The middle way

The most commonly cited reason for mezzanine’s ascendancy is its repayment flexibility, which has made it attractive to sponsors seeking to exit partially investments through a recapitalisation. With high leverage now making that option more difficult, the primary LBO pipeline has weakened over the last two quarters.

While issuance would normally drop or remain flat in this scenario, as appears to be the case in the high-yield bond market, where issuance is roughly in line with last year’s totals, sentiment among mezzanine issuers and investors remains buoyant.

The first quarter of 2006 was particularly strong for the asset class, with 39 deals worth €4.64bn coming to market, versus 28 deals worth €3.194bn in the first quarter of 2005, according to figures from Thomson Financial. The first quarter was also last year’s high water mark in terms of number of deals and was only €700m short in volume terms.

Mezzanine’s performance may be caused by developments in the asset class itself and in the broader factors affecting its use. As Nathalie Faure Beaulieu, managing director of pan-European mezzanine at European Capital said: “The requirement for second-lien, mezzanine and PIK products is still increasing. This will continue to be the case, particularly as the percentage of the economy under the control of private equity in European countries is growing.”

Private equity’s rise has been a major theme of the last few years as depressed stock market valuations and increasing fund sizes have allowed sponsors to tackle much larger deals. But while increases in the number and size of LBOs partly explains mezzanine’s upsurge, its outperformance versus rival asset classes suggests a deeper affinity among sponsors for the product.

Reasons for this affinity are varied. Mezzanine’s claim to flexibility is just as valid when applied to a trade sale or IPO scenario as to a recapitalisation. But that is not the only pull for sponsors. In common with other parts of the financial structure, deep liquidity has been eroding pricing of late. Just a few years ago, pricing in the mid-teens, with warrants attached as standard, was the norm. Not only are warrants now a rarity, but pricing has dropped to below 8% on stronger credits.

What is even more remarkable, however, is how the cash/PIK ratio has been moving steadily in favour of the pay-in-kind element, bringing the advantage of reduced demands on available cash during the life of the deal. Notable recent transactions favouring the PIK side have included the AA’s recent recapitalisation, which paid 3.5% cash versus 4.25% PIK. UPC Norway’s LBO at 4% cash versus 6% PIK, and the LBO of flooring manufacturer Nybron, which paid 3.625% cash versus 6% on the PIK.

These deals are near the edge of the bell curve in pricing terms, however, as the strong demand for all three allowed the sponsors to demand aggressive terms.

“It is unlikely that a cash-pay element below 4% will become a trend,” said European Capital’s Faure Beaulieu. “Sponsors wishing to reduce cash requirements on a deal are more likely to reduce the term loan A rather than the cash-pay element on the mezzanine.”

Another development that is boosting the product’s appeal is its increasing sophistication. The single mezzanine tranche has now diversified into multiple elements, either ranking pari passu or with varying priority. This multi-tranching has allowed sponsors to tailor structures to appeal to different investor groups, or to split tranches across various tax jurisdictions to allow local deductibility.

In recent months, deals for Fitness First, Peacock Group and the AA have taken the multi-tranche route.

A fourth factor appealing to sponsors is the tendency of mezzanine investors to hold their allocations. This is becoming rare in the leveraged market, which has seen the senior debt market mimic its high-yield counterpart by developing not only considerable secondary liquidity for the cash product, but is beginning to see active risk trading through the nascent CDS market. While this development may be welcome in a benign default environment, canny sponsors are ever wary of the practicalities of a workout situation given a downturn.

“The lower level of secondary trading in mezzanine is attractive to sponsors, as is the fact that it is usually callable and is easy to refinance. It is also a more friendly product; the sponsor is dealing with institutions and individuals that are known to them,” said Faure Beaulieu.

Although these advantages have helped mezzanine to out-do the high-yield bond in the past year, continuing strong liquidity has brought its own checks and balances to the asset’s growth. The main threat continues to come from second lien, which continues to offer price advantages to issuers.

Unlike the US, where most mezzanine is fixed-rate rather than the floating-rate instrument common in Europe,

rising interest rates offer no respite from its onslaught, leaving mezzanine investors to come to terms with being in a more subordinated position than in the past.

While ranking further from the assets may be more difficult in these days of heady leverage, the credit-driven approach of the specialist mezzanine shops provides at least some comfort.

As Faure Beaulieu said: “We accept there will be an element of second lien in structures. It is total leverage and credit quality that are the final arbiters in our decision to participate in a deal. The key things for us are cashflow, coverage ratios and the flexibility to sustain the business plan if economic conditions change.”