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The future of mezzanine

Mezzanine has become an increasingly popular area of private equity for investors over the last few years. But just how far can the market grow? And how will the rising levels of capital flowing into the market affect returns? Amy Carroll reports.

The European mezzanine market has enjoyed phenomenal growth over the past decade. The supply of attractive deal flow has been high and gross annual returns have been solid. The European market has become increasingly sophisticated and a spate of high profile fundraising successes over the last 12 months suggest that investor appetite for the asset class is growing.

But the nature of success is that it breeds competition. European mezzanine has benefited from a favourable set of circumstances over the last few years and a growing number of players are seeking a piece of the action. The AltAssets Mezzanine in Private Equity report examines whether the industry can sustain the levels of growth it has become accustomed to in an increasingly crowded market, or whether it is emerging from a golden age the likes of which it is unlikely to enjoy again.

The value of mezzanine investment in Europe has soared from E1.5bn in 1997 to E5.5bn this year. This strength of demand has been fuelled by the gentle expansion of buy-out activity throughout Europe, combined with a tight supply of alternative debt. Despite the macroeconomic downturn, this increase in buy-out activity is set to continue and as a result, Europe’s mezzanine market will also maintain its momentum over the medium term at least. The report predicts that Europe’s mezzanine market will be worth more than E7bn by 2006 with the most dramatic period of growth expected in 2003 and 2004 when alternative sources of financing will be at their most scarce.

The report also highlights some key underlying differences between the US and European mezzanine markets. US mezzanine is typically judged to involve both higher risks and higher returns than its European counterpart. This is because of the difference in the make-up of the mezzanine population in the two markets. The most prolific providers of mezzanine finance in Europe, by both volume and value, are banks. European mezzanine therefore contains a higher proportion of debt than its US counterpart, which is heavily dominated by independent specialists who favour a higher equity component.

But Europe’s own historic returns also bode well for the future of mezzanine over the medium term. Gross returns on mezzanine fund investments have compared favourably with returns on buy-out funds and the intrinsic risk of mezzanine investment has been significantly lower than that in the buy-out industry. Mezzanine funds have produced an average gross annual return of around 18 per cent over the last 15 years. The top quartile funds have generated returns of about 33 per cent, just below the top quartile for buy-out funds, but the bottom quartile mezzanine returns have fared significantly better than in the buy-out market.

Institutional investors have increasingly been drawn to these attractive risk-adjusted returns in what have been extremely tough economic conditions, and mezzanine firms are certainly experiencing a more favourable fundraising environment than other sectors of private equity. Nordic mezzanine exceeded its E200m target with a E240m closing in October this year, French Euromezzanine also closed above target on E427m, and in September, Goldman Sachs closed the largest ever mezzanine fund at $2.7bn, which is to be invested in both the US and Europe. The level of institutional investor confidence in the asset class was also demonstrated in an AltAssets survey of 100 institutional investors conducted in the second quarter of the year, which revealed that 27 per cent of institutions investing in private equity had increased their allocation to mezzanine in the last two years. Mezzanine presently accounts for about four per cent of the average private equity portfolio in both the US and Europe and that is expected to increase to closer to six per cent over the next five years.

But mezzanine funds have only been able to generate the levels of returns that they have because of the relatively under-populated nature of the market. The report predicts an increase in the number of new entrants in the European mezzanine industry over the next two to three years as familiarity with the asset class continues to blossom. This swelling pool of capital destined for mezzanine investing means that the supply of funds will ultimately drive down gross annual returns on mezzanine investing from their present range of 15 to 20 per cent to somewhere between ten and 15 per cent.

Banks are expected to continue to be the most prolific entrants to the European market, drawn to mezzanine by both financial and strategic factors. The increased involvement of banks will mean that independent specialists will feel the pressure to differentiate themselves. The effect will be to push independent specialists into their own niches, whether regional, structural or even sectoral. It will also heighten the barriers to entry for new independent players.

The impact of increased competition will be compounded by a general deterioration of financial conditions. Returns on equity, which constitute a non-negligible proportion of the returns on mezzanine, have fallen dramatically and are expected to remain under pressure. A recent AltAssets survey of more than 80 buy-out firms found return expectations now averaging 17 per cent, significantly below the 25 per cent plus level that used to be a targeted industry standard. These lower equity returns, combined with an increasingly competitive market, will make the operating environment for mezzanine providers far more demanding in the future. But despite an increasingly competitive market and an anticipated fall in returns, mezzanine will continue to present an attractive risk-adjusted alternative for traditional investors in private equity over the medium term.

The report, Mezzanine in Private Equity is now available. Please click here for further details and to purchase.