MOVING INTO MEZZANINE

If American billionaire Robert Miller thinks there's an opportunity worth pursuing in Asia, it's probably a good idea to pay close attention. Miller made his fortune from the Duty Free Shoppers Group (DFS) he co-founded in 1961. The company, now owned by LVMH, has 150 stores in 14 countries in Asia and the Pacific Basin, making it the world's largest duty free retailer. So which opportunities does he have his eye on now? As you would expect, there are many, but one is a form of financing with which private equity professionals in Europe and the US are well acquainted: mezzanine debt.

Since the 1970s, Miller has been putting his not inconsiderable fortune to work through Hong-Kong based investment firm, Search Group. The vehicle, which is reported to have an annual target return of at least 15 percent, acted as sponsor for the Search Asian Mezzanine Capital (SAMC) fund, which raised $100 million (&€83.4 million) in 2002 from Miller and a clutch of wealthy families to invest in companies in North Asia.

When SAMC was launched, chief executive Henry Stein said the timing was right because the capital markets were not able to provide young companies with financing and there were few private equity funds operating at that end of the market – meaning that mezzanine could step into the funding gap as a viable alternative.

Two years on, and Stein's optimism has been at least partly justified. SAMC recently participated in the acquisition of Hong Kong model train manufacturer Sanda Kan Industrial by JP Morgan Partners and has invested a total of $50 million over the last 12 months.

It has not all been plain sailing for mezzanine investors, though. For one thing, initial confidence in mezzanine as an alternative to both stock markets and private equity has been undermined somewhat by the explosive growth of stock markets in the region and their increasing receptivity to small, fast growing companies. In addition, private equity funds have latched onto the opportunity for high returns in the region and the supply of capital is growing fast.

Overall, as a subset of the private equity financing market, the growth of mezzanine has been a little disappointing. It's not as if the product is an unknown quantity in Asia, but its use has so far been largely restricted to infrastructure-type investments. Against a background of steady economic growth ever since the Asian financial crisis in 1997, demand for the financing of large infrastructure projects has increased – and subordinated debt has played its part.

But mezzanine has not achieved widespread recognition as a possible financing solution for private equity transactions. This is despite the fact that funds active in the region are increasingly turning their attention away from restructuring opportunities and towards a new generation of fast growing, mid market companies, particularly in China – just the type of businesses, in fact, for whom mezzanine would appear to be a natural bedfellow.

Industry sources say reluctance to embrace intermediate capital may be partly attributed to the risk-averse nature of locally based banking groups, which are hesitant even to provide meaningful amounts of senior debt funding to private equity transactions. Stein says the combined portion of senior debt and mezzanine in Asian deals is typically around the same as just the senior debt portion in US transactions.

The other major obstacle appears to be the reluctance of management teams to relinquish control of their businesses. In China, for example, private equity is entering an environment where banks only started lending to private companies very recently and the only external investment typically came from family and friends.

Slowly but surely, attitudes do appear to be changing. The new Singapore-based MezzAsia Capital fund, which was launched last year and is owned by French bank Crédit Agricole, recently made its first investment of $23 million in Alok Industries, an Indian textile manufacturer. The UK's Intermediate Capital Group has completed two deals in the region, most recently providing $19 million in PIK mezzanine to refinance part of the equity provided by CVC Capital Partners and JP Morgan Partners when they acquired directories publisher Yellow Pages Singapore for an undisclosed sum in December 2003.

A number of international buyout houses have been attracted to Asia by an improving economic climate, high current and projected growth rates and pressure on corporates to spin off non-core assets. There is no reason at all why mezzanine specialists should not be able to climb on the bandwagon. “Compared to the US and Europe, the scarcity of mezzanine financing in the region is apparent,” says MezzAsia Capital managing director Stephane Delatte. It is unlikely that situation will pertain for long.