Average mezzanine contributions to European LBOs are steadily increasing and have more than doubled over the past three years. Investment banks are hungry for deals and have already shown they understand the market by becoming more creative with innovative structures such as the Ontex and Telediffusion de France arranted/warrantless melange and the Focus Wickes hybrid mezzanine note issued earlier this year. Although the investment banks are keen and have been making waves at the top end of the deal spectrum, the mid market for mezzanine is awash with funds and enthusiastic participants. Angela Sormani
looks at the attractions of the mezzanine market and where it goes from here.
The notable development in the LBO finance market in the last three years has been the growth of mezzanine. European mezzanine issuance was close to €3bn in the first half of 2003, compared to just over €1.5bn for the whole of 2000. This has been fuelled by an increase in the number of and size of leveraged buyouts generally and a growing appetite from banks, institutions and new dedicated mezzanine fund entrants,” says Paul McKenna of ING Acquisition Finance, the bank which, with Royal Bank of Scotland, arranged the much-publicised hybrid £225m mezzanine note for the Focus Wickes recapitalisation earlier this year (see EVCJ September 2003, page 37.)
While there is an abundance of equity chasing mid-market deals in Europe, banks providing senior debt remain cautious and capital structures are not overly aggressive. Private equity investors also want to avoid over-leveraging their businesses to ensure they can withstand a tough trading climate for the rest of 2003. The mezzanine market will benefit most from this decrease in senior debt lending and also from the fact that mezzanine is an ideal debt product to facilitate partial exits through recapitalisations.
As private equity funds are under greater pressure to generate returns and traditional exit routes such as trade sales and flotations remain tough, equity investors will increasingly look to refinance their portfolio companies using mezzanine capital either to obtain equity rebates or to finance expansion and bolt-on acquisitions.
The demise of the high yield market is also an issue.
High yield used to win over mezzanine simply because there was more of it and it was not as expensive. But high yield has had a bad run over the years and the reluctance
of senior debt investors to support transactions has left the market open for mezzanine players to pick up the pieces.
David Wilmot, director at Duke Street Capital Debt Management, says: “The mezzanine market has grown because of increased deal sizes and overall volumes of deals, its attractiveness to both sponsors and investors and periods of difficulty in the high yield market. An argument to put to investors when raising a fund is that in the current climate an investment in high yield, whilst benefiting from liquidity, loses against mezzanine in terms of security positioning, and the volatility of returns. For a sponsor, mezzanine may be more expensive, but more flexible.
An increasing appetite
Goldman Sachs’ mega $2.7bn mezzanine fund raising this year is proof of the demands for this asset class. Goldman’s is the largest international mezzanine vehicle raised to date; its closest rival, CSFB’s DLJ Investment Partners II raised $1.6bn in November 1999. Lehmans launched its dedicated mezzanine group last year and has aspirations to grow to Goldman-type size with a first close of its maiden fund at €500m scheduled for year-end.
There is growing convergence between what you can achieve from a mezzanine fund and what you are expected to achieve in private equity. Investors in a mezzanine fund typically receive regular payments by way of coupons while also participating through so-called equity kickers in the potential upside of the fund’s underlying investments. So mezzanine is attractive to investors looking to earn robust returns (15% to 18% if all
goes well) on investment but who are also keen to see money coming back early and consistently.
Blair Thomson, partner at SJ Berwin, says: “Given this period of volatile returns, mezzanine funds are of particular interest to institutional investors. Because they generate return at current yield and are perceived to be a less risky asset class, many investors are increasing their allocation to mezzanine.”
Institutional investors that restrict their range of investments to the classic financial instruments such as shares and bonds are in a dilemma, says Dr Matthias Unser of VCM Venture Capital Management, which is currently fund raising with Golding Capital Partners for a mezzanine fund-of-funds with a target of €100m (see fund news this issue for full structure details.) He says of these investors: “The negative performance of the global stock markets over several years is reflected in the performance of their whole portfolio. And safe government bonds now do not suffice to attain the yield these investors strive for. Alternative forms of investment such as private equity or hedge funds are available to them which do frequently offer excellent return possibilities, but which cannot be taken advantage of by many investors with a special need for security.”
And so professional portfolio managers in this situation are seeking alternative investments that have a good return potential and at the same time contribute to optimising the portfolio due to a low correlation with other asset classes. Insurance companies in particular place great importance on the generation of regular income to reach their goal of paying guaranteed interest.
For this reason mezzanine has been attracting increasing attention among institutional investors. Colin Swanson of Bank of Scotland says: “There is a growing institutional appetite for mezzanine as an asset class. Returns have been fairly stable and are arguably more attractive, on a risk adjusted basis, than private equity at the moment. Private equity houses are also seeing the attractions of setting up their own mezzanine funds. But this is an area that can be fraught with difficulties due to the conflict’s that may arise. There are also some institutional investors who previously might have just done private equity and are now starting to access the mezzanine market through mezzanine funds, CLOs and even direct investments.”
The usual suspects among the independent mezzanine providers such as veteran ICG, which is currently seeking to raise £82m through a placing and open offer, Indigo Capital and Mezzanine Management, which this summer held a final close of €115m on the first dedicated central European mezzanine fund, continue to do well. But the most noise of late has come from the new entrants setting up third party funds. Among these are groups such as AIG Mezzvest, a division of CapVest backed by US insurer AIG, and GSC Partners Europe, which at €1.1bn is the largest fund dedicated to the asset class in Europe.
Newcomer Hutton Collins was launched in 2002 by Graham Hutton, former chief executive of Morgan Grenfell Private Equity, and Matthew Collins, ex-head of European leveraged finance at Merrill Lynch, and is currently in the market with its first fund. The fund’s original target of €500m has been revised to €300m and the firm is hoping for a close by year-end. The firm already has three deals on its books, having co-arranged the €300m Telediffusion de France buyout with Royal Bank of Scotland, arranged the PIK preferred mezzanine in the Pizza Express deal and participated in the PIK preferred tranche in Coral Eurobet.
There is also trend emerging for private equity houses to diversify into the mezzanine space. Nordic group CapMan, with its well-established Finmezzanine division which has provisional plans to raise its fourth fund next year, falls into this space as does EQT, which earlier this year announced a first closing of €160m on its planned €300m fund. The fund, led by Patrick de Muynck and Michael Föcking, who joined from Royal Bank of Scotland, will invest in mid-market Nordic deals as well as sponsorless transactions. While the business is independent from the private equity fund, the group sees itself as having an advantage with in-house expertise and being used to structuring those sort of deals. The group also has a strong industrial risk-analysis capacity, which is not traditionally a feature of mezzanine providers.
Other firms looking to move into mezzanine investing include The Carlyle Group and there have been murmurings that CVC and Duke Street Capital, which already has a
CDO capacity, are also considering their options.
This trend has been ongoing in the US, which has seen many private equity houses successfully offering a broader alternative asset range. But in Europe the idea has raised eyebrows because of perceived potential conflicts. The suggestion being that many private equity houses would not want the mezzanine tranche of their deals to be arranged
by a rival. The counter arguments being the existence of Chinese Walls and the fact that in reality few private equity firms regularly compete with one another. Whether private equity firms looking to raise mezzanine funds can get institutional support is another question, however.
Pekka Sunila of independent mezzanine house Nordic Mezzanine, which has just closed its most recent fund on €240m in just under a year, exceeding it target of €200m,
says: “We understand that large private equity houses have a constant need for mezzanine financing and setting up a mezzanine fund alongside their private equity fund can solve that problem. But there can be a potential conflict of interest between equity and mezzanine and this may cause problems when raising a captive mezzanine fund. But that does not mean to say that such a fund will be impossible to raise, just that some potential investors may be critical of this issue.”
On the other hand this trend can be seen as a positive development for the industry because private equity houses will be putting more mezzanine into deals and this will help the continued expansion of the instrument. The rationale however is clear to many of the mezzanine players: private equity houses have seen the returns that can be generated
from mezzanine. Timing may also be an issue given that private equity’s return expectations have diminished of late, particularly in light of the risk profile.
But it is not all plain sailing raising a mezzanine fund. As always a track record is an advantage when fund raising. The institutional investor market is very due diligence focused and very much led by what it can judge from a player’s track record and expertise. Paul McKenna of ING says: “There is a lot of interest in mezzanine as an asset class, but it does not follow that is ‘easy’ to raise mezzanine funds. Mezzanine is not risk-free – remember Magnet and Isosceles and, more recently, Finelist. Investors are interested, but there is a clear recognition that it is a higher risk piece of paper and the prospective new fund managers have to demonstrate to prospective investors a sourcing and investment track record. It therefore helps if, as a prospective mezzanine fund, you initially have access to your own capital – witness some of the US investment banks’ strategy in this area.”
Pekka Sunila adds: “In the market where we were fund raising the general awareness of mezzanine products was not that high so you had to do some educating. A good track record from our first fund helped us and also the fact that we completed our first exit [from Nycomed Pharma] while we were fund raising so it was good timing for the fund.”
A new entrant trying its luck in virgin Italian territory is Italian Mezzanine, (see fund news this issue for full details.)
Set up by Italian banker Roberto Liguori with the backing and industry expertise of Gianfilippo Cuneo, founder of Bain, Cuneo e Associati, the fund is aiming for a final close at €100m in spring 2004. The new fund will make around 10 investments in Italian mid-market companies.
There is strong growth potential for buyouts in Italy but it is still a developing market and often mid-market companies are wary of taking on private equity backing. In the Southern European countries managers build a business for the long term and are less inclined, compared to their European peers, to sell a business on. And so owners may see mezzanine as a less threatening because a mezzanine provider is not seeking to take control of the company.
As commonly seen in Europe, Italian Mezzanine’s definition of mezzanine is secured subordinated debt with warrants used to fill the gap which may arise between equity and senior bank debt. Until recently this gap did not exist in Italian LBOs, as local banks were often willing to senior finance up to 70% of the equity value of a target company. Today Italian banks are taking a more conservative approach (in line with European standards), and are not willing to lend at over 55% of equity value or 3.5x Ebitda. This has given rise to a growing need for mezzanine, which, at present, remains largely unsatisfied in particular in the mid-market segment.
The challenge, according to Liguori, is to have the right balance of strong ties with the local private equity players and banks, good technical skills and an in-depth understanding of the local market (both in terms of local regulation and business mentality). “You have to educate the owners to understand why the mezzanine is priced at 18%, for example, when banks have been pricing at around 6%. It will take time to educate those unfamiliar with the asset class, and that’s why the fund will initially focus on investing in private equity sponsored LBOs, rather than sponsorless deals,” he says.
The price is right
The hybrid nature of mezzanine capital makes pricing comparisons difficult. Price pressure will remain, but is really driven by the more recent market in and demand for warantless or interest-only mezzanine, a product ICG first used in 1994. Long-term, between 16% and 18% for traditionally structured mezzanine is still the benchmark.
Colin Swanson of Bank of Scotland says: “We are encouraged by the fact that pricing has remained fairly robust. The level of defaults have been relatively low at the high end and although there has been a lack of exits if you can get a 14% to 16% IRR on a contractual piece of mezzanine as a result of a refinancing this is attractive.”
A standardisation in the investment process is also manifesting. For example, market standard mezzanine loan documentation is evolving and mezzanine providers are also becoming increasingly disciplined in the amount and quality of due diligence they expect and perform.
Large mezzanine tranches (up to €300m) are increasingly common and this trend is expected to continue. Indeed players now envisage that for the right transaction up to €500m of mezzanine could be considered. Paul McKenna of ING says: “The size of mezzanine tranches has been increasing, but anything above €300m in Europe is in my view still a challenge. As much as €500m is theoretically feasible, but in practice the range that most mezzanine underwriters are comfortable with is in the range of €100 to €250m.”
For these larger deals warrantless mezzanine has become a prominent feature in the market. The returns for warrantless mezzanine are driven by both cash pay yield and payment-in-kind (PIK.) PIK is a lump sum cash payment, at a pre-fixed rate, on repayment of the debt. Both US and European institutions are attracted to this instrument because it has the potential to achieve near traditional mezzanine returns, while giving the protection of being in the same financing entity as the senior debt providers.
“Banks and CDO funds may want warrantless as it’s less risky and they would prefer something with a nice yield to it and not necessarily taking so much risk,” says Kevin Murphy at Indigo Capital. But it very much depends on the nature of the business. “If you’ve got a solid business with stable cash flows, you may incline more towards a warrantless strip, but if there’s a company with a real growth story there and you’re looking to take more risk on the upside, you’d generally seek to use a warranted piece. Deals such as Ontex earlier this year have mezzanine tranches that appeal to various players. Tranche B is a contractual piece attractive to institutional investors, while tranche A was warranted, more attractive to traditional banks and fund,” says Swanson.
The €1.6bn Telediffusion de France transaction also offered the best of both worlds with a €300m mezzanine package comprising a mixture of warranted and warrantless notes
co-arranged by Hutton Collins and Royal Bank of Scotland.
Pricing on the warrantless tranche was 11.5% over Euribor, split 5% cash and 6.5% roll-up (another term for PIK), while the warranted tranche paid 3.75% cash, 5.5% roll-up plus warrants.
The choice was intended to capture a wider universe of investors, because traditional mezzanine houses managing third party funds have, until recently, been unable to accept the lower upside resulting from no warrants, whereas CDO investors have preferred the known return associated with warrantless mezzanine’s cash plus roll up coupons. The deal also stood out for the support shown by ICG, which took €50m of both portions.
Leaving out private equity
Many private equity houses don’t mind giving away equity in the form of warrants in order to align the interests of the mezzanine provider with their own. But others are wary about potential dilution of their stake in the business and prefer a purely contractual repayment and so will go down the warrantless route.
Warrants are the norm in sponsorless mezzanine (situations where there is no private equity investor on board) and as warrantless mezzanine grows in popularity and private equity houses shy away from dilution of their equity stakes, mezzanine funds may be forced to chase the more lucrative warranted mezzanine from non-buyout situations to meet return expectations. Growing competition among funds may leave smaller players struggling to find a meaningful role, which may be another factor in pushing mezzanine investors to find their own, sponsorless deals.
Inevitably higher returns mean higher risk because there is no equity sponsor beneath the mezzanine in a sponsorless deal. Indigo Capital is one player that favours the sponsorless route. It controls the deal, so if it goes well, the firm benefits. Getting the blend of private equity mentality and debt perspective spot on is the challenge, however.
Murphy of Indigo Capital says: “The sponsorless deals are less visible and harder to find so there’s less competition in that space. Around a quarter of Indigo’s deals are sponsorless. We like having the mix. By definition a sponsorless deal is going to be harder work. When you work with a sponsor they are thinking of the same sort of rights and protection as you and so the burden is shared, but then so is the upside.”
Bank of Scotland also favours a high percentage of sponsorless deals. The bank’s mezzanine book over the last 18 months has been split 62% sponsored and 38% sponsorless. And yet professionals estimate that only around 10% of mezzanine finance in the UK is sponsorless. However, the discreet nature of these transactions, which are normally family-run businesses, may explain the disparity. The US is a much more transparent market and here the figure for sponsorless is higher at 50%.
As the deal issuance landscape continues to grow across Europe the mezzanine market should see more issues of warrantless mezzanine and an ever greater depth of traditional mezzanine to support the larger transaction market. The only setback the market might have is if high yield manages a comeback; a doubtful scenario in the imminent future if
the high profile resistance from senior debt investors for the Legrand and the Brake Brothers buyouts is anything to go by.