Not mezz-ing around

European mezzanine saw a drop of 30% last year compared to 2006, according to research by unquote" and Private Equity Insight featured in the European Mezzanine Review 2008. However, as the credit crunch hit, institutional investors began to desert the second lien and CLO markets that had crowded the traditional mezzanine space, which means that happy days are on the horizon for mezzanine (see graph, European LBO junior debt issuance, opposite). "Pre credit crunch, around 60% of all investors that invested in debt were CDOs, CLOs and hedge funds. Now that these have, to a large extent, deserted the market, there is a large gap that needs to be filled," says Martin Eriksson, head of Intermediate Capital Group's (ICG) Nordic team.

Mezzanine is again viewed as an option to fill this space between senior debt and more junior debt forms, meaning good news for mezzanine funds. "There has been a definite come-back of mezzanine post credit crunch," says Markus Sjoholm, senior partner of CapMan's buyout team. Pekka Sunila, executive director of Nordic Mezzanine, agrees: "Banks are expressing caution and are being more selective on which deals they are willing to finance. We are definitely getting more calls now than we did last year." Banks have also become reluctant mezzanine providers. "Some banks have withdrawn completely from providing stretched senior debt or mezzanine from their own balance sheets, increasing demand from mezzanine specialists. Availability of warrants has again become more common as well," highlights Pertti Nurmio, senior partner of Eqvitec Mezzanine.

Senior debt has also become more costly, but in order to maintain a healthy deal-flow, buyout firms need to bear the additional costs or turn to other financing alternatives, and mezzanine is a product that is increasingly being used to top-up leverage proportions. "Using leverage has become more expensive, terms and conditions are tighter and equity proportions have increased, and thus mezzanine has increasingly become popular," says Petri Sandell, partner of EQT Expansion Capital.

Tentative come-back

Even if the signs are pointing in the right direction for mezzanine, the comeback will be less dramatic in the Nordics than in other regions where banks had been more aggressive in the run up to the credit crunch. "We did not notice the competition as much from second lien debt. Nordic transactions are usually not in the deal-bracket where this junior debt product has been used," explains Sunila. The Nordic banking community has helped to support a more stable leverage market, as Sandell concurs: "The local banks have been more conservative and they continue to support LBOs very well."

But even with a relatively healthy banking market, a considerable contraction can be seen post credit crisis. The deal activity has seen a massive drop from EUR8.1bn in Q1 2007 to EUR2.2bn this year (see graph on cover). However, the volume of deals remains fairly constant with 27 deals completed in Q1 last year, compared to 24 in the first three months this year. Sandell explains that the largest ticket of LBOs is currently frozen, while the smaller deal sizes paint a much more optimistic picture, but even here investors feel the pain. "It is said to be business as usual in the mid-market, but even here we have noticed a tightening of leverage, meaning an increased need for mezz," explains Sjoholm.

The leverage multiples have also come down and the equity proportion in a transaction has been pushed up. "Currently we are seeing leverage multiples at 4x times EBITDA and mezzanine levels are 1.5x times on top of that in a typical Nordic transaction, which is a 1.5x fall of the leverage multiples pre credit crisis," says Sunila.

Vendor price expectations are also a major concern. For over six months sellers have been slow to react to the correction in prices after the leverage melt-down, but they still won't budge, creating a stalemate in the market. "Buyers are keen to buy, while sellers still have a wait-and-see approach to make sure that they are not selling below par," Sunila says. "We have also seen that the prices still have not come down that much," agrees Eriksson. Thus, it seems like the dry-spell is set to continue, which can affect the demand for mezzanine as well.

That said, the demand for mezzanine and junior debt products remain strong in a more troubled environment. "The supply side for subordinated debt has gone down, while the demand remains the same, so there is an explicit need in the market to meet this demand," says Sandell.

Competition

Even if mezzanine has less competition now than it had before the credit crisis, there are still factors that affect the popularity of the product.

"In smaller buyouts, our toughest competition was previously from aggressive lending from certain banks or other financial institutions providing warrantless subordinated loans," says Nurmio. At the larger end of the spectrum, London-based banks assembled aggressive structures to get larger slices of the pie. "The more aggressive banks are now licking their wounds, leaving more room for the Nordic banks that traditionally have been investing on a club-deal basis," says Eriksson. He explains that the simpler structure of five or six banks investing together with a similar strategy has made the process more straightforward than in larger and more complex debt structures where there have been multi-layers of investors involved. Now things have changed and the hunger of these complex structures is no longer there. "Banks are simply more risk averse than they used to be," Sjoholm explains.

Recapitalisations have also been seen as competing with mezzanine and continue to be an alternative. With the debt market remaining relatively healthy in the Nordics, refinancings are still possible and GPs can be more inclined to do this rather than convert debt into equity with a mezzanine package. But this notion is disputed by Sunila: "Recapitalisations are still possible, but it is very difficult. The rules of the game have changed since the time when 'everyone' did a refinancing after 12-18 months," he says.

On top of this, the Nordic mezzanine market is still relatively small and immature compared to other European markets, bringing about its own limitations (See Mezzanine in the Nordics box, next page).

Boosted confidence

The Nordic buyout market has been one of the "winners" of the credit crisis and deal momentum has remained steady, even if deal values have decreased. "I believe the Nordic region will become a more popular place to invest going forward," says Sandell. Thus, it is expected that more international funds will enter the Nordic market due to the overall health of the region, creating increased demand for mezzanine to support deals.

The fundraising environment has also filled mezzanine providers with new confidence. LPs are forced to be more creative and include new fund types, which can mean that mezzanine can be on top of their wish list. It has been said in the market that mezzanine funds in fundraising have received a great deal of support in the market. With the credit crunch limiting buyout funds' activity, momentum stagnates and LPs seek to become more diversified. "In a tougher environment, mezzanine funds are increasingly interesting to reach the returns that LPs are seeking," says Eriksson. Nurmio concurs: "Investors seem to realise that there is now added momentum for mezzanine which historically has provided good risk-adjusted returns where defaults rates are low."

However, it is not all plain sailing for the Nordic market. With the uncertainty on the direction of the financial markets, the long-term trend is difficult to predict. "It fundamentally comes down to the development of the banking sector. If we see more write-downs, the market will continue to be sticky, even for mezzanine providers," Sunila says.

Even with a dark cloud hanging over the global economies, the Nordic mezzanine market has great hopes for the future. "Currently, we believe that the Nordic market has reached a sustainable level and activity will be positive. But it is naturally conditioned on how the global economy and debt market develops going forward, which is difficult to predict," notes Sandell.

It is also important to bear in mind the flexibility of the product which can be used in other areas outside LBOs, which also fuels mezzanine's popularity. "While volumes of buyouts have somewhat decreased, mezzanine is also a viable instrument for various other purposes like expansion financing, generation shifts, recapitalisations and restructurings amongst others, and therefore demand for the instrument is expected to continue," says Nurmio.

According to research by CEPRES, Center for Private Equity Research, an academic research consultancy, mezzanine tranches of up to EUR5m produce the best returns of 17% IRR and 1.6x money multiples. The larger mezzanine investments of above EUR40m produce less prominent results of 1.1x money multiples and 12% IRR. However, the story is reversed on realised deals where mezzanine tranches of above EUR40m produce an IRR of 40% and a money multiple of 1.4x.

- Martin Eriksson, head of Intermediate Capital Group's (ICG) Nordic team; Markus Sjoholm, senior partner, CapMan; Pertti Nurmio, senior partner, Eqvitec Mezzanine; Petri Sandell, partner, EQT Expansion Capital

Mezzanine in the Nordics

Historically, the Nordic market has been a small one for mezzanine. In 2003, there were only eight deals that contained mezzanine worth a total EUR212m, according to statistics by unquote", featured in the European Mezzanine Review 2008. However, in 2007 mezzanine featured in 23 transactions for a total value of EUR1.6bn, indicating demand in the market for the product.

The region's largest deal by far, the buyout of Danish telco TDC, contributed to mark 2006 as record year for mezzanine when total value totalled EUR1.7bn, up 64% from the year before, split over 25 deals.

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