FriedbergMilstein is nearing the finish line on a $584 million collateralized loan obligation that will be the first CLO to invest primarily in mezzanine debt. Merrill Lynch is the underwriter for the FriedbergMilstein Private Capital Fund that was initially slated at $450 million. "It's a unique animal that can invest up and down the capital structure," said an investor, who noted the deal will initially be senior secured loans, but the manager has two years to migrate to mezzanine securities. The IIR on the projected deal is 18-19%, which is higher than the anticipated equity returns on conventional CLOs. Eric Green, senior partner responsible for structured investments at FriedbergMilstein, and Merrill bankers declined comment.
A mezzanine CLO has not been attempted before for several reasons. The massive amount of equity required, in this case 20% of the deal, is a major stumbling block. This is approximately two-and-a-half times the average equity component in a CLO. "From an investment bank perspective selling $120 million of equity is very hard to do" especially as this is a new type of transaction, said one banker.
The oversized equity is required because mezzanine debt has a far lower recovery rate than syndicated loans, it's illiquid and there is a higher chance of default. Standard & Poor's is assuming a weighted average recovery rate of 39.6% for the transaction with the subordinated loans and mezzanine debt given a 25% recovery rating. This compares to a 55% recovery for the first-lien secured loans. Even with the mammoth equity piece, one banker said the deal is still potentially overleveraged as 10% of mezzanine loans need to be restructured. However, another CDO banker responded that the rating agencies are being punitive on the mezzanine as they have a small issuer bias. An S&P analyst added that the assumptions are conservative and the agency is not giving credit to contingent PIK interest and warrants.
Another barrier is that the manager also needs to be highly specialized to originate and manage these investments. To solve this problem, the managers tend to be better compensated, leading some CDO participants to raise eyebrows at the fees on offer for the managers, describing it as hedge fund-like. One CDO banker said upfront fees on this deal will be above $15 million and the manager will get 20% of the equity performance after a 10% IIR hurdle. However, the banker responded, "It's higher than a typical CLO because they have to originate the collateral. They will go and find middle-market companies and negotiate terms. It's much heavier-lifting."
The fees are also lower than those for the proposed Business Development Corp.'s, the heavily criticized structure a number of private-equity firms attempted to raise this year to sell shares to the public to invest in middle-market credit. Finding collateral in a timely manner is also an issue. The fund navigates the problem through enabling the manager to invest in senior secured loans initially and then migrate to mezzanine over a period of time. The AAA notes on the deal will also have a delayed-draw feature to prevent negative carry. This compares favorably to the BDCs, which proposed raising capital and then investing. "This deal is a reaction to the BDC. This solves a lot of the issues including transparency and significantly lower fees," the CDO banker said.
