Mezzanine was once considered a stop gap, a temporary solution for completing large transactions when the European high yield market was recuperating on the sidelines. But European junk has failed to recover fully from its injuries and instead mezzanine has cemented its place in the leveraged finance product team. Taron Wade reports.
There is strength in numbers, so the saying goes. And no where is this phrase more apparent than in the strength of the mezzanine market as more and more investors discover the asset class.
So many in fact, that the financial world is starting to take notice. "Mezzanine is now a legitimate alternative to high yield," says Paul Piper, head of UK mezzanine at Intermediate Capital Group in London.
Although this year's mezzanine volumes has not yet topped last year's record, the leveraged deals that have been priced have included bigger mezzanine tranches than ever before. The subordinated debt for the buy-out of BertelsmannSpringer in September was Eu265m in size and the mezzanine debt for the buy-out of Gala Clubs in March was £190m. The Viterra and Ontex transactions had mezzanine tranches of Eu197.50m and Eu165m, respectively.
Volume for the first nine months of this year totals a healthy $3.120bn versus the first nine months of 2002, where it totalled $3.211.
Bankers agree that the size of mezzanine tranches continues to grow, but there is some debate about the potential maximum capacity. Some say that the size could reach Eu500m in a buy-out, but others believe that estimate is far fetched.
Paul McKenna, managing director and head of leveraged syndicated financing at ING in London, says he doubts a deal as large as Eu500m would be feasible in today's market. "The theoretical size of the mezzanine market may well be around Eu500m, but in order to syndicate a deal successfully, you would have to rely on all the existing players playing and playing big," he says. "That would simply be too unpalatable an underwriting proposition for most arrangers."
But larger tranches are definitely here to stay. And alongside this growth, there has been a spate of new funds being raised this year. Although this is not always related to actual deal flow at the time, the larger funds are helping to fuel the presence of larger mezzanine chunks in LBOs.
Goldman Sachs, for example, raised a record $2.7bn for its new fund GS Mezzanine Partner III in September. The original aim was to raise about $1.5bn - close to Goldman's $1.3bn second fund, but fundraising exceeded initial expectations.
Other houses are also in fundraising mode. Lehman Brothers, which started a dedicated mezzanine group in 2002, has invested Eu150m since last October. A first close of the fund, which is aiming for Eu500m, is expected by the end of this year. Scandinavia private equity fund EQT is raising its debut Eu300m fund and Nordic Mezzanine is also in the midst of raising Eu200m for its second fund. After revising its target raise to Eu300m from Eu500m, newcomer Hutton Collins is also seeking capital.
Finnmezzanine, part of Nordic private equity firm CapMan, has invested 60% of Eu150m and has provisional plans for a new investment vehicle next year. AIG-MezzVest has invested Eu400m of its fund and a follow-on fund is also planned for 2004 or 2005, depending on deal flow. Additionally, IFE Conseil has decided to start raising a follow-on fund.
"More and more players are getting involved," says Kirk Harrison, head of mezzanine at Barclays Capital in London. "Most of the investment banks will now underwrite mezzanine, although not all of them will hold it," he explains, adding that there are now four principal groups of investors interested in mezzanine.
First there are the traditional mezzanine funds, such as ICG, Lehman Brothers and Goldman Sachs. Then, there are CDO managers and other institutional investors that are looking for the yield mezzanine offers. There are also banks that have typically only invested in the senior portions of LBOs now increasingly looking at investing in mezzanine. Lastly, some high yield investors are interested in the product since there has been a dearth of high yield issuance. "Not all of them can buy it, but there is definitely an increase in demand from them," Harrison says.
In a twist to the fundraising trend, Mezzanine Management raised Eu115m in July for its first Central European fund. This is believed to be the first fund to focus solely on the region and was described by competing firms as "groundbreaking". Franz Hoerhager, mananging director, said at the time of launch that the ingredients for an active buy-out market have been emerging in the Eastern European market - similar to 1992 in the Western European market when companies were reorganising themselves in preparation for the European single market. The fund is targeting companies in sectors where there has been little consolidation as well as recently privatised companies. "They are on their own and looking for partners," Hoerhager said.
The high yield factor
One of the reasons mezzanine has emerged as such a strong asset class over the past 18 months is the fact that the European high yield market has continued to be an unreliable source of capital. Although there have been some high yield bond transactions, a deep and liquid market is not yet present in Europe. "High yield in theory is priced cheaper than mezzanine because of its liquidity, but in the European market, there is little liquidity," says Rory Brooks, founding director of Mezzanine Management in London. He adds that the European high yield market needs to mature along the lines of its US counterpart before it is a consistent alternative to mezzanine in Europe.
Many in the mezzanine market point to the fact that in some instances high yield debt is not as well suited to the LBO market.
"In many cases there is reluctance to do a roadshow and adhere to the public reporting requirements," says Brooks. "The sponsors also like being able to pay off the debt without paying a premium."
But there is also a camp of those who think there is room for both high yield and mezzanine in the LBO market. "The market is trying to find a level at which it is appropriate to use each type of product and the indifference range is Eu100m-Eu300m," says Adam Hewson, head of European high yield and mezzanine capital markets at UBS in London. "You can't really do a high yield deal below Eu100m and mezzanine above Eu300m is challenging."
The decision depends on whether a company wants to be public or private, the timescale for repayment and the ease of restructuring a deal. "Restructuring is much easier with mezzanine buyers," Hewson says.
"The high yield market is coming back," says Barclay's Harrison. "It's had a difficult 18 months, but for the right transaction, high yield is a cheaper alternative." He admits that if the high yield market does return, there will be fewer mezzanine transactions. "The pie is only so big," he says.
The use of either instrument will be sponsor-driven. "European sponsors in general have historically shown a preference for mezzanine debt, while US sponsors will use high yield more readily," Harrison adds.
A middle ground
There is, however, a medium ground developing. This year the market saw the first hybrid transaction with the mezzanine note used in the buy-out of Focus Wickes. The £225m deal was underwritten by Royal Bank of Scotland and ING.
These mezzanine notes do not give investors as much call protection, instead compensating them with an increase in overall returns and a significantly enhanced security package.
Specifically, the non-call four, high yield-style call provisions are in place, unless there is an initial public offering or a trade. In those cases, the notes are non-callable in the first year and then callable at 103%, 102% and 101% in years two, three and four.
Investors were compensated for this compromised call structure with a hybrid semi-annual, fixed rate coupon and also an accruing element, which gave them an overall return of 12% on the sterling tranche and 11.25% on the euro tranche.
The note also dealt with the increasing reluctance by European high yield investors to accept structural subordination. There was high profile resistance from senior debt investors during the execution of high yield bridge take-outs in the buy-outs of Legrand and Brake Brothers. Both of those deals included upstream guarantees, which in general terms, give high yield bond investors many of the same privileges that mezzanine investors have had historically and rank the bond holders pari passu with trade creditors. Without guarantees, high yield investors rank behind senior lenders, mezzanine investors and trade creditors.
The hybrid notes for Wickes were designed to alleviate concerns by the senior banks through a mezzanine-style requirement for two-thirds of noteholders to act together in calling for a default alongside an increased 179 day standstill on the upstream guarantee and no enforcement rights on the second lien in the event of a default. Because the notes are publicly traded, they also contain other high yield features which give senior banks a stronger position, such as weaker incurrence-based financial covenants.
The future of upstream guarantees is still a grey area. Some bankers believe that senior lenders are getting more comfortable with them as they appeared in the structure of the buy-out of Seat Pagine Gialle, while others think this will be an continuing debate.
ICG's Phillips says his firm is not opposed to upstream guarantees for high yield bondholders so long as, as a quid pro quo, senior leverage is reduced and offers better pricing. What he is worried about, however, is the increasing trend of mezzanine to be syndicated widely. In the past, there were always two or three big mezzanine houses that would participate in a deal. "What is going to happen when there's a workout and no true mezzanine leader?" asks Phillips.
He also points out that high yield debt is not just a tool for the LBO industry, but in general is a form of medium term financing for below investment grade rated companies. "It has been used successfully in Europe to resolve liquidity crises for a number of quoted companies," he says.
For example, it was used in the restructuring of HeidelbergCement. In that instance, Heidelberg was using the market to lengthen its debt maturity profile.
The troubled Ba1/BB+ German corporate issued a Eu700m seven year deal in July as part of a refinancing. The other parts of the refinancing package, which was worth Eu2.6bn in total, included a Eu404m equity rights offering and a Eu1.5bn syndicated multi-currency term loan and revolving credit facility.
The warrant question
Although many in the market downplay its importance, the presence of warrantless mezzanine in the buy-out market has created much debate. Although there have always been some transactions priced without warrants, they have tended to be just one-off deals. But now, with deals structured offering two pari passu tranches, one with warrants and one without, it has become a common occurrence. "Warrantless mezzanine has existed in the past, but in recent years there has been a increase in funds offering to invest without warrants," says Christiian Marriott, head of investor relations at Mezzanine Management. "It has become a feature of the market, especially in larger deals."
Indeed, debt backing the Eu1.6bn buy-out of Télédiffusion de France (TdF) from France Télécom had a mezzanine portion split into two parts, one with warrants and one without. BertelsmannSpringer, Linpac and Ontex deals all have warrantless tranches. And the mezzanine portion of the buy-out of Viterra was composed entirely of warrantless debt.
The argument in the market stems from the idea that mezzanine investors need the equity upside to offset any losses in the portfolio. But others say that there are investors that want to get the higher coupon payments warrantless mezz offers, especially in an environment of recaps and secondary buy-outs, where the potential for equity growth is not as high.
Barclay's Harrison says he is not surprised at the number of market participants interested in buying warrantless paper. "In today's market sponsors are paying full multiples for businesses, so the warrants do not always have as much upside potential and many investors would rather have a contractual return," he observes. "I would expect to see more split tranche structures as it enables arrangers to maximise their potential investor base."
"It shows that the market is becoming more flexible, which is a very positive move," says UBS's Hewson.
But some big mezzanine investors are not interested in tranches without warrants, and some say that those firms which invest only in unwarranted are being taken for a ride by the private equity firms.
"Some mezzanine investors may advocate warrantless because they think the opportunities for 'cleaning up' are few and far between," says ING's McKenna. "They may be right, but personally, I think there are opportunities to clean up, even with mature businesses and market leaders. The difficulty as an arranger is persuading the financial sponsor to give away the warrants."