With lending from traditional quarters – namely, the major banks – still difficult to come by for companies large and small, it would appear that opportunities must abound for investors who are looking for something extra from their fixed interest portfolios. While credit funds offered by traditional fixed interest managers remain in demand this year, another form of debt investment is also catching on – mezzanine finance. GREG BRIGHT reports.

Mezzanine finance is not new. It has been provided for years by ‘sponsors’, typically banks or other institutions, to assist in the financing of buyouts or infrastructure-style investments. Outside investing in mezzanine finance is not even new, at least not in the US and Europe. But what is new is the disaggregation of the market in recent years and the emergence of specialist mezzanine finance managers who are tapping funding from pension funds. At a seminar produced by Conexus Financial, publisher of this magazine, in Melbourne late July, several specialist mezzanine debt managers presented before an audience of super fund investors and asset consultants. The common theme was that mezzanine debt offered potential returns close to those offered by private equity, but with reduced risk.

The consensus from a panel of investors who reviewed the day was that mezzanine finance may well represent a good opportunity over the next 12-18 months in particular, however, because of the massive dislocation still present in various markets, it had to compete with a lot of other opportunities in the alternatives space. Mezzanine finance refers to the layer of financing between senior secured debt and ordinary equity. Because it ranks behind senior secured debt it has a higher return to compensate. It typically takes the form of a loan, with current income or payment in kind, but also captures some upside from equity participation. According to Tim Russell, a managing director and head of mezzanine finance for Goldman Sachs JB Were, Australia is a relatively immature mezzanine market in comparison with the US and Europe, probably because of the dominance of the big banks here. “Historically, mezzanine in Australia was a bank’s market,” he says.

“It was characterised by low volumes and was used by the banks to earn a higher return on a small part of the capital structure of the investment they were financing. This meant that ‘inter-creditor rights’ (the differing rights between each loan class) were relatively relaxed or poor because the underwriters were the same institutions.” However, he says that between 2005-2007, as the private equity market took off, the seeds were sown for an institutional mezzanine market. He says that recent changes are expected to prompt further evolution into a more independently managed institutional model. The Basel II regulation has meant that banks no longer want to underwrite or hold mezzanine, he says. Like private equity, mezzanine investing is for the long term and funding terms need to be matched to the investment duration. It is also complex, Russell says, with bespoke solutions aligning interests with those of the financial sponsor.

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