Mezz gets set to face challenges

(This article was taken from Private Equity Europe, the pan-European publication from the publishers of unquote")

At the end of what can only be described as a turbulent first quarter for European private equity, the main issue in the buyout market continues to be the scarcity of activity. Aside from the ongoing problem that vendor/buyer price expectations remain out of kilter as a result of poor trading visibility - which is obviously also dampening the confidence of potential purchasers - the main difficulty continues to be the limited availability of debt financing, as banks go on de-leveraging battered balance sheets.

Off the back of this there is currently fervent discussion of attractive opportunities for mezzanine houses in the coming months. Squeezed in the boom years by the appetite of major banks to underwrite large and cheap leverage packages, as well as the emergence of new intermediary products such as second lien; many observers are now predicting that the product will see a sharp increase in dealflow as buyout houses look to fill the liquidity gap.

From lenders to sponsors
But just like their private equity counterparts, mezzanine providers are currently being forced to spend much of their time working on a tricky portfolio of legacy investments from the pre-crunch vintage. Indeed, there is a rich stream of anecdotal evidence attesting that many firms are coming to restructurings with their mezz strip so far under water that they are simply walking away - or, worse, being cut out of the process altogether through back-door pre-packs. "There have been several cases where the mezz strip has been completely written off in restructurings; in some cases for a small piece of equity and in others for nothing at all," confirms Philippe Minard of Mezanove.

However, according to Cécile Levi of AXA Private Equity's mezzanine team, much of what is being talked about in this sense does not represent the activity of true mezzanine players. "You have to make a clear distinction between real mezzanine investors, who have fewer cash constraints and are much more orientated towards the private equity model of supporting businesses, and others that got into the space in the last few years such as hedge funds or CLO."

This echoes the sentiment of many mezzanine professionals, who are currently discussing the need for subordinated lenders to follow the lead of private equity sponsors (whose investment will, too, likely be under water) and stump up new money to stay at the table. Rather than doing so as an extension to the original loan, this cash will allegedly be used to buy an equity stake in the business, with the hope that the richer returns on offer will not only re-coup the original investment but offer the opportunity for some profit. "If you are convinced that the business in question has a future and you want to protect your investment then you need to be ready to take some controlling interest. You can't live in these times as a subordinated lender without being prepared to do so," Minard asserts.

Risk related rewards
Though undeniably a necessary action to avoid effectively sitting by while the incumbent portfolio crashes, realistically this will not prevent a drop in the anticipated performance in these investments. In fact, with trading visibility so poor and the economic outlook - despite the swathes of fiscal stimulus money - remaining bleak, some of these new cash injections will likely end up merely compounding losses. In order, therefore, to keep the current fund profitable and maintain track record, there must also be a focus on exploiting the anticipated deal opportunities as and when they arrive.

But there remain questions over the scale of the dealflow that will come mezzanine's way. It is worth noting, for example, that the expectation of a rise in attractive investment opportunities has been around since the credit crunch first emerged in late 2007. Since that point, the volume and value of buyouts involving mezzanine has actually dropped considerably (see chart).

This, though, is largely due to the overall drying up of activity in the market and does not reflect the extent to which conditions have moved back in favour of the mezz houses. "The squeeze over the boom years was always one of terms and conditions and not volume. Now is a great time for us in relation to terms and conditions as demand for the product is up - there is just much less volume," explains Rory Brooks of MML Capital Partners.

Indeed, Levi claims that for true mezzanine players in the core small- and lower mid-cap areas of the market, the squeeze that happened was not that manifest in terms of pricing, but was much more related to the risk/reward ratio of the deals. Similarly, though pricing trends have now turned back in favour of the product, there are suggestions that the scale of the rise in pure percentage terms is not as large as might be thought, and nor is this what is making the product attractive again. "Everything is done very much on a case-by-case basis at the moment and there is no consistent theme. The trend is definitely better for mezzanine but this is not all that evident in pure pricing terms and is much more related to our position in the capital structure: we are taking much less risk for better reward," comments Minard.

Capital constraints
Given that many hitherto safe asset classes have turned sour in the last 18 months, it is no surprise that LPs and GPs alike are targeting a move into mezzanine now that the risks involved have declined. There have been many rumours over the past year regarding private equity managers launching dedicated mezzanine vehicles, and both LP sentiment surveys and discussions with placement agents suggest that such funds are part of a select group of offerings that could secure capital in the current climate.

Moreover, given that such funds are often fairly moderate in size, even the relative lack of dealflow may not pose a substantial threat to their success. "Considering the shortage of senior debt and the average size of core mezzanine funds, there doesn't need to be a huge volume of deals for capital to be deployed effectively," says Levi.

That said, the fact that mezzanine is clearly not immune from the problems plaguing the rest of the market, coupled with more general LP liquidity concerns, means that raising funds is still likely to be an uncertain and time-consuming task. Furthermore, many mezzanine funds actually leverage their fund with bank debt to maximise capital for investment without having to raise huge sums of money from limited partners. This source of finance, along with that used on a transaction level, has unsurprisingly dried up. "There are huge needs in the corporate world that banks - particularly those that have been part-nationalised - are under pressure to meet and mezzanine is going to be far down the priority list," Minard explains.

The combination of a limited pool of capital, the pressure to make the model work without recourse to leverage, and the dearth and questionable quality of deal opportunities currently may serve to detract those considering a shift into the space. According to Brooks, such concerns will also push LPs to focus ever more on track record and specialism, echoing the environment in other areas of the market. "There is a lot more curiosity about the space but everything is track record now. Questions are being asked as to whether now is the time to fundamentally change what you do."

Ground zero
Assertions that the coming months are going to be a golden ago for mezzanine providers are perhaps overstated. Far from being insulated from the current crisis, mezz players are suffering similar traumas with legacy portfolios as private equity firms, and new deals are going to be equally hard to come by. Additionally, with the LP capital pool reduced there will likely be a renewed focus on track record, putting increasing pressure on these concerns.

However, the product is witnessing a return to fundamentals. Terms and conditions, particularly in relation to factors of risk, have returned to levels common pre-boom and, for those that can invest wisely, there could be profitable opportunities to be exploited. Furthermore, with the lessons from the credit crunch likely to linger in the memory for a long time to come and the banking adapting to a new wave of regulations, mezzanine houses are going to see these more favourable conditions pervade. "Mezzanine won't get squeezed out like it did in the boom years again. Banks will lend in smaller quantities and in areas they know; they won't be able to go about their business in that industrial manner," Minard asserts.

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

• Topics
• Financing
• UK / Ireland
• DACH
• Nordics
• France
• Southern Europe
• Benelux
• CEE
• Industrials