Investors gorge on mezzanine debt

TIME WAS, NOT so long ago, that big buyouts necessitated a call on the high-yield bond market. How things change. At the beginning of July this year, CVC Capital Partners and Permira announced that they were buying the Automobile Association (AA), the UK car breakdown, insurance and finance business, for £1.75 billion ($3.25 billion). The financing package included a whopping £400 million of mezzanine debt arranged by Barclays Capital.

Charterhouse Capital Partners got similarly impressive support from mezzanine investors for its £1.35 billion management buy-out of Saga Group, the UK provider of products and services to the over-50s, raising £325 million.

Mezzanine finance, which combines elements of subordinated debt and quasi-equity, traditionally provided a thin extra layer of funding for deals sandwiched between the base of straight equity and senior debt on top. Now the filling is bursting out of the sandwich.

“Mezzanine debt is available in huge numbers,” says Nigel Ward, head of international finance at law firm Ashurst. Ashurst lawyers advised on the financing of both the Saga and AA deals. “Offer letters go out north of €400 million, which was unheard of, and the pricing is coming down to a level where some players are saying it is too low,” he says.

In the first three quarters of 2004, European mezzanine issuance exceeded €3.8 billion, compared with 2003’s total new investments of €3.2 billion. Bear in mind that, because the market is private, most statistics underestimate its size.

This summer, Robin Doumar left Goldman Sachs, where he was head of the European mezzanine finance group, to become managing partner of Park Square Capital, which launched a €1 billion mezzanine fund in October. “The true value is probably closer to between €4 billion and €4.5 billion,” he says. Fitch rated more than twice as many mezzanine facilities in Europe in the first half of 2004 as it did in the first half of 2003.

If the growth of the European mezzanine market is striking, so are the new ways in which mezzanine debt is being deployed. The most important sources of mezzanine deals this year have been secondary buy-outs and recapitalizations. But, critically, mezzanine now competes with high yield to finance bigger buy-outs. Last year, deals worth more than €100 million accounted for 17% of all European buy-outs, but drew on 42% of all mezzanine facilities. “Saga and AA were massive deals even by high-yield standards,” says Doumar.

Underpricing risk

There is some alarm at the increasing availability of mezzanine debt. In October, Intermediate Capital Group chairman John Manser publicly criticized the way that some buy-outs were being financed and the amount of money coming into the mezzanine market. He said that ICG was refusing to invest in highly leveraged, syndicated deals where mezzanine loan terms did not reflect risk.

“John Manser is right,” says Doumar. “You have to have a long-term view.”

There’s heavy competition to provide mezzanine debt. With no recent high profile European defaults, mezzanine providers see the opportunity for a relatively high return – say 11 or 11.5 basis points over cost of funds on a standard mezzanine deal of about €150 million.

Investment banks and commercial banks are keen on the asset at the moment, attracted both by its value relative to other subordinated debt and by underwriting fees. Boosted by its role on the AA deal, Barclays Capital was the most active lead arranger of European mezzanine in the first three quarters of 2004. RBS was in second place, arranging over €650 million-worth of mezzanine, according to Thomson Financial. Both banks target both high-value and mid-market deals. “RBS is everywhere,” says a mezzanine investor at an independent fund.

“When the banking environment is good, banks often want to lend a bit more debt for a longer tenor, and call it mezzanine or stretched senior,” says Adrian Lurie, executive at Indigo Capital, a mezzanine investor.

Traditional mezzanine investors such as ICG, AIG MezzVest, and mid-market independents such as Indigo or Mezzanine Management, are also growing.

Hedge funds pile in

In April, ICG closed a new mezzanine fund with equity commitments of €668 million. With gearing, ICG Mezzanine 2003 has cash resources of up to €1.5 billion. Park Square Capital has raised Europe’s largest independent unleveraged mezzanine fund. At Goldman, Doumar was responsible for European commitments from a $2.7 billion global mezzanine fund.

New investors are also entering the market – yield-seeking hedge funds and CDO structurers keen to get mezzanine assets on their books. Competition is driving down price. Hicks, Muse, Tate & Furst’s acquisition of UK breakfast cereal and food manufacturer Weetabix was financed in part by £120 million of mezzanine debt. The price of the facility was twice cut by 50 basis points, dropping from 10.5% to 9.5%.

Breaking the 10% barrier was too much for many of Europe’s more established mezzanine investors, and US hedge funds stepped in to fill the gap, along with some CDOs. As a US sponsor, Hicks, Muse was presumably comfortable with hedge funds providing the liquidity it needed. Some European investors take a different view. “There’s almost no secondary market in European mezzanine debt, but one will grow,” says one. “What do you do if you don’t want your paper in hedge fund hands? Are they investing in mezzanine for value creation, or because they have to?”

To put mezzanine to work in larger deals, borrowers and lenders are innovating. Saga’s mezzanine was split into a £250 million senior tranche and a £75 million junior tranche. If its junior mezzanine tranche is included, the AA mezzanine facility in fact totalled £475 million.

As well as tranching deals, arrangers and issuers are structuring them to target the new mezzanine investors.

Traditional mezzanine investors have taken their returns in cash, payment-in-kind (PIK) notes, and in warrants. These warrants are valued on the assumption that a bought-out business can be sold at a multiple of earnings in a few years’ time for an amount that will give the warrant holder a total return equal to the agreed mezzanine price. They get a potential equity uplift too.

Alternatively, they can forgo the warrants and settle for a fixed rate of return. Over half of all European deals are now done without warrants. This partly reflects the greater bargaining power of borrowers. It’s also a function of the trend to use mezzanine debt for recapitalizations.

“On smaller, first-time deals, you need some stability on the margin uplift,” says Fitch analyst Pablo Mazzini. “But when deals are recapitalized, some of that uplift has been taken, so you see more warrantless deals.”

The third factor driving warrantless mezzanine is the new demand from hedge funds and CDOs. The AA’s senior mezzanine was itself split into a warranted tranche and a warrantless tranche. “The AA deal is the classic bifurcation,” says Mazzini. “Within the same deal you have warranted and warrantless mezzanine catering respectively to old and new investors.” The Weetabix deal’s mezzanine was warrantless.

Warrantless mezzanine is less suitable for old-style mezzanine investors, which are structured like private-equity funds to make a return above their peers’. “We don’t disapprove of warrantless deals but we certainly don’t go out of our way to do them,” says Indigo Capital’s Lurie. “We can’t outperform unless a proportion of our income is based on deals going well.”

The rise of warrantless mezzanine could have longer-term consequences. Because of the amount of money chasing deals, leverage in European buyouts has been growing. Seven times ebitda is now reckoned to be the market standard (“seven-and-a-half is the new five,” as one banker puts it).

Using warrantless mezzanine in highly leveraged deals stores up problems. If the credit cycle turns again and private-equity firms start making losses, a significant number of deals could go into workout. If both borrower and lender share an equity interest in the survival of a business, they are more likely to do a deal to keep it going. Warrantless mezzanine removes that common interest. When a default looks likely, so does a stand-off.

“When you do a deal with extra leverage, the trade-off is that you have some sort of equity upside,” says Christiian Marriott, director, investor relations, at Mezzanine Management UK Ltd. “If you’re borrowing at seven times ebitda, warrants give you an alignment of interest.”

That alignment doesn’t just come into play when deals go wrong. If a business does well, a borrower can go back to its mezzanine lenders and ask for more money for a value-creating acquisition, for example. “In bad times and good times the guys with the warrants are more commercial in looking at the equity value,” says Lurie.

In June, Doughty Hanson & Co agreed to sell German car parts and repair company ATU to KKR for three-and-a-half times what it had paid two years earlier. “The mezzanine in that deal has outperformed the base case,” says Marriott. “That happened because there were warrants.”

Professional mezzanine investors also worry about what their newer counterparts are doing with the mezzanine debt they hold. While existing CDOs might have covenants that prevent them investing in lower-priced mezzanine, there are fewer restrictions on newer funds using mezzanine debt to build up leverage. Some say these funds are run by senior-debt professionals who have not seen how mezzanine debt behaves throughout a credit cycle.

“We don’t consider the bigger pieces of mezzanine that are being syndicated in the market attractive at the moment on grounds of leverage and pricing,” says Andrew Phillips, head of fund management at ICG. “That’s a very sweeping statement, and we are buying plenty of mezzanine, but there have been more grounds for caution this year than last year.”

Leveraging risky assets

ICG has about €5 billion of assets under management in sub-investment-grade debt, about €2 billion of which is invested in CDOs. Those CDOs invest in senior debt, leveraged loans, high-yield bonds or mezzanine debt.

“We don’t actually put an awful lot of mezzanine into our CDOs,” says Phillips. “Ten per cent to 20% is a pretty substantial bucket and that is a lot of mezzanine to find.” While ICG can use its own loans to back its CDOs, the majority of CDO managers are reliant on investment banks syndicating mezzanine paper to them.

ICG’s concern is that, if a CDO is typically geared up nine or 10 times, including mezzanine assets makes the whole product too risky. “You can see in the pricing that mezzanine is riskier than leveraged loans and high yield,” says Phillips. “Our philosophy is that the sexy bit of a CDO is the leverage, so you need the underlying asset to be quite boring. We don’t see many mezzanine assets out there that are safe enough to put into a fund that is geared up 10 times.”

The full value of warranted mezzanine is hard to translate directly into value in a CDO. “When the leveraged finance group rates mezzanine assets, it does consider warrants when analyzing the overall capital structure of the company. We use their issuer rating as an input in our CDO analysis,” says Marjan van der Weijden, senior director at Fitch Ratings. “But when we look at rating the debt of a CLO and mezzanine loans are included, we give no credit to the equity upside because it is an uncertain cashflow. The upside of including mezzanine assets in CLOs is mostly for the benefit of the equity investors who will potentially benefit from the extra yield.”

Conversely, CDO managers like mezzanine assets where cash pay and PIK notes have replaced warrants. “If there is compensation for the lack of warrant that comes in cash, and that cashflow is contractual and predictable, there might be a benefit,” says van der Weijden.

Although the presence or absence of warrants does not directly affect a rating, some investors worry that rating agencies, like CDO managers, simply don’t appreciate mezzanine debt’s extra risks. Where previously the rating agencies have specified a maximum size for mezzanine buckets of 25% of a CDO’s assets, they are now giving minimum limits.

“We haven’t spoken to the rating agencies about it in a while, but we do know that there are CDOs out here with minimum mezzanine buckets,” says one mezzanine investor. “This implies that, because they throw off so much cash, they de-risk the whole deal. But are investors getting paid for the extra risks?”

“This annoys the more professional mezzanine investors,” says one member of the leveraged finance team at a large London-based fund manager. “ICG’s is a very powerful message. We’d echo it.”

The arrival of hedge funds in the market is also worrying. Hedge funds are now active buyers of broadly syndicated mezzanine, which doesn’t apparently sit with their traditional strategy of buying relatively liquid assets using short-term, uncommitted money. “It does seem counter-intuitive that they should be investing in mezzanine,” says Phillips.

Demand from hedge funds and CDOs means that investment banks, which until recently would only structure and pre-place mezzanine debt, are more confident underwriting it. That magnifies the problem.

Historically, professional mezzanine investors have arranged, underwritten, and had the capacity to hold the bulk of mezzanine debt, and have controlled small mezzanine syndicates. When deals have threatened to blow up, they have been in a position to act quickly.

The market informally bases assumptions of default and recovery rates on the mezzanine assets going into CDOs on the performance of an investor like ICG, which has low default rates and, in particular, high recovery rates for its mezzanine investments over the past 15 years.

With investment banks syndicating mezzanine debt more broadly, the likelihood of getting through a workout successfully is reduced.

Increasing default risk

“With mezzanine being the riskiest piece of paper in a CDO, it’s crucial what default and recovery rates are,” says Phillips. “Now, if you syndicate far and wide, you might have eight banks in Paris and London, half-a-dozen CDOs, and hedge funds in LA, who will take far longer to work out a default. A senior bank with a problem asset is not going to hang about while the mezzanine syndicate sorts itself out.”

So when default rates rise, recovery rates will fall and the gap between mezzanine debt’s perceived and actual suitability for backing CDOs will get bigger, not smaller.

Even more contentious could be the inclusion of second-lien facilities, which some CDO managers think they can book as part of the senior bucket even though they are mezzanine debt.

The traditional mezzanine investors can still underwrite some deals. ICG was sole arranger and underwriter of e130 million of mezzanine financing when 3i bought French public transport operator Keolis from BNP Paribas, Vivendi, and SNCF in July. Because SNCF, the French public railway operator, still owns 44.5% of Keolis’s new holding company, it was a particularly complicated transaction.

“It’s almost a privatization. You needed to understand the risks involved,” says Christophe Evain, executive director, ICG. “It was interesting that there is still room for a mezzanine house to arrange a deal.”

But the banks are still a competitive threat, squeezing the independent mezzanine strip out of transactions and pushing warrantless mezzanine in larger deals. “That will probably restrict us to the mid-market,” says Lurie.

Against this background, the arrival of Park Square Capital is a positive development. Although it throws more money at the crowded top end of the market, its fund is unleveraged and Doumar and his team have a reputation for doing deals that are not too aggressively priced or risky.

“Park Square has probably called it quite right,” says one senior member of the investment team at another mezzanine provider. “The balance sheets of its institutional backers are crying out for even 11% returns, so in a way it validates the asset class.”

“We provide pure mezzanine, which is contractually subordinated to the senior debt but has a preference claim over the equity,” says Park Square partner Michael Small. “Some people are using the term mezzanine euphemistically, when they really mean stretched senior debt.”

Nevertheless, the purists will face new challenges as the European mezzanine market grows. “Local law issues mean it’s not atypical in a continental mezzanine deal for the credit support to look more like high yield than mezzanine,” says Ashurst’s Ward. “It is structurally, not contractually subordinated. That can be worrying.”

The growth of European mezzanine might level off, but it is unlikely to fall again as it did in 2003. LBO pipelines look healthy and demand is still increasing. “Sponsors who were not big users of mezzanine are looking to improve their return on investments,” says Small. “Mezzanine will be a bigger slice of what we think will be a bigger cake.”

Whether deal sizes will keep growing is more debatable. AA and Saga might not be templates for next year’s deals. “AA might have been a high-yield deal in a better high-yield market. This time next year, if someone has done a £700 million mezzanine piece, I would be surprised,” says Marriott. “The money is there, but not the deals.”

Although the market wants to see a correction, it cannot predict what form that correction will take.

Some hope that a few large deals going wrong will leave investment banks with underwriting positions that they can’t sell, forcing them to leave the market. At the very least, if leverage in Europe continues to increase over the next 12 to 24 months, a mezzanine syndication might fall through. “That could bring the market back to a more reasonable level,” says Evain.

Otherwise, a significant number of deals being done now risk going into workouts in two years’ time.

Even Andrew Phillips is reserving judgment. ICG did, after all, buy a large chunk of the AA deal. “We are cautious, but I’m not saying we’re right,” he says. “Everything feels likes it’s going to extreme levels and normally you’d see some sort of correction, but one is at risk of sitting on one’s hands.”

But with still more cash in the system, leverage increasing, and mezzanine returns going down, that may well be a risk worth taking.