European environment for mezzanine investment 2003

The increase mezzanine has witnessed in the last few years is down to more than a simple expansion in overall European private equity and a pro-rata increase in the instrument. After all, the volume of mezzanine transactions has been rising at a time when the overall trend within the European buyout market is one of fewer deals and deal volumes having been falling year-on-year consistently since 1998. At the same time, mezzanine's share of both overall private equity volume and value has been increasing. Clearly there are other factors that help to explain why the use of mezzanine in the European private equity market has expanded so in recent years, argues the European Mezzanine Review 2003 newly published by Initiative Europe in association with Mezzanine Management.

One of the more important developments to be seen in the European private equity industry in recent years has been the emergence of mezzanine as a real alternative to the high yield bond market. Although high yield bonds can be a useful source of large amounts of relatively cheap debt, the experience of some equity investors with it has been mixed. Coupled with problems over telecoms issues (which served to stigmatise high yield bonds in the eyes of many) and a number of defaults in Europe, this has led many in the market to question whether high yield is the only, or even the right, source of subordinated debt for private equity backed companies. The high yield bond market is, however, extremely cyclical, disappearing for six months of every year and then picking up.

There is evidence to suggest that the market is once again moving, with transactions like Legrand in 2002 and the SEAT transaction in 2003 providing a boost. Nonetheless, mezzanine finance has increasingly been viewed as the preferable way with which to finance transactions. This is a turnaround from the position three to four years ago when the high yield bond market had been introduced in Europe. The perception then was that mezzanine finance was facing extinction, with mezzanine houses struggling to compete with high yield, particularly given the relatively small sums of debt they were able to supply. As stated above, this position has now changed and for many mezzanine is the preferred instrument.

Crucially, mezzanine is now able to compete with high yield in terms of the volume of debt that can be supplied. The arrival of new players in the European mezzanine market and the increasing 'one-stop-shop' approach taken by banks to leveraged finance resulting in them including mezzanine within their tailored funding packages have meant that mezzanine's capacity has increased substantially in the last few years. The market now has the ability to supply mezzanine in amounts up to E300 or E400m (or more), enabling it to compete with high yield on all but the largest transactions. However, many of the new arrivals that have helped to boost the supply of mezzanine in the market have been looking for warrantless mezzanine. Their focus is more on the running yield mezzanine provides and the rolled-up interest and PIK element, than upon the potential equity upside that the warrants in traditional mezzanine can provide. Much of the mezzanine that has been put into place in the larger transactions in recent years has been warrantless mezzanine and if the high yield bond market returns in force some of these warrantless mezzanine players could face difficulties. There is, however, still a mismatch between the amount of capital that can be raised by high yield bonds and the amount that can be supplied by the mezzanine market.

Therefore for certain deals (such as SEAT) the only option will remain the high yield bond market, as the level of subordinated debt required puts them beyond the reach of mezzanine. What has been seen is the middle ground between deals that are more appropriate for mezzanine and deals that are more appropriate for high yield widen. The minimum for high yield has fallen (down to around E100m) whilst the amount of leverage that can be raised from mezzanine has increased considerably (E300m-E400m is not unusual now). The result is that there is a wide range of deals that can use either mezzanine or high yield and equity sponsors have a choice between the two.

Given the range of transactions for which either high yield or mezzanine is appropriate, a number of advantages that mezzanine has over high yield have also contributed to the instrument's growth in recent years. Mezzanine's benefits relate to its increased flexibility, stability and security over high yield bonds, as well as its private nature. The latter means that financing can be put in place behind closed doors and out of the glare of the public markets. This has obvious benefits for equity sponsors, especially if restructuring or refinancing is needed. Private equity investors also know with whom they are dealing where mezzanine is concerned, and the number of parties is usually smaller. With high yield bonds the number of investors is usually far larger and, due to their publicly tradable nature, the ultimate bondholder is often now known. As a result, it is easier to get round a table and work through any difficulties that may arise with an investment when mezzanine is involved than when high yield bonds are used. This may be a slightly naive view, however, particularly where large deals are concerned. Such transactions will often involve a sizable number of mezzanine investors, making getting them all round a table to thrash out issues something of an unrealistic prospect. Furthermore, mezzanine investing is becoming increasingly institutionalized.

CDO funds, fixed income investors and other institutional investors are increasingly taking slices of mezzanine as part of an alternative asset allocation strategy. Such investors see their investments as a way to achieve running yields and possibly some capital gain, although they will usually be focused on warrantless mezzanine positions. They will have little interest in getting round a table with a buyout house and thrashing out issues relating to the company's development. The flexibility of mezzanine in comparison with high yield bonds is certainly something in the instrument's favour. High yield bonds can be time-consuming to put in place, given the need to roadshow the issue around investors.

Mezzanine, by contrast, can often be put in place far quicker, particularly when one or two groups come on board to underwrite the entire investment. Mezzanine can also be structured to fit with the particular circumstances and cashflow model of the investee company in question, with features like PIK (payment in kind) and PIYC (pay-if-you-can - where a proportion of interest payable on the mezzanine debt is accrued and only paid if certain cashflow trigger levels are reached) particularly useful when short-term cashflow concerns are acute for an investee company. The terms on which mezzanine is lent are also arguably easier to renegotiate if the circumstances of the investee company change, especially the case given that in many circumstances the taking of warrants serves to align the interests of the mezzanine investors and equity sponsors.

The call protection given to most high yield bondholders is one reason why high yield is not always attractive to equity sponsors, even when the size of the deal makes it a suitable instrument to use.Most high yield bonds cannot be repaid for the first four or five years after launch without paying a hefty premium, in order to allow investors to enjoy some performance from their bonds. These non-call periods can cause problems for equity sponsors looking for a quick exit via IPO or trade sale from their investment, as repaying the bonds during the non-call period can be extremely expensive and eats into the performance of the exit. Mezzanine, by contrast, is more flexible and allows for a smoother path to exit.

There have been some moves, however, to make the high yield market more attractive to equity sponsors where call structures are concerned. The most novel has been the recent eight-year high yield bond issued by UK home improvements retailer Focus Wickes, which is backed by Apax Partners and Duke Street Capital, in July 2003. The structure of the issue has been described by its leads - ING Bank and RBS Financial Markets - as the first publicly-traded mezzanine note and it shares characteristics of both high yield and mezzanine. In return for a higher yield and increased credit protection, investors have given up the normal right to call protection for the first four or five years.

Instead, Focus Wickes' bonds have more of a mezzanine-like call structure and can be called after a year upon an exit event (an IPO or trade sale) at a declining premium. The intention with the structure is to give Apax and Duke Street a smoother path to exit (an IPO is planned for the company), without having to clear up the high yield bonds at an expensive premium. Whilst the structure of the Focus Wickes bond should do this, it remains to be seen whether it will lead to similar deals being structured in the future. High yield bondholders will not necessarily always be as keen to give up call protection in return for higher yield and better credit protection.

Mezzanine arguably offers equity sponsors increased stability over high yield bonds. This is a reflection of the private, non-publicly-tradable nature of mezzanine resulting in an investor usually knowing who the actual mezzanine providers are. Furthermore, the illiquid nature of mezzanine means equity investors can be relatively confident a mezzanine provider is going to be around for the next three years or more. For institutions investing in both mezzanine and high yield, the former can provide them with increased security in comparison to the latter. The contractually subordinated nature of mezzanine means that investors have security over the whole of the company in question, including the actual operating companies of the corporation using the debt. High yield bonds, by contrast, are often structurally subordinated, with their security only being over the holding company.

In addition, mezzanine also has increased credit protection in comparison with high yield bonds given the stricter covenants it usually extracts, including anti-layering covenants to prevent further debt being issued with a claim superior to the mezzanine. High yield bonds usually have far looser covenants, although the Focus Wickes bond discussed above has attempted to improve the credit protection of bondholders, offering guarantees from all the operating companies, as well as second liens and anti-layering covenants. One of the most important drivers behind the increase in mezzanine in recent years has been the increasing supply of the instrument to the European market.

This is an excerpt from the European Mezzanine Review 2003 which has just been published by Initiative Europe in association with Mezzanine Management. The data supplied for the report has been compiled by Initiative Europe; all details have been confirmed, where possible, with the mezzanine providers involved in the transactions.

For further information on this and other research products compiled by Initiative Europe please contact: Jules Longhurst, DL +44 1737 784 213, Email JLonghurst@initiative-europe.com

• Tweet  
• Facebook  
• LinkedIn  
• Google plus  
• Send to  

• Topics
• France
• Consumer