Mezzanine matures

European mezzanine finance has come of age. Only a few years ago, when it was being compared with the nascent European high yield market, many were proclaiming its death. Ironically, many of those same people are now extolling its virtues as dealmakers generally sideline its public counterpart following 18 very turbulent months.

?Last year was a peak year for mezzanine across Europe? says Terence Wong, Executive Director at PRICOA Capital Group, referring to market research carried out by Initiative Europe during 2001 for his firm. ?And we as a firm have been investing in mezzanine since 1986? he adds. The rise and rise of mezzanine financing (and the concomitant decline in high yield's deployment) is also graphically illustrated in the accompanying chart, from Standard & Poors' PMD.

Many in the LBO sector feel this is a trend that will continue through the current year and are cautiously predicting another good one. ?Mezzanine will be a bigger percentage of total funding [in the LBO market] even if the whole is smaller? comments Tom Attwood, Managing Director at Intermediate Capital Group (?ICG?) another of the more established mezzanine providers. Indeed, for Q1 of 2002, this seems to be true: rating agency Fitch's universe of 2002 New Issuance reveals that some 55 per cent of new deals have been issued with mezzanine, with an average mezzanine facility size of 15.5 per cent of total funding ? within a range of 12.5 per cent to 20 per cent.

The meat in the sandwich
So what is mezzanine finance and how does it work? As the name suggests, mezzanine is a type of debt finance that, legally speaking, is an intermediate ?layer? which fits between the senior facilities, generally arranged and provided by banks, and the shareholders' funding for a transaction. What this means is that if a company, which has such a facility in its capital structure, was to return all invested capital (including borrowings) to its providers the mezzanine financiers would join the queue ahead of the owners but after the bankers. In other words, it is the meat in the investing sandwich.

The returns available from mezzanine are similarly mid-way between those offered by the (private) equity markets and higher risk senior loans. So-called ?traditional, European? mezzanine generally has three main components to its return:

  • ? A cash margin above the cost of funds (mezzanine loans are almost always floating rate liabilities); and
  • ? Accrued or ?PIK? (?paid-in-kind?) interest; and
  • ? A warrant ? the ?equity kicker? ? entitling the holder to a fixed number of shares or fixed proportion of the fully diluted ordinary equity of the investee company.
  • In combination, the ultimate target for most mezzanine providers is an internal rate of return (IRR) of 15 to 18 per cent.

    The interest components ? although they can vary quite widely ? tend on average to fall within fairly predictable bounds, reflecting the typical maturity of such facilities of around ten years. The accompanying chart compares such yields with the longer end of the senior debt market.

    The warrant component therefore tends to provide the ?plug figure? ? the approximate number of shares required to meet the desired return based on (typically) an agreed set of projected figures and a 3 to 5 year exit horizon.

    Warrantless mezzanine
    This is not the only form of mezzanine finance available, however. More recently mezzanine has also been structured without warrants. These are generally, though not always, led by investment banks rather than specialist mezzanine providers (despite also being subordinated obligations). Such facilities have often looked rather more like ?stretched? senior obligations than ?traditional? mezzanine as described above ? if one compares the returns on offer. Though they have varied hugely (and have also often been ?flexed? following their launch into syndication), it is usually the PIK margin that varies the most. Within the past two years the range has been from four to five per cent up to nearly ten per cent. Such structures are typically ?driven by CDO demand and new [leveraged loan] market entrants? comments PRICOA's Wong, a view echoed by the majority of market participants.

    Although a number of specialist mezzanine funds do not normally participate in such facilities at all, most accept that there is a place for them, especially in larger transactions, and do not view them as a threat. ?The larger end of the market ? is generally skewed towards the coupon [as the form of remuneration] rather than warrants because of bank involvement,? observes Martin Stringfellow of Indigo Capital. ?We would be happy to do deals without warrants? Wong states, ?but only with much stronger prepayment protection similar to those offered in the US mezzanine market?. Christine Vanden Beukel, a partner at GSC Partners, goes further: ?90 per cent of the time we don't care if there are warrants or not. We're also happy to do all PIK – but the returns generally need to be higher for an all-PIK deal.? The fact remains, however, that most mezzanine traditionalists do not report having invested in such a facility for some time, ?the last time we did a deal without warrants, excluding bridge transactions, must be over five years ago? adds Wong.

    Not just for LBOs
    Although mezzanine is most commonly associated with highly leveraged transactions, this is by no means its only application. ?Buy-outs have historically only formed 50 to 60 per cent of our portfolio,? says Stringfellow, whose firm is a specialist in providing funding to mid-size companies. He reports seeing a ?fair range of opportunities of different types, ? a high proportion of which are non-buyouts? at present. Others too are looking to diversify the type of transaction that they become involved with. Attwood at ICG, for example, says that ?we have significantly increased our marketing resources towards acquisition capital for mid cap companies and refinancing opportunities ? i.e. companies that need to refresh their balance sheet as a consequence of recession?.

    The proportion of total mezzanine advances made to non-LBO borrowers, unfortunately, is not a statistic that is available ? ?it remains true that we are dependent upon the underlying performance of the LBO market which, in turn, is driven by activity in the M&A market? states Attwood.

    Boutiques
    The providers of mezzanine finance are increasingly diverse, though there still remains a ?hard core? of key lenders who see most of what is on offer. Who exactly it was that ?founded the market? is an almost impossible question to answer. However, it is probable that the longer-established players in the private equity market – such as 3i plc, who also have a long history of providing very tailored financing packages ? structured the first mezzanine loan, even if it wasn't called ?mezzanine? at the time.

    Nevertheless, it doesn't take long when reviewing the European mezzanine market to encounter names such as ICG, Mezzanine Management and PRICOA. What these and the other providers, for whom mezzanine finance is a core product, have in common is that they are all very much ?boutique? operations that have between them quite literally built what is now a significant and sophisticated market.

    Ironically it is this image of a small core group of mezzanine participants that is proving a hindrance to the further development of the market. For many, particularly among the banking community but also still within private equity circles, the perception remains of there being limited capacity. For these people, it is accepted wisdom that for a big deal with an appropriate opening for subordinated financing, the only solution is the high yield bond market. Others are keen to counter such an assumption: ?supply is really not the issue? states Vanden Beukel, ?the market is able to absorb €300-400 million [for a single deal]?. Referring to some of last year's ?jumbo? deals, she continues, ?in such a situation, if the question had been asked, the deal could have gone to the mezz market?.

    ?Mezz tranches are bigger now ? funds have continued to be raised in the past twelve months and there's more liquidity in the market? echoes Carmen Alonso at HVB Mezzanine, a relatively new entrant to mezzanine. In a sense the difficulty is that this is a chicken and egg situation ? until somebody does ask the question no one will know how much the mezzanine market can accommodate. It's clear though that the amount of money under management (where again, numbers are hard to come by) has undoubtedly grown very significantly in recent times. Also, somewhat ironically, the difficulty is that, as Vanden Beukel points out, ?big deals are somewhat few and far between?.

    Alternatives
    What therefore are the funding alternatives currently available to a deal sponsor and at what cost?

    Firstly the high yield market, for many, remains difficult ? and not just in terms of access to it. ?There is a continuing conflict at [UK and European] sponsors as to whether they like high yield or not? says Vanden Beukel, ?most are not particularly enamoured with it. We have, more recently, been losing out to vendor financing? she observes, referring to the trend towards sellers effectively providing a portion of the funding for their disposal. Or, to put it another way, taking a discount while making it appear, superficially at least, that they are not (see this issue's Deal Mechanic for a closer examination of this).

    ?It's very like the last recession ten years ago. many banks are showing signs of caution? points out Attwood, hinting at opportunities for mezzanine and, as with ten years ago, the likelihood that the current deal ?vintage? will be good as transactions are more carefully considered, firstly for their rationale as a whole but also in terms of their funding structures. ?After September 11 there was little or no business done in the fourth quarter. We, however, have closed five deals in February as activity seems to be resuming? he adds. ?The pipeline is adequate? he responds, when asked about the outlook for the remainder of the year. ?The rapid growth of the mezzanine market was temporarily stalled, along with all other asset classes within the leveraged capital markets, in the aftermath of September 11th. New issuance seems to have picked up again in 2002? comments Rachel Hardee at Fitch. Interestingly, Stringfellow at Indigo Capital feels that the market is currently ?more receptive to the argument that mezz is the right solution ? due to its longer term nature and the philosophy of its providers?.

    As for the investment banks, ?Bank players ? tend to play in the mezzanine market on an opportunistic basis. Typically, such players virtually always syndicate the mezz they have underwritten, often by bringing in specialist mezzanine providers? states Fitch's Hardee. Vanden Beukel amplifies this point ?many are not building books ? they're not true mezz providers. Frankly, most make my life easier ? we work with them all the time?.

    And what of the deals themselves? ?During the summer [last year] and for the rest of the year, the quality of deals was awful? points out one observer who wished to remain nameless. Though they were alone in being this candid, perhaps the ?9/11? effect masked some of the reality. As for particular areas of activity, ?In aggregate, Europe is now much busier than the UK? points out Tom Attwood, a view broadly reflected by the community as a whole. ?Germany and France are particularly busy for us? comments Alonso at HVB.

    But there is also another factor to be considered, and that relates to price expectations both for transactions and for mezzanine facilities themselves. ?Deals are more difficult to get done. The price expectation gap is quite big? comments Wong, referring to the identifiable difference that currently exists between vendor and acquirer perceptions, and partly addressed by vendor finance. ?Valuations have come down over the past year, [but] prices are still too high. There is still room for multiples to come down further? adds Stringfellow. Commenting specifically on the potential impact of this on the mezzanine market, Wong at Pricoa says ?clearly the exit horizon is stretched ? multiples dropping implies a longer hold period for private equity, but mezzanine has the advantage that it can be refinanced leaving only the warrants.?

    As for facility pricing, despite the wide variation in its terms, ?non-warranted? facilities do appear to be having an impact on sponsor expectations. ?The spread over cost [of funds] is relatively constant, but there is return pressure from lower interest rates? observes Christine Vanden Beukel. ?Supply and demand is well balanced ? the fact that [some] deals aren't done is not a capacity issue? she adds.

    As more people include mezzanine in their thinking about deal financing and as more deals begin to flow through 2002 so the market in Europe looks set to grow further. This remains something that its participants are viewing phlegmatically though. Says Attwood at ICG: ?The key to mezzanine is getting your money back ? the upside will look after itself?.

    Robin Burnett worked in the European leveraged finance market on both the buy and sell side, for nearly 10 years. He is now a training consultant at BG Training and works as a freelance writer.