Triumph of the middle

The first half of 2007 saw traditional mezzanine investors squeezed out of large LBO capital structures as mezzanine facilities were dropped in favour of increased senior debt or second-lien and PIK tranches. Moreover, aggressive non-traditional investors were pushing down prices on the remaining mezzanine tranches to levels that the traditional investor was not able to bear.

When liquidity fled the leveraged market over the summer, mezzanine investors found their once precarious position reversed as competing investor types rapidly exited the market.

Funds that had largely sat out the top of the market now have liquidity to deploy in new deals that are set to be tailored to the conservative demands that they and European regional banks, which have also balked at aggressive structures, now demand.

“Second-lien and holdco PIK were dependent on leveraged investment strategies from CLOs and hedge funds,” according to Fitch Ratings. “Mezzanine, on the other hand, has a committed base of long-term investors with funding in place, which will remain open for business when new primary deals emerge.”

As well as being less dependent on leverage to fund investments, mezzanine funds are less likely to be holding devalued paper thanks to the decision to avoid investing in more aggressive structures.

“Mezzanine investors had been marginalised before the liquidity squeeze. As a group they were disciplined about staying away from deals that did not meet their investment criteria,” said one underwriter. “Where deals were overly aggressive they did not invest and are now in a far more comfortable position.”

And as the leveraged loan market continues to face enormous challenges, the role of mezzanine investors is now hugely enhanced.

“We face fewer competing products – second lien is now gone to a great extent, and PIKs are becoming marginal. As an investor we are now in the nice position that we can do any large syndicated deals that come along,” said one mezzanine investor.

Dry pipeline

Although conditions now favour investors, the real impact of mezzanine funds’ enhanced position has yet to be borne out by newer more favourably structured deals.

“Conditions look good for mezzanine, but the pipeline is more of a hope than a reality right now, as there are few deals being underwritten,” according to a banker. “Businesses can command lower prices so there are fewer auctions, outside of forced sales.”

Indeed, the pipeline for big new deals looks set to remain dry until early in the new year, though investors note that things are slowly improving and mid-market deal flow has remained steady.

But as market participants slowly come to accept the market reality, there now has to be a process of discovery that will determine the new market norms. So far, investors say this means that most deals are either at an early “prices are to be discussed” stage, or club deals with a mezzanine tranche and some mid-market transactions.

“Volumes have been slow to return, but as investors we are happy that when they do they will reflect a better market. Structures going forward will look like they did two years ago, probably still warrantless but priced above rather than below 10% and with a €100m mezzanine tranche rather than the €20m or €302m we saw in the first half,” said one mezzanine investor. (pull quote)

An underwriter agreed with much of that prognosis, saying: “Investors are looking for margins above 10%. What they will get may be a range from 10.5% for callable deals to 9.5% for non-call one or non-call two deals. When deals come, investors will be able demand enhanced call protection and bigger equity contributions.”

And while the pipeline is thin, there are still investment opportunities, according to investors. “The mid-market continues to tick along,” said one. “There are deals around with €15m to €20m mezzanine tranches and funds that are not able to buy mid-market deals have been able to put money to work in the secondary market at attractive prices.”

Funds have benefited from the liquidity squeeze in other ways too.

“The turnaround in liquidity means that the mid-market will not now see the kind of aggressive structures that had pushed mezzanine investors out of bigger deals. The direction the market was taking had meant it looked to be only a matter of time before the mid-market followed suit,” according to an investor.

Along with the lack of attractive supply in the early part of the year, mezzanine funds’ portfolios had been devastated by prepayments as sponsor-backed companies took advantage of the excess liquidity to refinance with more borrower-friendly terms and structures.

According to Fitch Ratings, the total amount of prepaid mezzanine in the first half of 2007 was €4.2bn out of 26 transactions, 54% above the same period in 2006. At the same time, the time to prepay was cut from an historical average of 25.7 months since 2004 to 24 months in 2006 and just 18 months in the first half of this year.

With the refinancing of LBO debt now halted, and call protection likely to be strengthened, investors no longer have to face the prospect of portfolio hyper-churn.

Where just months ago mezzanine investors were the sick man of the leveraged loan space, the intervening liquidity squeeze has vindicated their eschewal of “relative value” pricing and leveraged investment strategies.

While underwriters sit long on unattractive deals, sponsors are bereft of backing for new acquisitions and loan investors hold devalued assets, mezzanine investors are uniquely well placed to benefit from the crisis.