He believes that long-term active mezzanine managers can reduce the inevitable default rates, with better access to information, investments selected on credit quality and with terms structured to protect on the downside and by ensuring a seat at the table in the event of problems. Private equity buyout managers like to use some element of mezzanine in their deals because this will free up more of their equity capital for other investments, allowing greater diversification. Kohlberg Kravis Roberts & Co (KKR), one of the world’s largest private equity managers, has a specialist mezzanine finance unit. Marc Ciancimino, a London-based KKR director and mezzanine specialist, says that sponsors may over-equitise transactions at the moment because there is about US$500 billion of uninvested private equity capital around the world but because of depressed prices, sponsors have to compete with high-yielding alternatives such as bank loans and distressed debt.

He says that sponsors need to prove they can generate outperformance, especially after the past two years of write-downs and mezzanine is accretive to equity returns as long as its cost is cheaper. The main reasons mezzanine is favoured over high yield, according to Ciancimino, are: certainty of execution; flexibility on design of terms; and because of the sponsor/dealer relationship through the life of the transaction. While bond markets can open and close depending on capital market conditions, mezzanine is private marketbacked by committed investors. Mezzanine tends to be designed to satisfy a defined group of investors rather than the lowest common denominator. As sponsors are discovering, he says, dealing with a large syndicate of bond investors is not easy, whereas dealing with a smaller group over several deals creates confidence on both sides. With unsecured debt, defaults by investee companies represent a continuous issue for mezzanine fund management. As the fund managers say, though, it is not the fact that some companies inevitably default on loans, it is how the manager recovers its money that matters.

Research sponsored by SOPEP (Sal Oppenheim Private Equity Partners), which produced the world’s first mezzanine finance fund of funds in 2003, shows that, on average 12.2 per cent of mezzanine loans default, but, on average, 44.1 per cent of the money is recovered. The research, conducted by the CEPRES – Centre of Private Equity Research, covers 4207 deals between 1982 and 2008 in the US, Europe and Asia. The mezzanine market is split about 60 per cent in the US, 35 per cent in Europe and Eastern Europe and 5 per cent Asia. In the US, about 70 per cent of mezzanine deals are for buy-outs and 30 per cent for growth strategies for investee companies. In Europe it’s 88 per cent for buy-outs.