mezzanine. “What this means is huge opportunities for companies providing mezzanine,” she says.

So, what did the traditional players do when the market got tough? Some stayed in and did slightly less business, often being forced to give way on pricing. Some took advantage of the fact they were opting out of the traditional mezzanine market to develop new businesses. These included taking minority positions in MBOs that did not have a traditional private equity sponsor – the so-called sponsorless buyout model – see page 24.

The main dynamic affecting the current mezzanine market, says Investec’s Cottrell, is that the credit squeeze has led to a repricing of risk to more normal levels. With the banks facing a reported €70bn of unsyndicated debt a lot of the senior debt originators are not in much of a position to do further lending. While these issues will be gradually worked out over the coming months, there is some uncertainty around how many people will be willing to take senior debt on to their books in the future, believes Cottrell.

He argues that often the issue is less about pricing than the size of leverage multiples. Four or five years ago senior multiples were around three to four times EBITDA in the lower mid-market where Investec operates. Six months ago multiples had reached five to five-and-a-half and today they have fallen to four to four-and-a-half. Despite this fall, there has not yet been an obvious follow-on in terms of lower pricing for companies. This is probably due to the fact there are still a lot of private equity houses with cash on their balance sheets that they need to deploy.

A mega mandate

It is clear that the mezzanine market in Europe, while affected by the slowdown in the buyout market, is far from dead. In October AlpInvest Partners received a €2bn mezzanine mandate from Dutch pension funds ABP and PGGM. It is one of the largest mezzanine mandates ever awarded and represents a significant step up for AlpInvest compared to its previous 2004 mezzanine fund, which was €700m and invested mainly in the US. The new mandate will be invested globally and an allocation of 50% to Europe is expected. AlpInvest said it intends to invest 75% of the new mandate in direct investments and 25% in fund investments.

Erik Thyssen, managing partner at AlpInvest, says: “The reason for the step-up in size in the new mandate is we wanted to become more active in mezzanine on a global basis. In the past we’ve had an emphasis on the US but we wanted to further develop activity in Europe and Asia. We see a good opportunity for mezzanine.”

He points to last year’s replacement of mezzanine with second lien in many deals and a deterioration for mezzanine in both the margin and also in terms of documentation: “We’ve been reluctant to do mezzanine in Europe since the last quarter of 2006, but now we see that in the mid-market and the upper mid-market, which is still open, that mezzanine is becoming an important part of the financing structure. We also see terms becoming more favourable to investors.”

The reason AlpInvest’s mezzanine investment has focused on the US in the past is down to two factors, he says. One is AlpInvest’s earlier investment model of teaming up with independent GPs, although it did later participate in the bank mezzanine market. “The mezzanine market in the US is more focused on the mid-market compared with Europe and we found a more favourable risk-return profile in the US,” says Thyssen.

He adds that he sees renewed interest in mezzanine in both the US and Europe, as well as evolving interest in Asia, where the private equity market is still developing and there is increasing demand for more sophisticated financing products.

The outlook for mezzanine is certainly much more positive than it was before the credit crunch, but there are still uncertainties as to whether mezzanine funds can deploy their money given the slowdown in deals. ICG, for example, closed a €2.25bn fund in March 2007.

Christophe Evain says mezzanine will be an important part of the capital structure of future deals. The banks have been cautious since July on structuring new deals, he says, and instead of selling the debt to institutional investors they’re holding on to it, often in club deals. “Senior leverage is down, which means to have an attractive capital structure private equity investors will need some sort of subordinated debt or mezzanine. We have the spare capacity to provide what they need.”

David Wilmot, a managing director at Babson Capital says: “Sponsors still have the appetite and capacity for new deals. They’re more sensitive than before of the need to have the right financing structure in place and to work with mezzanine providers who are prepared to remain committed to their deals, rather than disappear if things get tough.”

Wilmot believes that there will be more opportunities for mezzanine providers who have targeted the European mid-market: “If a mezzanine fund is targeting solely large cap deals, as some seem to be, I think they’ll find it very difficult. But the mid-market is still very much open and offers a major opportunity for mezzanine.”

But deal flow will be an important factor in determining whether mezzanine funds can take advantage of the more benign conditions for their product. “There’s likely to be significantly more demand for traditional mezzanine in buyouts but the only question is whether there will be enough deal flow to absorb it,” says Augusta & Co’s Thomas Warnholtz.