Entering through the mezz door

Many German-speaking institutional investors are still finding it difficult to show much enthusiasm for private equity investment at the moment. Unlike their peers in Scandinavia, the UK or the Netherlands, they discovered the asset class late. Too late arguably: those making their first allocations near the end of the 1990s arrived just in time to catch the end of the bull market and saw their private (as well as public) equity investments decimated when valuations collapsed. The wounds that some of these investors sustained at the time still hurt, and few institutions feel sufficiently recovered to return to the market for a new round of alternative investment just yet.

However, what these investors also realise is that putting all of what's left of their cash into relatively safe and hence low yielding asset classes isn't going to generate the returns they require, especially now that questions about their ability to cover their liabilities are high on the agenda. This is why German market practitioners report that the big investment institutions have started to take a cautious interest in alternative investment again. Few are ready yet to embark on a fully-fledged private equity programme. But maybe the time is right for putting a toe (back) in the water?

Some see encouraging signs: Munich-based fund of funds managers VCM Venture Capital Management and Golding Capital Partners believe there are enough investors in Germany, Austria and Switzerland that are at exactly this point in their investment planning. These investors need their capital to work harder, but they are scared of private equity's J-curve, let alone the possibility of losing money.

One way out of this dilemma, say VCM and Golding, is to pursue what might be described as a ?private equity lite? strategy that looks to limit risk without altogether eliminating the possibility of earning superior returns. In order to offer investors access to such a strategy, the two houses are launching a dedicated mezzanine fund of funds, the first of its kind in Europe (HarbourVest Partners has one in the US), that intends to invest in up to 15 mezzanine investment funds in Europe and the US.

From the point of view of the risk-averse investor, mezzanine has the advantage of combining defensive, fixed income style performance characteristics (stable cashflows from day one provided by a coupon) with the prospect of enhanced returns that derive from mezzanine's participation in an investment's capital gains. In addition, the diversification element of a fund of funds structure, combined with mezzanine's relatively lower default risk, provides investors with the kind of downside protection that many require in the current climate. All told, according to VCM and Golding, who are looking to initially raise €100m, the fund's risk and return profile provides it with a high probability that it will deliver its target return of approximately 10 per cent net.

Good timing
The fund, which according to VCM managing director Thomas Schwartz is aiming for a first close near €50m by the end of the year, will make between 10 and 15 investments in mezzanine investment funds operating both in the US and Europe. It aims to generate an internal rate of return of approximately 10 per cent.

VCM Golding Mezzanine primarily aims to attract medium-sized pension funds, insurance companies and endowments in Germany, Austria and Switzerland. Depending on their specific legal and fiscal requirements, investors will be able to choose between different legal structures to invest in the fund.

Commenting on the initiative, Jeremy Golding, managing partner at Golding, said: ?The German market is having a tough time, but the mood is getting better. People are talking about private equity again. VCM Golding Mezzanine, which in terms of its risk and return profile is comparable to a corporate bond fixed income product, is attractive to investors who are looking to earn an attractive return on investment but who are also keen to see money coming back early and consistently.?

Prior to launching VCM Golding Mezzanine, the two managers teamed up with the Center of Private Equity Research (CEPRES) at the University of Frankfurt to build a database of approximately 900 mezzanine transactions completed in Europe and the US between 1986 and 2002. According to Golding, quantitative analysis of the data confirmed that mezzanine investments offer an average return of approximately 10 per cent, low default risk and limited correlation with other asset classes such as quoted equities and corporate bonds.

The venture seems well timed. Mezzanine is in demand -just ask Goldman Sachs, the investment bank, which in September closed Goldman Sachs Mezzanine Partners III on $2.7bn, just seven months after launching the fundrais-ing campaign (see also this month's Sixty Seconds Interview with Goldman's Robin Doumar on page 72).

Meanwhile as a funding instrument, mezzanine's popularity is not far from its peak. According to data published by Initiative Europe in conjunction with Mezzanine Management, the London-based mezzanine provider, €4.1bn of mezzanine capital was invested in Europe in 2002 (2001: €5.2bn, 1995: €450m), with the larger LBOs absorbing mezzanine tranches worth hundreds of millions, a trend that is set to continue. In the US, according to LCD, the capital markets data service owned by Standard & Poor's, some 33 per cent of transactions completed so far this year have drawn on mezzanine capital, against 30 per cent in 2002 and 39 per cent in 2001.

Providers of mezzanine capital take a positive view on the market going forward, hoping to be involved in the closing of funding gaps that open up both in Europe and the US as banks continue to scale back their lending to private equity backed transactions.

This bodes well for practitioners looking to use structural innovation to attract new investors to the asset class. However, whether investors will favour this model over more conventional private equity fund of funds products that come with greater risk but offer a higher return on investment remains to be seen. Feedback to date has been positive, say its architects. As an innovation designed to help foster the German-speaking buyside's familiarity with a private equity investment mind set, it is a welcome addition to the menu of less orthodox but still sufficiently familiar instruments that are on offer today. After all, moving into private equity proper on the back of a positive mezzanine experience will not appear the great leap into the unknown that committing to the asset class may seem today. The German-speaking institutional investment market is huge. Mezzanine may well help take part of it closer to unquoted investment.