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Mezzanine: alive and kicking hard

After a slow start, 2002 has proved to be an exciting one for the mezzanine investing community. Not bad for an asset class that was said to be dead in the water just a few short years ago.

Optimism is in short supply these days. With stock markets plummeting, economies across the world teetering on the brink of recession, the threat of war and the uncertainty that causes, there aren't many people in the world of finance who are looking too pleased.

But there is one group that looks for all the world like the cat that got the cream: the mezzanine finance providers. At least, that was the overall impression from last week's Mezzanine Finance conference in London, organised by IIR.

Three or four years ago, everyone was predicting the death of this hybrid type of financing (it comes in a variety forms but simply put, provides companies with a combination of debt and equity funding and investors with a combination of the risk/return profiles of the two). Back then, Europe's high yield bond market had recently been born, was developing fast and was able to provide the large amounts of capital needed to finance larger deals. The mezzanine houses were struggling to compete, especially as they could only offer a small pool of capital.

But what a difference a few years makes. With default levels on high yield bonds soaring and with banks becoming increasingly wary of lending large amounts of senior debt, arrangers and private equity houses are increasingly turning to the mezzanine market to help finance deals. In fact, this year has seen some mammoth deals being part-funded by Europe's mezzanine providers - Charterhouse Development Capital's secondary buy-out of betting outlet company Coral from Morgan Grenfell Private Equity, France Telecom's sale of TDF to a consortium and PAI Managements secondary buy-out of linen manufacturer Elis from BC Partners. What has most surprised many in the financial community - not least the mezzanine providers themselves - is that they have been able to put up substantial amounts of capital in these deals. In some cases the mezzanine component of a deal has been as high as E300m. A number that size was unheard of even a couple of years ago.

It seems then that mezzanine has stepped up to the mark. With the trend for fewer but ever larger buy-outs, the mezzanine market has moved with the times. Until recently, mezzanine funds were relatively modest in size - even those managed by firms that had been in the market for many years. Unlike their private equity brethren, they felt little pressure to increase their fund size dramatically with every new fundraising round. And indeed, there are still some very experienced players that have chosen quite deliberately to limit the size of their funds in order to concentrate on the middle market: Indigo Capital is one, Mezzanine Management another. But there are others that could easily be classed in the mega-fund league, such as GSC Capital Partners, which launched its first European fund in 1999 and raised a total of E1.1bn, and ICG, which has grown to manage several billion euros. The emergence of such giants, even the smaller players agree, is having a beneficial effect on the whole market. The fact that mezzanine can provide ever larger tranches of capital means that it is now being taken more seriously by private equity firms and other deal sponsors. It also means that mezzanine providers are able to influence more easily the terms under which they participate in a deal.

This demand for mezzanine has brought about the inevitable surge of interest from new players. More banks are looking seriously at mezzanine, as are CDOs and private equity firms. Investors should expect to see an increase in the number of mezzanine funds being marketed to them - both from existing and new players. And many will be wondering whether it's an asset class worth considering. As one fundraising mezzanine player commented at the conference, one of its major selling points is that it's not an asset class that involves start-ups or high tech. Those who had their fingers burnt in the venture capital boom of the late 1990s may well be tempted.

Indeed, many investors are increasingly looking at mezzanine as serious investment - the relatively high numbers of investors at the conference is just one indication of the level of interest it is receiving. Again, this is quite a turnaround. Only a few years ago, many in Europe had barely heard about it let alone understood it. But with insurance companies running into difficulties as far as their capital adequacy levels are concerned and with pension funds in a similar sticky situation, mezzanine seems as though it could be a viable investment choice.

One of mezzanine's main attractions for cash-hungry investors is that, in the words of MetLife's David Lindstrom, it provides an ‘attractive risk/reward profile in uncertain times'. Investors receive a contractual return from the debt element of their investment so that, unlike in private equityinvestments, they start seeing returns early in the investment's life. But they are also able to participate in the upside, which comes from the warrant element of the investment. This enables them to boost their overall returns (return expectations are in the high teens). Some investors are so attracted to the market that they are looking at setting up direct mezzanine investing capabilities, something MetLife already has. Others, inevitably the smaller investors, are looking at investing in specialist mezzanine funds.

So it all adds up to quite an eventful time for mezzanine providers at the moment. The sector provides a beacon of light in an increasingly gloomy financial world. It's hardly surprising that many of the players are going about their business with a spring in their step. They have every right to feel pleased with this turnaround in fortunes. But they should also be wary. The challenge for them to ensure that they make the most of this resurgence of interest in the market from sponsors and, importantly, from investors. If they want this current success to continue, they should perhaps learn a lesson or two from the recent experience of the private equity market. Many firms promised their investors too much and behaved as if they believed that the good times would last forever. They are now regretting it. As ICG's Tom Attwood said: ‘Any fool can lend money. The trick is to get it back - and more.'

The Mezzanine Finance conference is just one of the events organised by IIR. For more information, please click here.

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