Momentum in mezzanine

Investors in private equity are continually on the lookout for new, profitable strategies. As it turns out, one of the current market's most solid plays was always there, lurking between the senior debt and the equity piece.

As the buyout and venture capital markets have got rougher, mezzanine fund managers have taken the opportunity to highlight the relative attractiveness of their strategy. Not only do mezzanine funds offer less risk than leveraged buyout or venture capital funds, they offer current return mechanisms that allow limited partners to generate quarterly returns on their investments – an attractive feature in a market largely devoid of capital distributions.

Firms specialising in mezzanine that are currently raising funds say they are seeing an increased interest from limited partners. That said, a step forward for mezzanine would represent a larger piece of a smaller pie. In the US, mezzanine fundraising fell by approximately 55 per cent in 2002, according to US-based publisher Alternative Investor. Mezzanine funds raised $2.1bn in 2002, compared to $4.7bn in 2001, a comparable drop to fundraising statistics for other private equity strategies. (Some industry figures suggest a 66 per cent drop in total private equity fund-raising activity from 2002 to 2001, thanks mostly to the bursting of the venture capital bubble.)

“It is not accurate to say that investors have been flocking to mezzanine,” says Lawrence Golub, founder and president of New York mezzanine specialist Golub Associates. “Investors have had a declining interest across all asset classes, with the possible exception of distressed. The magnitude of the decline, however, has been smaller for mezzanine than for buyouts or venture capital.”

Investors that were already committed to the asset class are the most likely to re-up, according to Martin Stringfellow, managing director of London-based Indigo Capital, which closed its third fund earlier this year on €475m. “Those investors have seen what's happened in the private equity world and recognised the value of mezzanine and increased their commitments to us,” Stringfellow says. “That's a signal to other investors with less experience to commit to mezzanine. Generally we found the market really receptive.”

Most of the mezzanine capital raised is managed by a small circle of firms. US house Oaktree Capital Management closed its debut mezzanine fund on $800m in mid-December. Boston-based Audax Group also closed a $440m fund in June. As for European mezzanine fundraising, Indigo Capital closed above target on €475m in January 2003, and GSC Partners completed a leveraged $1bn fund in 2002. In January, Scandinavian specialist Nordic Mezzanine announced a first close on its second fund, having secured €150m in commitments.

Despite the dire fundraising statistics, mezzanine fund managers say the turmoil in the venture capital and buyout worlds has caused investors to take a second look at private equity's more risk-averse cousin. This trend reflects a flight to safety by investors and the fact that deal flow remains solid for mezzanine funds. Mezzanine fund returns have also begun to catch up with the returns of buyout funds, say mezzanine fund managers.

On the transaction side, mezzanine firms are seeing an uptick in refinancing deals, many of them efforts on the parts of private equity firms to recapitalise portfolio companies as an alternative exit mechanism.

There was a total of €3.2bn of mezzanine invested in 2002 in Europe, down 24 per cent from 2001

In Europe, where the high yield market has never been as mature as in the US, mezzanine has taken on a much broader definition. To illustrate, the average amount of mezzanine financing per European deal in 2002 was €38m, in line with 2001, according to Initiative Europe. There was a total of €3.2bn of mezzanine invested in 2002 in Europe, down 24 per cent from 2001. Part of these trends can be attributed to huge tranches of mezzanine raised for large European buyouts recently. For example, the €1.3bn buyout of Coral Eurobet had a €330m mezzanine tranche, while the €1.6bn buyout of Telediffusion de France contained a €300m mezzanine strip.

In the US, mezzanine investments on that scale are still rare, because US firms tend to focus on the middle market to avoid competition from the highyield debt market, say US mezzanine fund managers.

Mezzanine sits between senior debt and equity on a company's balance sheet. The debt element usually has a yield in the teens. In addition, the investor has the potential for an even larger gain through the equity portion – generally in the form of warrants. The debt portion gives limited partners a consistent return, while the equity portion holds forth the promise of a windfall, though generally less than the potential upside of a pure equity play.

Graham Hutton, co-founder of London-based mezzanine firm Hutton Collins, says investor interest in his firm is increasing because, in addition to being considered safer, mezzanine has begun to offer comparable returns to, for example, buyout funds.

The current fundraising climate is nevertheless proving tough for Hutton Collins, which recently confirmed it had reduced the target for its debut fund, launched last year to raise €500m. But Hutton insists that the outlook for the mezzanine product is positive. “There's still a wait-and-see attitude for what private equity returns will be in the next cycle,” Hutton says. “On a risk-adjusted basis, mezzanine returns will look favorable. In the long term, we'll see mezzanine returns as attractive compared to other private equity asset classes.”

“One advantage of mezzanine is, if you build a conservative portfolio, we can pass through a current return of 12 per cent to 14 per cent on a quarterly basis,” Nicholas Dunphy, a managing partner of New York-based Canterbury Capital, says. “Getting money back is something limited partners like very much these days.”

With the projected returns for buyout and venture capital funds from the past few years being potentially negative, any positive return from a mezzanine strategy start to look even better.

The market has yet to see many mezzanine megafunds

“Equity funds have the potential for [either] high returns or really low returns,” Terry Bressler, director of business development for William Blair Mezzanine Capital Partners in Chicago, says. “Mezzanine funds may not provide extremely high returns, but on the flip side, there's better downside protection.”

No comparison
With all the positives mezzanine funds seem to offer, it is a bit surprising that fundraising hasn't been more robust. While there is more interest today than in the late 1990s, the market has yet to see many mezzanine megafunds. (CSFB Private Equity's $1.6bn mezzanine fund, which closed in November 1999, remains the largest such vehicle raised to date.) One possible explanation for this is that mezzanine, being a mixture of equity and debt, doesn't fit neatly into most asset allocation models. Another stumbling block, say market insiders, is the lack of a true benchmark.

“Mezzanine is an arcane form of investing,” Alastair Tedford, cochairman and chief executive officer of New York-based Albion Alliance, says. “It is not a core asset for most institutional investors, and that's one reason why there is a shortage of it.”

Because of its relative immaturity and the fact that so few comparable mezzanine funds are raised in a given year, no standard benchmark exists. Investors evaluate managers by comparing returns for a fund against returns of similar funds raised in the same year. “There aren't enough mezzanine funds in any given year to create a benchmark,” Tedford says. “With a mezzanine fund, you can balance your portfolio to have more or less equity. Because different mezzanine funds do different things, it's hard to compare them.”

This lack of comparability has hindered the asset class from raising more money, Tedford says. Pension funds, in particular, like benchmarks, and these institutions have yet to become big suppliers of capital to mezzanine funds.

Mezzanine specialists are hoping that will change. One thing investors like to see is solid deal flow. According to Hutton, fund raising and deal flow are linked, especially for a debut fund like the one Hutton Collins is currently raising. “That puts us in a favorable position because we've been able to invest money,” Hutton says. “We're seeing very strong deal flow; we've invested one-third of the money we've raised so far.”

As private equity exits are more difficult, mezzanine is an interesting way to recap the business

Deal flow is one thing that distinguishes the European mezzanine market from its US counterpart. While deal flow has been on the rise on both continents, the market for mezzanine in Europe seems to have expanded exponentially.

One reason behind that, according to Christiian Marriott, a director of London-based Mezzanine Management, is the relative immaturity of the high-yield debt market compared to the US. The dearth of high-yield has allowed mezzanine firms to step in, syndicate, and play important roles in deals. “High yield buyers are constrained in Europe and the mezzanine market has grown with new players and bigger funds,” Marriott says. “Being part of a €300m mezzanine syndicate is no longer surprising.”

Conversely, the US mezzanine market has traditionally stuck to backing middle-market deals, where high yield debt is rarely involved. Not only is there less competition from the investment banks for backing middle market companies, there are also many more investment opportunities. There are more than 300,000 companies in the US middle market, with between $1m and $100m in assets, according to Albion Alliance's Tedford. There are only about 9,000 publicly traded companies that are potential users of high yield financing.

US mezzanine providers argue they play a permanent, if cyclical, role in private equity. “We've seen several cycles,” Nicholas Dunphy of Canterbury, says. “Even if bank debt is lenient, people still look for mezzanine because they want to put in as little equity as possible and put in as much debt as they can. The demand may diminish, but it doesn't go away because sponsor group wants to leverage up.”

Lawrence Golub agrees that activity in the mezzanine market is negatively correlated to the bank-lending environment. “When banks are conservative, mezzanine investing is even more attractive,” Golub says. “But when banks loosen up, and are more accepting of lending to companies that are less than perfect, the market becomes more competitive.”

Alternative exits
Not only are companies becoming more interested in mezzanine financing, but larger buyout firms are seeing it as an alternative exit strategy now that the merger and acquisition market and IPO market are essentially closed. Firms are refinancing their stakes in order to return money to their own limited partners. Mezzanine firms are increasingly becoming involved in this alternative path to liquidity. “There is a lot of opportunity on the refinancing side,” Hutton says. “As private equity exits are more difficult, mezzanine is an interesting way to recap the business.”

Private equity firms are also selling assets to each other, and this has driven mezzanine deal flow as well. “With the slowdown in the M&A market, there has been more refinancing activity than there otherwise would be,” Tedford says. “With that slowdown, there has been something of an uptick in transactions where one private equity firm is buying what another is selling. The need for results drives that to a degree.”

Being part of a €300m mezzanine syndicate is no longer surprising

Mezzanine managers hope that LPs will see mezzanine as a surer way to get to such results. “Mezzanine is a good way to get some equity upside, but also get some returns currently,” William Blair Mezzanine Capital's Bressler says. “That's a valuable attribute.”