Mezzanine is a form of debt that sits between senior debt and equity on the balance sheet. As a hybrid’ financing tool it combines equity as well as debt characteristics in a highly flexible and often unique way, offering added value to all participants in a deal. This article outlines opportunities in the use of the mezzanine instrument, focusing on sponsorless deal opportunities and taking into consideration the peculiarities of the German market.
Served mainly by traditional mezzanine lenders such as RBS Mezzanine, the niche market for mezzanine financing has flourished in the last three to four years, resulting in the recent establishment of E1 billion-plus in-house funds by a handful of US investment banks. These latest developments are mainly the result the emergence of the mid-market’ mezzanine product which has become a common feature of LBO transactions like the management buyout of Takko and the merger of Pinewood and Shepperton Studios. In large transactions such as these the strengths of tailor-made mezzanine become apparent. Advantages in installation costs and speed, prepayment options, a known investor base, and the investor’s reluctance regarding bridging and pricing uncertainty often give mezzanine the advantage over high yield bonds.
However, the majority of mezzanine transactions involve sums considerably smaller than E100 million, which makes this instrument largely resistant to market entry attempts from the high yield bond market. Besides the use in LBO situations, there is an increasing trend to use mezzanine sponsorless/non-LBO situations. Currently, while precise pan-European figures for mezzanine investments are notoriously hard to obtain, US data shows that more than 40 per cent of all funds are applied to these type of opportunities. In the UK, the The Royal Bank of Scotland Leveraged Finance has already met this emerging market, setting up a Debt Ventures team at the beginning of 2000 to supply tailor-made subordinated debt solutions. Encouraged by the success of the UK Debt Ventures team, the Royal Bank’s Frankfurt based Leveraged Finance team has recently formed a German RBS Mezzanine Solutions team, to specifically cover the German market, with its traditional focus on debt instruments. The Mezzanine Solutions team recently completed its first non-LBO transaction as joint arranger of Germany’s fastest growing mobile service phone provider Victorvox AG.
To get a clearer picture about these sponsorless deal opportunities, they can be broadly categorised into expansion finance and reorganisation:
The general purpose of expansion finance is to finance internal growth (e.g. volume-, product- or geographical-expansion) particularly for smaller, privately owned businesses or neglected public listed companies, and also early-stage opportunities. Additionally, and equally important, expansion finance can be used for external growth via acquisitions.
Historically there have been occasions of wrongly deployed senior debt or even equity investments by local German banks. In the case of senior debt there has been a clear disregard of risks involved, and political interests have often dictated equity investments. Lending has been cheap, readily available and has generally limited the open-mindedness for risk-encompassing financial solutions among Mittelstand management. Fortunately, the increasing demand for expansion finance addresses these issues and involves more restrictive bank lending than seen in the past. The perceived aloofness’ of German domestic banks recently seems to be not only a result of historically experienced default rates, but also an anticipation of Basel II requirements, which will lead to a more differentiated lending policy.
Of course, a German Mittelstand CFO looking to buy a competitor is unlikely to call a mezzanine provider in the first instance. Most likely he/she will contact the Hausbank’ or the company’s auditor. But an increasing risk awareness will mean that in a growing number of cases alongside conventional bank funding the need for an additional higher risk/ higher return financing instrument will become visible. This will lead to the introduction of a mezzanine provider at the second stage. The benefit of this approach to the bank is clear as the customer relationship is retained instead of losing it to a one-stop-shop provider. Also, for the existing senior bank, mezzanine represents quasi-equity/ subordinated debt and stands for a stronger entrepreneurial commitment for the planned business initiative, as well as a reduction of risk, combined with unchanged margins. The use of (subordinated) mezzanine for strategic issues allows companies to free their balance sheet for the financing of “ordinary” investments with senior debt.
Mezzanine is not only more suited to risk than senior debt, it also offers shareholders the comfort of less dilution than equity. Because many Mittelstand majority owners would not want to put their shares on sale, there is an obvious market entry barrier for private equity. Similarly, for publicly listed c ompanies at SMAX or Neuer Markt, private equity represents a limited alternative, because in Germany there are significant legal impediments to public-to-private deals. In most cases shareholdings are widely spread and the concept of a squeeze-out mechanism’, remains some way off. In cases where shareholders accept dilution, they often have to realise there is not always an availability of equity from the stock exchange.
Compared with expansion finance, reorganisation covers a much broader field, and can be summarised as changes in the company’s shareholder structure or its balance sheet. Succession issues and are clean-ups’ of shareholder structures in family-owned businesses are also covered. Mezzanine as a sole financing tool or in combination with senior debt is a perfect instrument to flatten the road to a new shareholder structure.
Further opportunities can also occur in cases of a planned trade sale or an IPO, a secondary buyout, and occasionally the refinancing of shareholder loans. Because of its treatment as debt by tax authorities, mezzanine interests are fully, respectively 50% tax deductible (KStG, respectively GewStG), and there is no conflict with German thin capitalisation rules (8a KStG), which limit the amount of (tax deductible interest bearing) shareholder loans to a max of 1.5 times equity. Also from the perspective of the company owner, mezzanine represents an alternative to their equity/ shareholder loan injection, because it helps to diversify his/ her personal investment portfolio.
Turnarounds can also be reorganisation opportunities. Although in practice these transactions are tricky, a mezzanine approach is worth considering.
How to make it happen?
Having described the various opportunities, it is worth discussing the different types of mezzanine and the particularities of sponsorless transactions.
Mezzanine is a financing instrument that has almost no standard types. But the most common form of mezzanine contains three strands of yields: a running cash margin (c. 3.5-5.0%) over the interbank borrowing rate (EURIBOR), an interest rolled up portion of comparable size until the mezzanine loan matures, and an equity warrant, enough to yield another 3.0-6.0% to target an IRR of c. 16% to 20% in total. Facing a cyclical business with highly uncertain cash-flow projections and periodically tight times to come, a “Pay If You Can” clause takes away some cash pressure and softens covenant restrictions.
A further structuring option is mezzanine, which sticks from the risk/ return profile – closer to equity than to the debt and therefore an expected IRR north of 20%. On the other hand, the respective risk profile may allow mezzanine to be placed nearer to senior debt in regards of yield and maturity.
Historically there are traditional German’ subordinated financing instruments, like Stille or Partiarische Darlehen’ [equity participation bonds] and Genurechte’ [profit participation certificates], which offer hybrid characteristics and therefore a stronger entrepreneurial approach combined with debt advantages. Profit participation certificates for example, have no voting rights, their interests are tax deductible for the issuer of the bond, and they receive a guaranteed interest rate plus limited profit sharing, however also loss participation up to a nominal amount.
Convertible bonds have been used in the market for decades, and it makes sense for publicly quoted companies to use them as a mezzanine vehicle. However this has seldom been practised. The variety of German subordinated financial instruments’ shows there is a long established awareness and understanding of the the need for hybrid instruments.
Expansion finance and reorganisation mezzanine will play an increasing role and because of the flexibility described above, can be integrated into existing traditional German financing instruments’ or replace them efficiently.
Sponsorless mezzanine transactions show some peculiarities, which distinguish them from mezzanine provided alongside LBO transactions. The most important difference is the absence of private equity’s emphasis on exits. Different (or non-existing) exit incentives for shareholders/ owners compared to mezzanine providers make the alignment of interests a challenging task. The structure of the exit, especially the definition of trigger mechanisms and respective valuations, becomes key. In this regard, trigger events like IPO and trade sale are comparable to the LBO-situation. However, the likelihood of a virtual exit increases requiring tailor-made structures in terms of the value and the trigger of a cash kicker.
In most cases, sponsorless transactions are not driven by M&A advisors. A set timetable and a standardised procedure are not in place, which in LBO deals often speeds up the process.
As a further distinction, documentation becomes more time consuming, because the parties involved are not familiar with the respective documentation, like undertakings, financial covenants, intercreditor agreements, and second ranking securitisation agreements. Company owners have to get familiar with monitoring and reporting requirements, which are more elaborate than for ordinary corporate loans. Also the due diligence process has to be looked at closely as the budget for this should reflect the respective deal size.
Operating in the area of sponsorless transactions the particularities have to be gauged against the potential unities. The German RBS Mezzanine Solutions team believes the local market will follow the US experience and sponsorless transactions promise to widen the potential market and ensure future returns.