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Nordic mid-market mezzanine’s malaise

Debt markets in the Nordic region
Mid-market mezzanine has been all but entirely squeezed out of the Nordic private equity space
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The mid-market for mezzanine in Nordic private equity has come under increasing pressure from direct lenders and aggressive banks, to the point where the product is struggling to survive. Mikkel Stern-Peltz gauges the threat level

Mid-market mezzanine provider Nordic Mezzanine recently revealed to unquote" it has suspended efforts to raise a fourth fund indefinitely, due to the difficult conditions in the Nordic market for mezzanine finance. Having closed its previous fund in 2010 and completing its last deal in March 2015, Nordic Mezzanine's decision is symptomatic of a mid-market where dealflow for the subordinated debt instrument has all but dried up in recent years, according to unquote" data.

"We took some soundings of the market and the feeling is that the position of traditional mezzanine providers is somewhat squeezed on the deal side at the moment," Nordic Mezzanine CEO Vesa Suurmunne said at the time. "The pressure has mainly been coming from direct lending funds and banks in the Nordic area which are currently very aggressive, compared to those in continental Europe."

Though the firm says it is not winding down and may return to market at some point in the future, that point seems quite far off given the current state of play of Nordic debt and the underlying macroeconomics.

Difficult conditions
In addition to what is the lowest central bank interest rate environment in the world economy, there has also been an increase in the number of alternative debt providers and unitranche lenders. Coupled with a traditional lending market dominated by a handful of very relationship-focused banks with capital to deploy and aggressive strategies to do so, it is difficult to see where mezzanine providers fit into the region's core mid-market.

Partner and co-founding member of debt advisory firm Marlborough Partners, Gurjit Bedi, takes a stark view on mid-market Nordic mezzanine: "That market is virtually non-existent, in the pure form of mezzanine. Nordic mezzanine funds are in a bit of a no-man's land. Mezzanine will typically be in a mid-market deal and for most deals there really isn't an opportunity for mezz because senior leverage is pushed out at higher attachment points and is competitive, and sponsors would rather put in the extra equity. They're also having to compete with the unitranche product as a one-stop-shop solution."

But even unitranche is finding limited traction in the Nordic market, according to Jan Wiklund, a partner with Nordic small-cap and lower-mid-market debt fund Armada Mezzanine. "There have not been too many unitranches in the Nordic region since the Lehman crisis," says Wiklund. "There are a handful of players looking to provide unitranche, but only one or two handfuls of larger transactions have been completed. There are more today than five years ago, but it's a small market because of the large appetite of the Nordic banks."

In the top end of the market, Bedi says mezzanine has generally been supplanted by second lien, PIK or an increased proportion of senior debt. He suggests some Nordic banks do not have appetite to entertain mezzanine in the debt structure, instead preferring to push an all-senior package: "That's because in the restructuring cycle it's just one more party to deal with at the table and some select lenders have had bad experiences."

Because of the competitive nature of the Nordic debt market where the sponsor has the upper hand, lenders have become increasingly likely to take pure cash yield instead of cash/PIK combinations or equity kickers typically favoured by mezz funds.

Unreachable returns
While some European mezzanine funds may have a flexible mandate that allows them to participate in unitranche or second lien structures, a major hurdle for the continued survival of mezzanine funds is the relatively high return requirements of LPs, which can't necessarily be met by deploying capital in unitranche transactions. Direct lending funds operating in the same region generally have lower return requirements and are therefore able to compete on more favourable terms with banks and other alternative providers, further pressuring the mezzanine-focused providers.

The average yield target for mezz is typically in the 11-12% range, while for unitranche it is in the 8% region. According to Armada's Wiklund: "If you compare the market with six or seven years ago, when base rates were significantly higher, it is clearly a different interest rate environment today, and that would for sure have had an influence on your contractual return."

High returns from mezzanine funds seemed achievable in the last fundraising cycle for the Nordic firms, but the unwavering low-interest environment has seriously hampered mid-market vehicles in hitting their targets. Nordic Mezzanine's most recent fund was a €320m vehicle closed in 2010 and such a size became difficult to effectively deploy when the mezzanine product's popularity waned in the years following as competition increased.

No room to manoeuvre
"The Nordic region probably has the least space in Europe at the moment for mezzanine, and that probably rings true to why someone like Nordic Mezzanine isn't raising a new fund," says Bedi. "They would have found it challenging deploying their capital in the region in the last cycle and it's not unsurprising that with a high yield and upside requirement from an investor like Nordic Mezzanine, there really isn't a lot of space in the market."

Though the Nordic mid- and large-cap market for mezzanine has been squeezed out, the lower-mid and small-cap market still sees some activity. Finnish GP Armada Mezzanine held a final close for its most recent fund in May 2015 after a year on the road, raising €103m. The fund provides mezzanine and unitranche funding, with an approximately 50/50 split between the two debt types.

The Nordic region probably has the least space in Europe at the moment for mezzanine, and that probably rings true to why someone like Nordic Mezzanine isn't raising a new fund" – Gurjit Bedi, Marlborough Partners

"Mezzanine does exist in the lower end of the Nordic market," says Wiklund. "There are not too many players up here and all of us tend to do between one and five deals per year, each. That means there's not a huge market to speak of, and it's an opportunistic market where there are people providing smaller unitranche and mezzanine."

Armada's current fund is close to 60% invested and Wiklund says it is on plan to hit its return target, having not been substantially hindered by the market conditions prevalent in the larger end of the market. "Of course, if you have a €500m fund, you're looking to deploy between €30-50m per transaction in mezzanine," he says. "That would be difficult to accomplish because of the competition in the larger deal space, which is greater than the lower end."

In the view of Marlborough's Bedi, the firms that do not evolve beyond strict mezzanine and unitranche deals face an uncertain future: "There is a chance of survival for those who evolve on the subordinated debt landscape, but, for those who cannot evolve and deploy their capital, there will be question marks about whether they will be able to raise a new fund."

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