Africa special: Find a happy medium with Ethos Mezzanine

When Phillip Myburgh founded Mezzanine Partners in 2005, the business predominantly focused on providing additional leverage in buyout transactions in South Africa. Now called Ethos Mezzanine Partners, having been acquired by Johannesburg-based investment house Ethos in 2016, its geographic focus has shifted to sub-Saharan Africa, and instead of buyouts, its emphasis is now on funding growth acquisition and replacement capital for middle- and late-stage businesses in East and Southern Africa. Myburgh talks to Private Equity International about this change in approach.

What drivers are behind Ethos Mezzanine Partners’ shift in focus?
A need for non-dilutive capital in the market segments that we target. The minute you introduce an equity sponsor into a business, you have to contend with two key aspects: the valuation of your business, because that’s key to determining the entry levels for the equity investor; and the fact a sponsor ultimately needs to exit that investment.

The second aspect can create divergent aspirations, since many entrepreneurs and business owners don’t necessarily want to exit their business, even over the medium term. Selling minority stakes is frequently more difficult than selling control. Tension can arise between the incoming equity sponsors and the founders or owners because the sponsors need to agree on terms that will ultimately facilitate their realisation of the investment.

As part of that process, sponsors usually insist on all sorts of ‘drag and tag’ arrangements which potentially expose the original owners to the risk of losing control or having to exit their business. That’s not necessarily what they want: they may just require growth capital because they’ve exhausted their own financial resources or need to diversify their exposures, and can’t raise any more senior leverage from the banking market.

In the absence of equity, the only other capital that provides scope for a prudently levered business to grow is mezzanine. It’s non-dilutive, and you don’t have to get into valuation questions, because typically these are self-liquidating instruments. They might have ‘equity kickers’ in the form of warrants, options or conversion rights, but often those are more an ancillary feature of the mezzanine fundraising instrument. For users of mezzanine capital, business valuations and equity exits are thankfully not the focal point of the discussions with their funders.

Are you competing on deals with private equity firms?
Usually owners of businesses have decided to raise capital in the form of mezzanine before they approach us. Their reasons for doing so may be manifold, including mezzanine’s ability to reduce their weighted average cost of capital; its unique flexibility which enables the creation of a funding layer specially crafted to suit their business’s needs; mezzanine’s ability to manage different stakeholders’ agendas; and, of course, its ability to defer or avoid any equity dilution for the business’s owners.

How does the mezzanine team interact with the rest of Ethos?
It’s an independent business. It has its own regulatory licenses and management structures, and the investment team is accountable first and foremost to its LPs. Obviously being part of a larger alternative investment group provides us with many benefits. From a support services perspective, our business is fully integrated into the Ethos group for things like finance, ESG, compliance, IT, HR, facilities management and investor relations.

From an origination perspective, new investment opportunities can be directed to those investment mandates within Ethos that are likely to be best capable of addressing the potential transaction needs. For example, an entrepreneur might approach the Ethos Mid Market Fund to raise equity but on further analysis realise that her funding needs are better suited to mezzanine finance. Similarly, one part of the business might require a layer of mezzanine funding in a transaction, and we could potentially participate in that.

But importantly, Ethos Mezzanine Partners is not a captive business. It is autonomous and unconstrained. It respects client confidentiality, and adopts a collaborative approach to provide its clients with intermediate capital funding tailored to meet their specific requirements.

How many opportunities do you look at on an annual basis?
We look at dozens. We used to do one out of every 20 that we looked at, but that ratio’s probably increased now that we’ve broadened our geographic focus. Going forward, we’ll maybe do one out of every 30 or 40. Certainly there are many opportunities. The key is picking the right ones, in the right sectors and geographies. And of course, managing expectations by being clear and consistent.

How involved is Ethos Mezzanine Partners in the businesses it backs?
Our touch is typically lighter than a conventional private equity investor, but probably more involved than a traditional senior commercial lender. We may have the right to appoint directors or a board observer, affording us the ability to influence strategic direction. We may contract for the ability to step in, in certain circumstances, and perhaps even have a list of protected matters that would require our consent. All of these features are a bit more characteristic of an equity investment than a traditional loan arrangement. But being an intermediate capital instrument, mezzanine will usually also incorporate a raft of debt features, including contracted returns, positive and negative undertakings, covenants and second-priority collateral claims.

We have access to the in-house Ethos Value Add team, a team of highly experienced management consultants that can be deployed into portfolio investments to drive particular strategic imperatives. For example, if a business was experiencing challenges with its working capital management, we could second someone from this team to look at how it’s dealing with inventory management and its receivables with a view to optimising its working capital cycles. Similarly, with the commissioning of new plants, expansions into new geographies or specific M&A initiatives, we have the ability to second people from this team either on a permanent or a part-time basis to help implement those strategies.

You’re currently raising Fund 3, which has a $200 million hard-cap. What’s the LP appetite for this strategy?
It has been well-received by LPs. Mezzanine is a non-correlated investment strategy that provides tactical diversification, which is especially important from a portfolio construction perspective. In different parts of the business cycle, business valuations and market liquidity will mean that conditions aren’t optimal to be making equity investments, or conversely, for proprietors to be issuing equity or disposing of their businesses. During these times, mezzanine offers an enabling layer of capital, that can unlock an acquisition, or provide a much needed layer of growth capital.

The instruments generally provide a good running yield, which helps mitigate the J-curve effect caused by management fees charged by private equity managers ahead of their investments generating returns.

Because mezzanine instruments incorporate strong debt features, and also usually benefit from a combination of downside protections, mezzanine portfolios are also less volatile. Many LPs like to introduce some of this predictability into their private equity portfolio of returns.

Another attractive feature for LPs is mezzanine’s largely self-liquidating nature. Aside from the risk mitigation that this brings, it also provides more predictability regarding the timing of investment realisations. In developing markets, where the exit alternatives available to traditional private equity investors may be much more limited, this is another attractive distinguishing characteristic of mezzanine as an asset class.

In addition, for hard currency LPs, the fact these instruments generate more predictable cashflows because of the contracted returns embedded in their terms means local currency returns are potentially more readily capable of being hedged. It’s easier to hedge predictable interest coupon returns than equity returns – the only simple way to hedge the latter (from a currency risk perspective) is to use options, which are very expensive, especially when they have a long time horizon and an uncertain strike date.

What are the challenges for LPs in investing in such a fund?
Our research into our targeted market opportunity shows the ticket sizes you want to be writing are in the $10 million to $20 million range. If you want to put between 10 and 15 deals in a fund, then you want a fund that’s somewhere between $150 million and $200 million. Of course, for many developed market LPs that is a relatively small fund. For some of these LPs the challenge is to reach the realisation that mezzanine is fit-for-purpose capital for the market segment we are targeting. It’s not necessarily going to be in their best interests to be investing in mandates which aren’t suited to the market opportunity.

This article is sponsored by Ethos and appeared in The Africa Special 2017 published in Private Equity International in September 2017.