Small mezzanine looms large

Mezzanine funds at the lower end of the scale – those typically making a large number of smaller investments from between $5 million to $25 million per deal – are the popular new kids on the private equity block, even though they've been operating in the financing segment for decades. The large-scale pullback by bank lenders and the volatility of the high-yield debt markets have made these mezzanine funds an attractive and cheap source of financing for small- to middlemarket companies to grow, expand and recapitalise their businesses.

With these lower-scale funds, the deployment of heretofore uninvested private equity capital is creating better deal flow among small- and mid-size companies for these mezzanine players to take advantage of. Also, many on the smaller end view the space as not overly populated, allowing lenders the ability to negotiate favourable terms and be more selective about the deals they choose.

While the mezzanine market may have its heavy hitters – The Blackstone Group's $1 billion structured debt vehicle closed earlier this year, Goldman Sachs' $2.7 billion whopper closed late last year, and CSFB's DLJ Investment Partners' $1.6 billion mezzanine fund raised in 1999 – the smaller funds typically hover at or below $150 million. Robert Finkel, president and founder of Chicago-based Prism Capital, says funds such as his firm's, which is currently working towards a second close on a $100 million target, create an option for investors for whom $10 million is too large a commitment.

The US private mezzanine debt market is geared almost exclusively toward middle-market companies requiring specific financing needs, such as for an acquisition, a plant expansion or a recapitalisation. Like the architectural term from which it derives its name, mezzanine debt is the small, in-between level of a deal's finance structure, sitting below senior bank debt in terms of repayment priority but above pure equity. Mezzanine funding is usually used to fill any outstanding capital gaps in the transaction.

The rekindling of M&A activity over the past year in the middlemarket sector has left private equity firms seeking additional capital not only for new deals, but also for addon finance opportunities and refinancings of portfolio companies. Highyield debt is still hard to come by for smaller deals. Additionally, the senior debt market remains tight compared to the aggressive lending days of 1996 to 1998, when banks put out senior debt at multiples of as much as four times EBITDA. Lenders have since stepped back to levels closer to 2.5 times EBITDA, according to market sources. And injecting more equity into a transaction – which already comprises between 35 percent and 45 percent of the transaction price – is not an option since more equity dilutes shares. As a result, private equity firms look to mezzanine vehicles to satisfy that capital demand.

“The pullback of senior lenders over the past couple years has greatly benefited mezzanine lending,” says Jim Philipkosky, a partner at Chicago-based CID Equity, which operates a $146.5 million mezzanine fund raised in 1998. “There was really a flight to fully collateralised lending and as a result, the piece that used to be stretch lending, provided by banks, is now being filled in by mezzanine lenders.”

Mezzanine financing has characteristics of both debt and equity. Subordinated debt for a middlemarket company carries a total stated interest rate that ranges between 14 percent and 16 percent. Meanwhile, the equity ‘kicker’ portion of a mezzanine investment involves a common equity interest, usually by way of warrants, to convert the debt into between 5 percent and 15 percent of a company's equity.

Mezzanine's subordinated debt position means a higher risk to the lender and can produce a greater rate of return, generally high teens to low 20s, of which 12 percent to 13 percent are coupon payments. The additional returns, hopefully, come from equity gains.

“Mezzanine is less volatile than pure equity,” says Marc Reich, president and founding partner of Avon, Connecticut-based Ironwood Capital. “In equity markets, the cycles have higher peaks and lower valleys. This is much more stable market.”

Historically, the largest providers of mezzanine capital have been insurance companies, pension funds and endowments, but have since expanded to include private equity groups, leveraged public funds, commercial banks and investment banks with captive funds. According to Venture Economics, the private mezzanine securities market has grown from $15.2 billion raised by 1998 to more than $37.3 billion by 2002.

With the late 1990s and early 2000 being a boom time for capital fundraising, Reich says his firm started raising its $85 million Ironbridge Mezzanine Fund back in late 2000 when it noticed that most other firms were forming equity funds. “We looked and saw that not many new mezzanine funds were coming online, though at the same time, there was no decreased need for mezzanine financing.”

Ironbridge, as well as Finkel's Prism Opportunity Fund, each share the distinction of being a Small Business Investment Corporation (SBIC), meaning the firm is licensed by the Small Business Administration and is guaranteed financing of up to twice the amount of private capital it raised. Though the majority of SBIC funds are equity, Reich says the handful of SBIC mezzanine funds that dominate the smaller end of the mezzanine spectrum – with portfolio companies claiming between $10 million to $100 million in sales – make for less competition, and in general the lower end of the middle market is spared having an excess of capital chasing around too few deals.

Mike Hermsen, managing director of the $265 million Tower Square Capital Partners mezzanine fund closed late last year by Springfield, Massachusetts-based investment management firm David L. Babson & Co., says smaller mezzanine funds tend to be more diverse, since they make smaller investments in many companies, while larger mezzanine funds make larger investment in fewer companies. “[Investors in small mezzanine funds] can diversity their exposure since these [small mezzanine] portfolios can include anywhere from 40 to 60 different companies in a variety of sectors.”

One of the downsides in the mezzanine space, according to Prism's Finkel, is that fund managers tend to move upmarket to make larger investments rather than staying in the smaller space that made them successful in the first place.

“Successful managers typically have gone on to raise bigger funds where they are now encountering increased competition and rate pressure,” Finkel points out. “You don't have lots of managers who want to be in a small environment because the management fees are too small. It's just human nature.”

Smaller mezzanine players believe returns can be better as a small fund, but the work is just as much, if not more. It's small wonder, then, that funds tend to inflate in size.

“It takes as much time and effort to invest $1 million as it does to invest $10 million,” says CID's Philipkosky. “[So] I work hard to invest x. If I invest 10x, I still do the same amount of work but the economics on the larger deal are better for me. A bigger investment yields a bigger carry.”

Overall, the next couple years look promising for smaller mezzanine funds. Deal flow continues to increase among small and middlemarket companies as private equity firms look to unload the committed capital sitting in their coffers. Investing in smaller enterprises may carry more risk because of their weaker perseverance in protracted economic downturns, but greater risk means a potentially greater relative return on investment.

“There is simply more value present in the smaller end of the [mezzanine] market,” notes Hermsen. “It offers better pricing and better economics. When we talk about getting a higher yield, it's not like we're getting something for free. The reason there's more yield is because it takes more work. It's analysis-intensive, seeing which are the good companies, which are the bad companies… There's more risk on the smaller end of things.”