As economic conditions have deteriorated further over the months since Christmas and the bad news has started to filter through from portfolio companies, mezzanine houses, just like their private equity counterparts, have found some of the businesses they backed have hit trouble.
“Everyone is focusing heavily on their existing portfolios,” says Rolf Nuijens of ICG. “There will be many deals that need to be restructured.”
The problem is that mezzanine lenders, unwilling or unable to follow their money, are being pushed out with just a small percentage of equity or none at all. “Mezzanine is being hammered on existing portfolios in which there are restructurings,” explains Robin Menzel, partner at Augusta & Co. “This is because the documentation got very weak over the past few years and because mezz houses often don’t like following their money. In the current environment, anyone that puts up new money gets control. In the old days, senior debt could put up new money and mezz would be ratcheted down to equity, but that’s not happening because the banks and CLOs can’t put up more money and the new money can now extract much great gain by often flushing mezz almost completely out of the new structure.”
“In restructuring deals, we are seeing sponsors keeping the control as they are the only ones willing to provide new capital where needed, thereby squeezing out mezzanine, and even senior lenders to a large extent,” agrees Pablo Mazzini, senior director in Fitch’s leveraged finance team. “In other, albeit fewer instances, it’s the senior lenders that are taking full control and wiping out equity.” Either way, mezzanine is losing out.
Lacking the funds
In addition to the poor documentation often seen in deals over the boom years, which afforded many mezzanine players poor protection in the event of restructuring, there is another reason some houses are not putting in new capital. They don’t have it. That leaves other participants in the deal with the upper hand.
“I’ve heard that some mezzanine players are not following their money in restructuring situations,” says Rory Brooks, co-founder of MML Capital Partners. “For some, it will be a judgment call of not wanting to put good money after bad, but for others, they are simply out of business – they don’t have the money to put in. Equity houses know this and are structuring deals in which they put in extra capital and offering mezz houses the opportunity to do the same, and are squeezing them out when they can’t.”
“In distressed existing portfolio company situations, the relationship that mezz providers have generally had with private equity sponsors and banks is breaking down,” agrees Menzel. “The mezz lenders cannot rely on sponsors or banks protecting that relationship any more as they do not see them as necessary for their future business. So we are seeing an increasing number of situations where the mezz lenders aren’t even being asked to the table on problem deals.”
All this means that, despite the fact there may be some great opportunities ahead for the mezzanine market as a whole, some players may not benefit from it because they won’t be around.
“The expectation on default rates for mezzanine in 2009 is around 15%, so there are substantial losses expected on the market,” says Oliver Huber, investment director at Golding Capital Partners. “Some will come out better than others, but everybody will have issues in their portfolio. As a result, I think we’ll see around 30% of independent mezzanine fund managers leaving the market over the medium term.”
As with the private equity market, some players will simply find they cannot raise a successor fund. “There is clearly LP appetite for mezzanine, but many of its biggest investors, such as the insurance companies, have their own issues and many are not willing to make investment decisions right now,” says Huber.
Yet, unlike the private equity market, there are no established mechanisms for dealing with the portfolios of those managers forced to exit from the market. There is no equivalent of the private equity secondary direct specialist sector that hoovers up orphan portfolios, for example. So what will happen?
Many will be watching events unfold at European Capital. After its parent American Capital delisted it this spring, European Capital was put up for sale, with its €2bn mezzanine portfolio likely to be split from the buyout part of the business. Potential buyers are believed to be Goldman Sachs, AlpInvest, Coller Capital and AXA Private Equity, most of which have mezzanine teams.
Yet there could be different types of buyer for other portfolios as they emerge. “Many of the traditional mezz houses in Europe are not set up to buy portfolios,” says Huber. “The smaller mid-market players may buy up some selected portfolio company positions, but selling larger pieces or whole portfolios will be challenging. This may be an opportunity for some of the hedge funds, who still have money, or the larger private equity houses.”