Stuck in the middle
The mezzanine-debt opportunity has not gone away. But Martin Steward finds that success will probably depend on both greater focus and flexibility
It is the story of credit in general, and mezzanine debt is no exception: when the banking system was sent reeling in 2008-09, it left a yawning finance gap into which the bravest capital-markets and other non-bank lenders could leap, to be rewarded with unprecedented yields.
Whereas before the crisis, providers of mezzanine debt enabled the sponsors of private equity transactions to ramp-up leverage without giving away too much expensive seniority in the debt structure, in its immediate aftermath they found themselves among the few providers of debt financing in any form. The banks and the hedge funds and CLOs to whom they syndicated senior debt were largely gone, and in Europe, particularly, second-lien financing was entirely gone – but LBO firms still sat with dry powder to put to work. The high-yield bond market stepped in to provide junior and senior debt for larger companies with EBITDA north of about €100m, leaving those mezzanine funds with enough cash on hand to take the senior tranches for smaller firms. Both received good junior-style yields for doing so.
“The real attraction wasn’t so much the yield on offer but the risk characteristics,” recalls Sanjay Mistry, an investment partner at Mercer, which went big on mezzanine as part of its broader illiquid debt recommendation to clients back in 2010. “The real shortage was in senior financing and mezzanine funds happened to be the ones set up, with cash on hand, to invest in the senior-oriented opportunity for mezzanine-type returns.”
Investor appetite to supply mezzanine still seems robust. USS Investment Management, the asset management arm of the UK’s Universities Superannuation Scheme, almost doubled its co-investment programme in private equity and mezzanine during 2012, for example. High-yield and mezzanine specialist Intermediate Capital Group (ICG) closed its mezzanine and senior equity fund ICG Europe V three months ahead of deadline late last year, having reached the maximum size of €2.5bn, €500m more than the original target. Not only is this ICG’s biggest-ever fundraising, but it has already put 30% of the money to work – the fastest progress any ICG fund has enjioyed, according to head of European mezzanine Benoit Durteste.
But today’s market is clearly not the same as the one mezzanine investors enjoyed in 2009-10. While there are more LBO deals being done, sustaining more demand for mezzanine, the number of those deals that would struggle to get done without mezzanine has declined.
“The last five years since 2007 have been the golden window of opportunity for mezzanine investing, but it’s closed now,” argues Alan MacKay, CEO of Hermes GPE, the private equity fund investor for the BT Pension Scheme and other, third-party clients. “There’s a rush of credit back into private equity transactions and some bubble-like symptoms in high-yield and mezzanine. In the US, where they have the combination of high-yield, bank loan and CLO markets providing credit, things have gone way into pressurised bubble territory. In Europe we are starting to see tentative re-emergence of CLOs. When mezzanine is in demand to get transactions done, it can be rewarded with very good returns, but when things flip the other way it instantly gets the worst of all terms: it’s not so much that the rates are headline-cheap, it’s more that the risk is higher now than you might want for mezzanine exposure.”
Even mezzanine specialists do not entirely dispute this view. Durteste notes that CLOs and ‘covenant-lite’ structures have returned to the US, and that while these senior lenders are much more selective than bank syndicates were before the crisis, once they are comfortable with a credit they are prepared to offer equity sponsors plenty of leverage in cheaper, senior-only structures.
While the CLO revival has a way to go in Europe, Mistry points to the considerable number of illiquid senior debt funds that have launched over the past year or so, precisely to compete with mezzanine in the finance gap.
“They look to lend at more traditional senior-type levels of return of 8-10%, and are therefore placing some strain on some traditional mezzanine-only players who are now less able to lend for mezzanine return of 12-15% at senior risk,” he says.
On the equity side, Durteste notes that multiples rising under pressure from so much dry powder and generally glum expectations for growth are limiting IRR expectations. “If that return is starting to get very close to what a mezzanine return would look like, mezz gets squeezed out,” he says.
There is disagreement about the extent of the shift in supply and demand for mezzanine.
At Neuberger Berman Alternatives, which manages funds of funds alongside secondaries, co-investment and direct investments in private junior debt, head of private debt Susan Kasser points out that senior debt is indeed freely available for the best credits – but that these businesses tend to command multiples well in excess of eight times EBITDA. At that point, the market starts to see a return to 2006-07 dynamics – mezzanine becomes a way of cutting back the expensive equity cheque.
“If the cost of equity is 20% for half or more of a company’s capitalisation, that turn or turn-and-a-half of junior debt becomes very important to your returns,” she observes.
“Pricing on junior debt is expensive relative to senior debt, but it’s cheap relative to equity.”
Crucially, however, whatever the disagreements over supply-and-demand dynamics, they do not appear to be depressing yields for those mezzanine tranches that are transacted, which stand at around 11-14%. This is not like the public high-yield market, in which banks seem willing and able to push investors’ boundaries with each new issue.
“We find that pricing is relatively sticky in the illiquid credit space, generally,” Mistry says.
“Pricing on mezz has remained relatively stable, much like senior debt, since the crisis,” agrees Durteste. “Mezzanine investors still need to generate recognisably mezzanine returns for their clients. Some players will certainly stray a little from expectations for mezzanine returns – but they typically find it difficult to raise another fund once they’ve crossed that line.”
But surely something has got to give? If supply-and-demand dynamics are not depressing yields, is the pressure being felt somewhere in the risk profile? Are mezzanine investors being asked to take a greater proportion of their return as payment-in-kind over cash, for example? Apparently not, according to practitioners. And even those reports of mezzanine being called in to finance deals at eight times EBITDA belie a much greater level of discernment in the market – that gearing is only being applied to the highest-quality, cash-generative credits.
“It’s clear that some of the sponsors have learned from the past and prefer to put in less leverage,” says Olivier Berment, co-head of private debt at AXA Private Equity which, like Neuberger Berman, is a fund of funds business that also invests in direct private debt.
“Leverage, all-in, was about six times before the crisis; now, including the mezzanine, we are at more like 4.5 times, perhaps going towards five times more recently. The market is less aggressive than in 2007 but in terms of remuneration it is about the same, so I would say the risk-reward is better for us.”
Perhaps the way to make sense of this is to accept that ‘the mezzanine market’, as such, does not look so great, but that certain deals to achieve fairly high gearing on good-quality businesses, with the flexibility to enter into ad-hoc structures and release financing quickly, might be.
“The people who do mezzanine well are very disciplined in avoiding risk, biding their time and investing wisely,” as MacKay puts it. “But they would complain that there’s a lot of dumb mezzanine out there chasing yield, including a lot of large pension funds and sovereign wealth funds that are belatedly chasing the opportunity.”
Trey Parker is an experienced mezzanine investor himself and head of credit research at Highland Capital Management, which is currently raising a distressed debt-for-control fund but is not at work in the mezzanine market. He says that “true mezzanine”, where the investor is the only or at least the controlling owner of the tranche, is commanding a “very interesting” return of 12% cash coupon plus 2-3% PIK.
“The struggle I have is when guys are out there doing mid-market stretch deals that are 80-90% LTV, getting paid 800-900 basis points,” he adds. “I don’t think you are getting enough compensation for the risk. A lot will say. ‘It’s the only place I can find yield anymore’ – and I think that’s ultimately what it comes down to.”
Mistry concurs that there is an element of truth in the suspicion that risk must have picked up in mezzanine – but adds that that is precisely why fewer deals are being struck.
“Investors are being disciplined and are having to work harder to find those transactions,” he says. “At the higher-rated managers that we look at we often find a bunch of transactions that are off-market and don’t get picked up by the data providers. Often they have a long track record and they are simply able to refinance their existing book, for example.”
Durteste says that the bifurcation of the market between the simpler transactions with significant debt capacity for completion and the more complex deals that require “alternative” means of financing suits ICG. There is still significant demand for the latter, he adds, in both the LBO arena but also from corporates that want to finance acquisitions without touching their bank syndicates or their capital structure.
“They could be a combination of senior debt and mezzanine, or mezzanine and equity,” says Durteste. “The ability to provide an ad-hoc, flexible solution suddenly becomes very valuable, and in the current environment there is real demand for it. These transactions require real origination capability because it’s unlikely anyone will knock on your door with them – you have to seek them out and often create them yourself.”
As Trey at Highland indicates, this usually involves taking the whole of the mezzanine tranche to facilitate quick decision-making. But here, Durteste makes it clear that mezzanine providers might also be called upon to provide senior debt. In other words, if you have good relationships with private equity sponsors and are prepared to dig them out, there are still deals out there that at least look similar to those that characterised the mezzanine markets of 2009-10.
At AXA Private Equity, co-head of private debt Olivier Berment is talking up this so-called ‘unitranche’ opportunity.
“We are doing unitranche not because we can’t find mezzanine but, to the contrary, because there is still room to provide senior debt which is not being provided by the banks,” he says. “Unitranche is much better than having four banks arrange a deal for 30-40 senior debt holders and a separate mezzanine tranche as well, which can get complicated when the company wants to draw down on its credit line for capex or acquisition. The sponsors want to make the debt world much more efficient, and much more a partner with them – and they are prepared to pay a premium for that.”
This is demanding, in terms of sourcing, due diligence, and capital: a company with €40m EBITDA with mezzanine at one turn of leverage and senior debt at four turns is going to have a debt structure worth €200m.
“But that is the opportunity,” as Berment says. “Who in the market is a long-term investor able to provide €200m of investment, with no syndication and one voice to make the process more efficient?”
It is a sentiment echoed by Mistry, who notes that his clients are most interested in managers and vehicles that are “less tightly-constrained in the type of financing they can provide”. The capacity to truly back a credit across its capital structure appears to be crucial to realising the best risk-adjusted returns from private debt – and avoid getting caught up in ‘dumb mezzanine’.