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What's up in mezzanine?

Mezzanine is going through something of a renaissance at the moment: sponsors are increasingly turning towards it to help finance deals and cash-strapped investors are beginning to recognise some of its more attractive characteristics. We asked three specialists for their view on what is happening in the market.

Our panel of mezzanine finance specialists are:

	Martin Stringfellow is a director of mid-market mezzanine specialists Indigo Capital. Set up in 1990, the firm has raised three funds that together represent commitments of around E700m.
	Nick Petrusic is a director of GSC Partners Europe, the European arm of US firm GSC Partners. It has so far raised one European fund, which closed at E1.1bn in September 2001.
	Tom Attwood is managing director of Intermediate Capital Group, a listed mezzanine provider, which manages two mezzanine funds, two CDOs and two CLOs. It has arranged and provided over E3bn of mezzanine during the last 14 years.

Why is there so much interest in mezzanine among users?
Petrusic: ‘The experience of users of high yield in the private equity community has been mixed in the past and so private equity firms and other users are looking elsewhere. There are a number of advantages that mezzanine has over high yield. One of these is that it is private. The reporting requirements are less onerous for the company. It produces the same information for the mezzanine finance as it does for the equity house and the senior bank group. Another is that a lot of the deals that we do involve some kind of restructuring - either disposals or acquisitions - and with mezzanine, you can do that behind closed doors. You don't have to disclose it publicly, you can do it quietly without the undue pressures public reporting can put on a company. The other thing is that you know who you are going to be dealing with. If you have E100m mezzanine in a deal, you are only going to have two or three serious holders who will be able to speak for the mezzanine. You wouldn't get that if you went to the public markets - there, you may have say ten investors who all come on board as a result of a road show and they wouldn't be close to the business as we like to be.'

Stringfellow: ‘From the users' perspective, it's clear that the banks are being more cautious than they have been in recent years. That is creating a classic funding gap that can be filled by mezzanine. The gap can't simply be filled with equity without harming equity investors' returns.'

Attwood: ‘There is increasing demand for mezzanine because the level to which the banks are prepared to lend and the required leverage at current prices that the private equity community is looking for leave a significant gap that has to be filled by other forms of lending. That can be filled by stretched senior debt, leveraged loans, high yield bonds or mezzanine. But mezzanine is being used for a number of reasons now. Firstly - and this has always been true - it is more reliable than certain other asset classes, particularly high yield. It is usually provided by one provider in a single cheque at closing. There is no need to go out on road shows, etc as you would for high yield. Second, mezzanine comes in the form of one or a small number of investors. That means that the private equity community has the enormous benefit of knowing who they are dealing with; in high yield, there will be hundreds of investors and you never know who they are. In the vent of a default, an acquisition or a refinancing, you don't know who you are dealing with. Third, mezzanine can now be provided in a substantial size. That means that with increasingly large transactions, mezzanine is, for the first time, a valid alternative.'

What are investors' attitudes towards mezzanine?
Stringfellow: ‘Investors' attitudes have changed in recent times. I think there is much more appreciation now among investors of the risk-reward equation. There is also an increasing recognition that mezzanine has a place in an investor's portfolio because it should be a less volatile instrument than some other asset classes but is still capable of producing returns above bond yields or public equities and close to private equity on a portfolio basis.

‘I think we are also seeing an increased diversity in the types of institution that invest in mezzanine. For pension funds looking for lower volatility than equities but higher yields than bonds it makes a lot of sense. The argument for mezzanine is easier to make now that people have realised that the internet is not Eldorado.'

Petrusic: ‘When we were raising our European fund two years ago, many investors in Europe didn't really understand mezzanine. I think there needs to be a lot more education about it before they feel totally comfortable with it. But there is much more discussion about the various asset classes happening now as some investors find that they need a running yield and mezzanine can help provide that. If we talk to an investor that has already bitten the bullet by committing to private equity, then we'd say to them that they would be in the same deals with a mezzanine fund, but they end up in a better risk position. I suspect that many of them have started realising this and are looking at investing directly in mezzanine positions themselves. We've already seen that happen. Having said that, I think that small and medium-sized institutions, if they invest in mezzanine, they'll invest in funds. They don't have the footprint or the resources to invest directly.'

Attwood: ‘Investors are becoming more interested in mezzanine, but it is taking a bit of time, especially in Europe. The interest we are seeing, though, stems back a year or two. Since convergence the yields on government bonds have come right down in Italy in particular and in Germany to a certain extent. Insurance companies in the Continent who have been promising their policy holders seven per cent returns have nowhere to go to get high yield. Mezzanine provides a high cash yield and this is enormously attractive to them at the moment. And, of course they should get the upside from the equity component further down the line.

‘We would argue that, given the position of mezzanine in the capital structure, given the strong security package, given the strong performance that it has historically reported, it provides a very attractive and substantial return for the risk that you take by investing. I would also add that it is not correlated with other asset classes, so there are significant benefits to pension funds and insurance companies because they get diversification without correlation.'

Where should mezzanine sit within an investor's overall portfolio?
Stringfellow: ‘It depends what they are looking for. Mezzanine is able to sell relatively low volatility and relative predictability of returns with good cash flow dynamics as well. It's an opportunistic product, so there is an argument for it to be placed alongside special situations and secondaries in an investor's private equity allocation. But in terms of the returns profile, it's more predictable and stable than private equity. The generation of your return from the warrant element is obviously back-ended, but in the meantime, you have generation of income. That is much easier to predict and plan. That predictable cash flow is what institutions are looking for at the moment. If a pension fund is looking at investing in bonds for their predictability, then they should also seriously consider mezzanine because the current return profile is similar to that of bonds, but there is the substantial added element of the upside in the form of warrants.'

How would you describe the risk-return characteristics of mezzanine?
Stringfellow: ‘It is difficult to generalise about mezzanine because it takes so many forms. The high-yield market is probably the best known “mezzanine” instrument. That operates very much along capital market lines in that people assume certain default ratios, certain gross yields and put them together to come out with an expected return overall. I think that mezzanine is somewhat different. First of all, we're looking for higher returns to compensate for the higher risks inherent in small and medium-sized companies - which is where we specialise - and in illiquid situations as well.

'At the same time, we are trying to avoid looking at things on a portfolio basis. We work hard to select the right deals and manage them post-closing to make sure they work. The returns on successful mezzanine deals are lower than equity and there is less scope to offset a loss on one deal with a home run elsewhere.  On the other hand as mezzanine investors we shouldn't be seeing negative returns on any deal. If you are in equity and you apply very rigorous valuation criteria then arguably, if your company has a dip in earnings you are in loss territory. You obviously wouldn't sell at that point, but it is potentially eating into your value. By contrast, with mezzanine, there has to be substantial value diminution in the company before the mezzanine is impaired.'

What are your return expectations over the coming five to ten years?
Attwood: ‘I would say that between ten and 12 per cent over LIBOR would be a reasonable return to achieve. From that, you clearly have to take account of the potential default rate and recovery rate. We at ICG have a default rate of under three per cent and a recovery rate of over 70 per cent.'

Petrusic: ‘We are currently seeing returns of around 15 to 17 per cent depending on the type of deal, leverage and subordination, which is partly a reflection of the drop in interest rates. You have to work out what the correct risk premium should be and I think that the range is 1,100 to 1,300 over cost of funds for a traditional mezzanine deal. That's where the market is and I don't see that changing.

‘Compare it with private equity, which has historically targeted returns of 30 per cent IRR. Mezzanine has historically targeted returned of 18 per cent, which means a differential of 12 per cent. That is fine as long as private equity continues to target returns of 30 per cent. But if private equity is only expecting to achieve 20 per cent, then our returns are going to change. That differential is going to have to change. But you have to look at this on a deal by deal basis and it depends very much on the way in which you structure the deal.'

Stringfellow: ‘Everyone is saying that returns should be lower than they have been historically. But if you look at returns by vintage year, some of the best have been generated in difficult economic periods.  If there is discipline in the market and prices do come down and structures are appropriate, then we should actually see good returns for deals now. Deals should be bought on relatively low multiples and they should reflect the relatively low earnings, so there should be substantial upside. Part of the point is that we are micro-investors, looking for the right opportunities at the right price.

‘We only do deals that will return late-teens returns or above for us. That doesn't mean that deals priced below that are wrongly priced if the risk is correspondingly lower. But overall, a mezzanine investor operating in the middle market should be targeting aggregate returns at least in the 18 to 20 per cent bracket and hoping that the upside will take you higher than that.'

Where is your deal flow coming from?
Petrusic: ‘We have a preference for the UK and Northern Europe because there are better recovery rates and insolvency regimes there. But we are going with the flow to a certain extent. We are seeing deals come in from the UK, Scandinavia, France and Germany at the moment. We don't tend to look at Southern Europe very much, although we'd never say never - they just have a higher bar for us. But it's worth remembering that because we specialise in larger deals, many of them are pan-European, so we don't rely on specific countries.'

Stringfellow: ‘We are seeing a real mix. We are seeing strong deal flow in France and in the UK. We're also starting to see more flow coming through from Germany, which has been weak this year until now. But we're not just seeing deal flow coming from buy-outs. They account for only around half our deal flow at the moment.'

What are the main issues in the mezzanine market at the moment?
Stringfellow: ‘I'd say that multiples are still too high. People are losing sight of the upside element of the returns, which you need to compensate you for the ones that don't work out - that applies to warrantless mezzanine. We have seen a shift in the balance between coupon and PIK versus warrants. Also people are still not discriminating between EBITDA and cash flow. That is a big problem.

‘But we are seeing sponsors more willing to recognise the advantages of partnership offered by a mezzanine specialist even if that requires giving away some warrants.  They see the benefits of having a supportive and constructive mezzanine partner because they have seen that if you are over-leveraged, you have got a lender that is only going to get money back on its interest and it can't get any better than that.

‘I think that specialists are benefiting from the tightening in the lending criteria and the lack of appetite among banks to finance deals with debt.'

Attwood: ‘The level of leverage is an issue. Total debt to EBIT on some of the deals is still quite high. The price being paid for some assets in LBOs is still pretty high. There is evidence to suggest that there is more cash coming into the system - more funds are being raised. That is just beginning, in some cases, to show some diminution in credit quality and that is risky.'

Petrusic: ‘I think the biggest issue for mezzanine players is to continue to adapt the way the market is changing. We should make sure that we are providing the right kind of service so that we are able to satisfy sponsor's requirements. We've come a long way over recent years. We have demonstrated that we have met the competition in the high yield market. Only three or four years ago everyone thought that mezzanine was dead, but it is now competing very strongly against high yield. It has bounced back to the surprise of the banks and the sponsors, but I also think that it has bounced back to the surprise of the mezzanine market.'

How is the emergence of larger mezzanine funds affecting the market?
Attwood: ‘I don't think that there is so much money being raised in mezzanine that it will affect the market. But it is possible that some deals get done that wouldn't otherwise get done. It's up to all of us to ensure that we keep the credit quality. That's the crucial thing.'

Stringfellow: ‘I think that is a benefit to the market. Most of the large funds will be inclined towards the traditional disciplines in terms of the credit criteria and the return criteria and structures. Because of their fund structure and their need to keep their investors happy that imposes a certain discipline that is sometimes absent, especially in boom times. Investment banks look principally at marketability of a deal.  Many of the secondary banks that were taking mezzanine paper in syndication have withdrawn and dedicated funds are becoming more important.  When you have more professional takers of paper, they should be able to influence the underwriting of deals being done.'

Petrusic: ‘The emergence of the larger players has increased liquidity in the market - something it was crying out for. Larger funds such as ours have been able to add flexibility. We are able to provide warrantless mezzanine in size. Had we not been around, I'm not sure that type of mezzanine would have developed as strongly. The established players had never really done that type of deal before.'

How do you think that the mezzanine market will change in the future?
Attwood: ‘People say that the mezzanine market is a new thing. It isn't. You can trace it back to over 100 years ago. Nothing has really changed, except that we call it mezzanine today and it is more structured. I can't see any significant changes in the future. But we are already seeing the emergence of new players and that is a good thing. The mezzanine market has been through a number of stresses, including the emergence of the high yield bond market. Everyone said we were dead then. But it clearly wasn't true. You have a small number of very bright players who have the speed and flexibility to provide borrowers with what they need - and quickly. It will just get a little more competitive.'

Petrusic: ‘I think that it will become more competitive as more players enter the market. I think that people are waking up to the asset class and they like what they see. As a result more money will come into the market. That money will come in the form of new funds being raised by specialist mezzanine players as well as in the form of insurance companies investing directly in deals and the banks and the CLO guys piling in.

‘Demand from sponsors will increase. They now have proof positive that size is no longer an issue in terms of how much the mezzanine market can provide. We have seen three or four very large deals recently that have been easily absorbed by the mezzanine market.'

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