QA With Capital Resource Partners Stephen Jenks and Sandy McGrath

Between them, Stephen Jenks and Sandy McGrath have a combined 20 years of private equity experience at Capital Resource Partners (CRP). Jenks, who joined the Boston-based firm in 1988, has managed investments in manufacturing, retail, consumer products and services, health care and financial services. Since coming on board in 1993, McGrath has focused on growth financings in business and information services, technology and software.

CRP provides mezzanine and equity capital for growth, leveraged buyouts, and recapitalizations. Through its $425 million Capital Resource Partners IV, the firm invests $5 million to $30 million in a range of industries, including business and information services, manufacturing, consumer products and services, software, telecom, and health care services.

Mezzanine financing is a pretty hot topic right now. When did you see the opportunities for mezzanine pick up, and how much of that is due to the economy?

SJ: It?s really been in the last couple of months, and it?s due to a combination of things. Obviously, the private equity market has a bit of a hangover and that?s causing general malaise, and people are working on a lot of issues in their portfolios. Interestingly, that condition coincided in time with a serious contraction in the senior lending market. What you?ve got is the segment of capital above and below mezzanine both in situations where they?re contracting. Their level of activity has decreased significantly over the past 12 months. I don?t know if mezzanine is doing anything different except that it?s the one segment that didn?t overbinge in ?98, ?99 and the first part of 2000. Therefore, it?s very healthy.

Do you think mezzanine is coming into its own just now, or is it something that has been evolving?

SM: What we?re seeing in this market is more of the fundamental characteristics of good mezzanine. In the early ?90s, it was principally a form of capital used to support leveraged buyouts. In this market, it?s being used to support growth, replacing a combination of unavailable senior debt and equity. The instrument itself has been around for a long time. I think what we?re seeing now is just how versatile it can be.

Besides the IPO window being shut and the scarcity of senior debt, are there other reasons why companies are seeking support from mezzanine financiers?

SJ: Because mezzanine has debt and equity characteristics, you can change the relative mix, depending on the situation. If it?s a situation that?s less risky, but maybe doesn?t have as much growth upside to it, you can create a structure that?s more debt-like. Your return may not be as high, but it?s more secure. Obviously, the converse is also true. What you have is a very flexible security that?s applicable to a great number of situations, and we try to leverage that flexibility to our advantage.

Is flexibility the key difference between mezzanine debt and pure private equity? Is it safer for investors?

SM: The trade-off is because it has a current interest component, the required equity give-up is less on a dollar-for-dollar basis. For companies that are in a stage of executing a good business model, it?s more cost-effective capital. If the management team and the existing equity owners of the business have faith in their business plan, this is a good product for them to use to finance their continued growth until they can access the public markets or senior debt and grow the business to a point where it will be sold.

Where does the pool of mezzanine funding come from? What kinds of investors do you attract?

SM: We are a private capital partnership identical in structure with a similar investor base to a traditional private capital or venture capital firm. In that respect, we have the same high-quality, blue chip names in our LP group that you would find in other well-known private capital firms. There are other sources of capital in our market. Financial institutions certainly have asset classes that are dedicated to the mezzanine arena. Insurance companies have also historically been players in this arena. Both of them tend to be a bit more institutional in their focus, but they are also sources of capital in the industry and are mild competitors for us.

Are there any other major players?

SM: There are other private capital funds that have been organized, like us, with a focus on mezzanine. There are also captive mezzanine funds that brand-name equity venture and private capital firms have raised to provide them the capital for their own portfolio companies. Today, there are a dozen to two dozen private capital firms that are focused on this strategy and back insurance companies and capital funds as well.

Are investors changing their asset class allocation to accommodate the growth of mezzanine financing?

SJ: If you look at our investor base, which are classic institutional limited partners, the public and private pension funds, the state pension funds, the large corporate pension funds and endowments, they put mezzanine in their private capital class. We are one with their venture capital and leveraged buyout investments. They look at it as three flavors, and we are the least risky of those three potential places to put capital. It?ll be interesting to see, given the returns on venture investing and LBO investing that we?re currently seeing, whether there will be much of any shift in the allocation within that small group. We really won?t know for another two or three years.

Why is mezzanine considered the least risky? Exactly what kinds of returns are you seeing?

SJ: It?s the least risky because of its debt components. We receive current interest payments on our investment. The current interest rate is typically around 12% or 13%. So when you put money in, you start getting it back immediately, and that certainly reduces the risk. Debt is senior to the equity on the balance sheet, so that reduces the risk. For example, in a downside scenario, when a company gets sold, the debt gets paid off before the equity gets its return. In most situations, we at least get our money back with our interest. Therefore, the floor of return that you can expect is much more secure. Also, the upside is more limited because of those same reasons. So we try to balance that security with potential upside to generate target internal rates of return in the mid-20s.

Have you changed your business strategy as the market has evolved?

SM: We were founded in 1987. At the time, there was a good opportunity to found an independently focused private capital firm in the mezzanine arena, as the space was less penetrated. We have since built on that franchise by raising four funds with total capital under management now just north of $900 million, and during that period, have used our capital to invest in a large range of industries and transaction types.

Can you give an example?

SM: We recently led a mezzanine financing for a specialty pharmaceuticals company, and there was effectively no senior debt in the transaction. The mezzanine debt was the most senior capital on the balance sheet. This was a company that was buying a number of established drugs that had established cash flow. If you went back a couple of years, the company would have raised probably $40 million or $50 million in senior debt and maybe $10 million or $20 million in mezzanine. In order to get the deal done in today?s market, they didn?t raise any senior debt and raised $60 million in mezzanine.

Therefore, we got to put more money to work at a targeted rate of return that?s higher than what it would have been without any significant senior capital on top of us. Not only has our balance sheet position gotten much better because there?s no capital on top of us, our potential rate of return has gotten higher. When you can have those two things work in concert, you really have a very nice investing environment.

How has that changed the role of mezzanine financing?

SM: If you went back two, three or four years, we weren?t doing any leveraged buyouts because the confluence of factors, we believed, were all negative. The prices being paid were relatively high and senior lenders were lending a fair amount of money to support those high prices, which created a lot of competition for the mezzanine piece and drove down the potential returns. The mezzanine players had to compete harder to get into certain deals and were willing to take lower potential rates of return. So you end up with a situation where it?s a high purchase price, there?s more senior capital on top of you and you?ve had to compete away a good portion of return just to get the money invested. That?s when we really focused hard and developed our late-stage growth strategy.

Now, it?s the opposite situation. The senior lender isn?t there, prices are coming down and mezzanine is in an environment where it doesn?t have to compete so hard, therefore, it can target higher rates of return.

Will you see that competition again?

SM: There are varying cycles. We?re going to enjoy this environment for a couple of quarters to a year. Financial markets are relatively efficient. When the mezzanine market enjoys what people perceive to be outsized rates of return, capital will flow in and reduce those returns.

Contact Robyn Kurdek: