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.
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.
Europe, however, tends to have relatively more larger deals – about 34 per cent of European deals are between US$15-40 million against 20 per cent of US deals. Interestingly, European mezzanine deals tend to have lower defaults and higher recovery rates than their US counterparts. CEPRES data shows that the total loss rates, after default and recoveries, are 2.8 per cent for European deals and 8.1 per cent for US deals. Matthias Unser, managing director of SOPEP, says there are about 40 mezzanine funds managers in Europe but most of these have a mid-market and national, rather than global, focus. Only a few focus on sponsor-less transactions, where no bank or institution is involved in the mezzanine component of the deals.
However, demand for sponsor-less transactions is increasing, Unser says, and many banks and hedge funds who previously competed against specialist mezzanine managers have exited the market in the wake of the GFC. The developing Asian and Australian regional market was pioneered by AMP Capital Investors about 12 years ago and, as with the US and European markets, specialist managers were increasingly challenged by hedge funds and investment banks until the GFC. According to Andrew Jones, AMP Capital’s global head of private debt, there remain a small number of specialist mezzanine funds in Australia and Asia, but demand for their services is now much greater with the pull-back of senior bank debt leverage multiples and with equity unable to fill the gap.
Jones says the supply/demand imbalance is driving returns for mezzanine such that funds are providing equitylike returns for debt risk. Fees will typically consist of 4-5 per cent for arranging the deal, coupon interest of 13-17 per cent, access to equity upside through warrants and/or equity co-investment – adding up to expected IRRs of about 20 per cent. The secondary market, Jones says, currently offers even more potential with forced sellers combined with limited buyers making for potential returns of 30 per cent or more. He expects primary opportunities (initial deals) to accelerate through 2010 as significant pools of committed capital become available, leading to an expectation that the purchase multiples and earnings base will bottom. Mezzanine managers use various mechanisms for downside protection for their investors. Jonathan Robinson, a partner in Asia Mezzanine Capital Group, gives an example in which his company was involved with a Chinese company, Yingliu International Holdings, which had postponed an IPO last year.
On the debt side, the manager had: a full share charge over the Hong Kong intermediate holding company and on the majority of shares until an IPO; a prohibition on any further debt until the second quarter of 2010 and subject to performance benchmarks thereafter; financial covenants requiring rapid deleveraging. On the equity side, the manager had: zero-exercise price ‘penny’ warrants which eliminated downside valuation risk; a non-IPO put on warrants to mitigate equity exit risk; absolute anti-dilution protection for any future pre- IPO equity raising to minimize dilution risk. Robinson believes that mezzanine investments can be conservatively selected and effectively structured with lower risk and less volatility than traditional private equity, while capturing a portion of equity returns. Project mezzanine finance most typically involves property or infrastructure deals.
In the Australian property market, there have been several significant changes for mezzanine financiers following the GFC, according to Dominic Lo Surdo, head of funds management for specialist property manager Ashe Morgan Winthrop. He says that vacancies are rising, yields continue to soften, transaction numbers are limited, debt markets are deleveraging and the profile of property buyers is changing. “The current economic climate has created a unique opportunity in the mezzanine debt market,” Lo Surdo says. “There is a massive funding gap … There is an opportunity for mezzanine finance to fill the funding gap with relatively lower risk by replacing senior (secured) debt.”
The investors’ panel at the mezzanine seminar agreed with the presenters that mezzanine funds represented a good opportunity, although they cautioned that opportunities abound in several asset classes post-GFC. Scott Hancock, executive director of specialist asset consultant Quentin Ayers, said that the next 12-18 months looked particularly good for mezzanine funds. Tony Tuohey, trustee of Vision Super, which has invested in mezzanine for several years, said that super funds were likely to ‘club’ together for these sorts of deals in the future. Michael Block, general manager, investments, FuturePlus Financial Services, questioned the after-fee performance of mezzanine funds and similarly structured alternative investments.