A Pyrrhic victory?

Limited partners got what they wanted from a successful mezzanine shop recently – but will their actions ultimately prove detrimental to returns?

GSO Capital Partners, a successful mezzanine fund manager owned by Blackstone, changed strategy for its second fund – because LPs asked it to.

A majority of limited partners demanded the firm get rid of its ability to make private equity investments from its mezzanine funds – and despite opposition from other investors, it complied.

GSO successfully closed its second mezzanine fund on $4 billion earlier this year, helped by a strong track record (its $2 billion debut fund was generating a net IRR of about 15 percent) and LP-friendly terms. For example, the fund has a ‘European-style’ waterfall distribution structure, under which the GP does not start to collect carried interest until LPs are paid back all capital plus an 8 percent preferred return.

However, most LPs also requested that the firm stick strictly to mezzanine investments, and knock off the small slice of equity exposure the team had been able to build into the debut fund.

While this portion of the fund was too small to make a huge difference to performance, the lack of private equity deals in the second fund could bring down the return slightly, according to LP sources not happy with the change.
Generally, LPs were concerned with having a hybrid mezzanine and private equity fund in their portfolio, sources said. They preferred a pure mezzanine fund that they could put into a specific credit allocation in their portfolios.
LPs like mezzanine for its “high current yield, where you sit on the balance sheet, [and] the risk adjusted return, which is powerful in a slow economic growth scenario”, one industry source told PEI recently.

The loss of the private equity focus in Fund II resulted in a big loss for GSO: Timothy White, a senior managing director at Blackstone who focused on the private equity exposure in Fund I, decided to leave the firm. White has decided to form his own mid-market private equity-focused firm instead, according to a letter the firm sent to its LPs.
White had been with the firm since the beginning, and had helped juice the fund returns with his equity focus. Only time will tell whether LPs made the right choice by forcing out this part of the strategy…