Mezzanine Rounds Fueled by Demand

When all the chips are counted, it seems that mezzanine fundraising in the U.S. will have raised a pitiful $2.4 billion this year, and that’s only thanks to an $800 million contribution from Oaktree Capital Management last week. Moreover, that total includes New Jersey-based GSC Partners’ $1 billion European fund, which technically closed last year.

The number is surprisingly low, given the increased demand for the product by issuers. That said, those funds that have braved the market have raised more than anticipated.

More than 20 mezzanine funds raised in excess of $6 billion both in 2000 and in 2001, according to estimates from Venture Economics, PE Week’s publisher. This year’s total does not take into account the capital that is made available by insurance companies, which, historically have been big mezzanine investors. Nor does it include those commercial banks that dabble in the marketplace. The main players in both these investor groups claim to have increased their allocations to mezz in the last year.

A hybrid form of capital, mezzanine financing fits between senior debt and equity on a company’s balance sheet. The debt element produces a higher than average yield, but providers must also take on equity exposure as half of their payback comes in the form of warrants that are exchangeable for company stock.

With borrowers finding their traditional methods of financing increasingly restricted, mezzanine is starting to gain more attention from issuers. As banks look to reduce their loan exposure, many companies are turning to the mezz market to see them through the downturn. For example, the asset class has also become popular among mortgage-backed issuers. Moody’s Investor Service reports that, while the bid-ask spread in the property sale market has shrunk of late, it remains wide enough to induce many property owners to consider refinancing instead of sale as a means to access capital. Mezzanine loans have become an increasingly popular way to help bridge the gap.

Similarly, the audience for the mezzanine product is expanding as investors become more concerned about the returns on their alternative investments. Mezzanine debt pays a quarterly cash coupon that funds distribute directly to their limited partners. Private equity and venture capital truly live up to their reputation as “patient” capital, rarely producing returns of any kind for investors in their early stages.

“That coupon, in today’s environment, would probably represent 60% or more of the total expected return that you would get from a mezzanine investment, and that coupon is received currently,” says Bill Sacher, co-manager of Oaktree’s newly closed fund. That cash coupon becomes more meaningful as the investor’s portfolio grows.

Having woken up to the idea of alternative assets fairly late in the game, insurance companies are now taking a keen interest in mezzanine debt. This is particularly true in Europe, where some firms have upped their allocations in the asset class to an unprecedented 5% in the last couple of months.

But if demand for mezzanine is on the up, why aren’t more funds out there raising money to invest in the product? For a start, the fundraising environment has been tough over the last 18 months across all asset classes. Since mezzanine is not as well established as some other alternative asset classes therefore, it is even harder to raise funds for. While the prospect of generating a current return in the form of cash coupon is attractive to limited partners, many are still wary of the risk this entails.

This gives the more established funds a head start. “Investors are looking for groups with significant experience in the asset class who have relationships with equity sponsors that are the most likely to use mezzanine,” says Kevin Magid, a managing director at Boston-based Audax Group. Magid co-led a $440 million mezzanine for Audax back in June, which exceeded its original target by $90 million (Oaktree also came away with $100 million more than it had aimed for).

And like Audax, Oaktree says that it benefited enormously from being part of a larger platform. Having access to deal marketing and due diligence resources of the general partnerships, as well as the industry expertise and equity sponsor relationships, certainly won’t have hurt the firms’ fundraising efforts.

That is not to say that a newcomer to the marketplace doesn’t stand a chance. GSC Partners also exceeded its target, raising a whopping $1.7 billion for its debut mezzanine vehicle. The majority of its investors were U.S. institutions.

Mezzanine fundraising will continue to gain momentum on both sides of the Atlantic as players become more comfortable with the asset class, say the pros. But it is unlikely to steal too much market share from the private equity and venture capital markets at this point.

“There is a supply/demand imbalance between the amount of capital that’s been raised by private equity firms versus the amount of capital that’s available for mezzanine,” says Oaktree’s Sacher. The money raised for investment in mezzanine so far is negligible compared to the $100 billion plus of unused commitments waiting to be put to work in private equity.

One bright spot, says Sacher, is that deal flow, which was sluggish for much of 2000 and 2001 due to the M&A slump, is picking up as more middle market companies turn to mezzanine for financing. Such deals have helped Oaktree make 7 investments so far this year for a total of $190 million-close to 25% of the fund.