New deals are likely to be thin on the ground for some time yet as market participants work out what the longer term effect of the crisis will be and as banks rein in their lending. Yet there are other types of deal to be had. The secondaries market in senior debt and second lien is still very active as investors go on the hunt for bargains.
While private equity firms have been busily setting up distressed debt arms, some mezzanine players have not been slow to spot the opportunity either. Blackstone’s acquisition of GSO Capital Partners earlier in the year adds distressed debt expertise to the firm and ICG is believed to be raising a distressed debt and recovery fund.
With senior debt trading at such a discount, for those with the experience, today’s market could be a highly profitable one. “We’re currently seeing a wave of technical selling,” says Robin Menzel, partner at Augusta & Co. “Senior debt has gone from trading solidly just above par to around 85 and then, since the collapse of Lehman, below 75. There is a secondary market, paper is cautiously trading and this will pick up as funds can buy performing loans in the low 70s. On a four year life expectation this provides 14% to 15% yield.”
It’s a trend noted by one mezzanine player who preferred not to be named. And he sees even greater returns from the current market conditions. “There are quite a few people focusing on secondary issuance and some only buying secondary paper at the moment,” he says. “When you have senior debt trading around the 70s, with some as low as 60, the yield on the senior debt is between 18% and 20% unlevered.”
It’s hardly surprising investors are flocking to the market. “There is a wave of new money coming into distressed debt,” says Menzel. “This is an opportunity of a lifetime. Are these funds catching falling knives by buying now? Maybe a little, but they are taking the view that these are longer-term bets. It is also impossible to time the bottom perfectly.”
“Mezzanine funds are getting involved in buying senior and second lien loans at very attractive prices in fundamentally sound businesses,” says Oliver Huber, investment director on the mezzanine side at Golding Capital Partners. “This clearly has a limited time span and my feeling is that a lot of the good opportunities have already been had.”
It’s also not an opportunity that will suit everyone, particularly at the more distressed end of the spectrum. Some will be content to stick to their knitting for the most part. “We will see mezzanine players get involved in buying paper in defaults or distressed situations, although this is a strategy that will only really work if you have a specialist distressed debt expertise in the team or even a dedicated fund,” says Huber.
Besides, many mezzanine houses, particularly those in the mid-market and smaller ends, say they want to be close to the businesses they back. “We will buy secondary paper at a discount, particularly when it’s an existing portfolio company,” says Martin Stringfellow, director and co-founder of Indigo Capital. “Otherwise, we’ll only do it where we can gain control over the whole tranche. There are some great trading opportunities out there, but we will pass on those – we see ourselves as a partner with the businesses in our portfolio.”
But it’s not just secondary trading of debt that offers opportunities. Secondary mezzanine portfolio transactions have historically been tricky to execute and therefore the market was small. Current market conditions look set to change that, as some mezzanine investors look to exit their positions to raise capital.
“We are looking at secondary portfolios now,” says Huber. “There were some on the market before the credit crunch, but they were hard to do because sellers wanted a premium – it’s very hard to justify paying a premium when you’re investing in an asset class with a largely fixed return. This has changed as banks and insurance companies are now looking to shed mezzanine assets – we’re seeing now more transactions some with substantial discounts. The decision to buy will clearly depend on the quality of the portfolio.”
“There are a lot of people with allocations and portfolios out of kilter and so would look to sell mezzanine portfolios,” says the mezzanine player. “This could be one of the market’s great opportunities – you’d have to know the market very well and move quickly. We’d definitely look at this type of deal and I know our competitors would, too.” Yet again, though, this is a market opportunity that won’t last for ever. Once investors have shaken out their portfolios and there is greater visibility in the market, the discounted portfolios will disappear, making the secondary market far less viable.