Taking A DIY Approach To Mezzanine Financing

The lack of financing options has led some firms to take matters into their own hands by raising their own subordinated debt funds.

“Many of these firms are tired of pushing away good deals that they’d otherwise be able to do if only they had the fund or the strategy to do them,” said Jeffery Davis, a senior vice president at placement agent CP Eaton. Davis, who’s already been approached by several buyout firms interested in raising captive mezzanine funds, said he would not be surprised to see a number of firms “move a little bit away from their knitting and come out with new products.” Indeed, sources estimate there could be as many as 20 new captive mezzanine funds in the market by the close of the first quarter of 2009.

Endeavour Capital, which acquires businesses in the Western United States with enterprise values of up to $250 million, has hit the market trying to raise between $200 million and $300 million for Endeavour Structured Equity and Mezzanine Fund I LP. Stephen Babson, a managing director at the Portland, Ore.-based firm, met last month with the Oregon Investment Counsel and walked away with a commitment, according to minutes from the meeting and a source with knowledge of the situation. The fund would be used to finance deals sponsored by Endeavour Capital, as well as deals led by other firms.

Also trying to raise a debut mezzanine fund is KRG Capital Partners. The Denver-based shop has just started marketing the sub-debt vehicle, expected to reach the $200 million to $300 million range. Unlike Endeavour Capital, KRG Capital would earmark the fund solely for its own deals, making the pool a so-called “captive” mezzanine fund. A source familiar with the effort said the firm would continue to call upon third-party lenders to lead mezzanine financings, with KRG Capital taking a piece for itself.

The benefits of raising such funds are many. Having the ability to at least partly self-finance a deal can give buyout shops an advantage at auction, where sellers often appreciate a buyer’s ability to promise certainty of closing. It also gives buyout firms an advantage when shopping around for mezzanine financing; if the price isn’t right, they can simply step into the breech themselves. Buyout firms today can expect to get between two and three turns of senior debt-to-EBITDA on their deals with the hope of squeezing out another one to two turns of leverage in the form of mezzanine financing.

From a business point of view, raising and managing a mezzanine fund gives firms another product to offer investors, and another source of fee income to help weather downturns. Some industry observers believe that the widespread raising of mezzanine funds could even mark the next step in the evolution of the middle market, similar to how large firms have set up their own in-house lending capabilities, such as Blackstone Group’s GSO Capital.

On the downside, firms investing subordinated debt in their own deals take the risk of over-exposing themselves, should a deal go sour. In addition, having interests as both shareholder and creditor can lead to conflicts should the company have trouble meeting its debt obligations. “Any sponsor with a captive mezz fund that does 100 percent of the mezz in their deals will likely be very sorry,” said Lawrence Golub, president of Golub Capital, a provider of both senior and mezzanine financing to equity sponsors. “Conflicts and disappointments will arise when there are tough deals, and the sponsor will be judged by all parties with 20/20 hindsight.”

And, needless to say, third-party mezzanine lenders, many of which also supply senior and other forms of leveraged loans, could view the development as a threat. “A sponsor firm with less than stellar relationships should be very careful before pursuing this path,” Golub said.

While the resurgence is fresh, the concept of captive mezzanine funds is nothing new. A number of buyout firms, such as Audax Group, Roundtable Healthcare Partners, Summit Partners, TA Associates and Veronis Suhler Stevenson already have long-standing mezzanine strategies that allow them to provide financing for their own deals.

Audax Group’s Audax Mezzanine Partners LP, a vintage 2002 fund, has generated an investment multiple of 1.3x as of Dec. 31, 2007, while TA Associates’s vintage-2000 TA Subordinated Debt Fund LP has an investment multiple of 1.4x as of the same date, according to California Public Employees’ Retirement System. Both Boston-based firms are investing out of vintage-2006 successor mezzanine funds, which have already generated investment multiples of 1.0x and 1.1x, respectively, according to CalPERS.