Adapting for survival

With extremely low default rates and a favourable risk-return ratio compared to other asset classes, Europe's leveraged finance markets have attracted a huge influx of investors in the last two years. Amid unprecedented market liquidity, arrangers have been able to invent new layers of debt for sponsors, which now have a whole range of subdebt tranches at their disposal.

The high-yield bond market has continued to mature, while sponsors can also now obtain longer-dated subordinated, or stretched, senior debt, second lien tranches and junior and senior PIK (payment in kind) loans and notes. “Life is extremely challenging for specialist mezz funds now, with returns at historically low levels and an inadequate supply of paper. There is plenty of new capital around and sponsors have a variety of subordinated debt products, and providers, to choose from,” says Simon Tilley, assistant director at Close Brothers Corporate Finance in London.

However, to date, mezzanine has in effect been supplemented, rather than eroded, by the other sub-debt products. 2005 was in fact the best ever year for mezzanine volumes and, judging by the first quarter of 2006, this year could exceed even those record highs. According to S&P's LCD, after a record-breaking €8.9 billion of mezzanine was raised for European LBO financings in 2005, 2006 kicked off extremely strongly with a volume of €2.7 billion. This is higher than any other first quarter on record.

For all but the very largest LBOs, mezzanine often wins out over bonds as sponsors' sub-debt product of choice in Europe. S&P's LCD shows that 12.6 percent of the first quarter's European LBOs had mezzanine, compared to just 1.8 percent with high-yield bonds, versus 9.4 percent mezzanine and 2.8 percent bonds in 2005 and 9.7 percent mezzanine and 3.8 percent bonds in 2004.

This is in part because many sponsors prefer the privacy of mezzanine, which can be discreetly placed without requiring a public roadshow. “Many sponsors prefer the private nature of mezzanine, which is less likely to be traded and does not involve the public reporting of high-yield bonds,” says Christine Vanden Beukel, senior managing director at GSC Partners' European arm in London.

Also, many sponsors favour the product's stability. The far more liquid high-yield market can be very volatile, with prices fluctuating widely in line with investor sentiment. The market has periodically shut down, leaving some sponsors wary of relying on it. Bonds also have onerous prepayment penalties, so sponsors planning a swift recap or exit will usually opt for mezzanine instead.

Although a few years ago, sponsors had to go the high-yield route for most large LBOs, mezzanine is now a real option for all but the largest jumbo deals. As more and more investors have entered the market, deal sizes have soared, culminating in Gala's £460 million mezzanine tranche in November. Most arrangers say they could easily syndicate €1 billion of mezzanine for a single deal in Europe today.

Meanwhile, although second lien has become an entrenched market feature in the last 18 months, it has grown in tandem with mezzanine as an additional instrument, rather than an alternative. There have been relatively few senior debt and second lien-only structures, and most investors doubt second lien will seriously threaten mezzanine volumes. According to S&P's LCD, in the first quarter, while mezzanine represented 12.5 percent of total LBO debt – the highest level to date and up from 9.4 percent in 2005 – second lien represented just 3.6 percent, up from 2 percent in 2005. Similarly, PIK and other junior subdebt products are not expected to grow into major asset classes that could ever rival bonds or mezzanine.

INTRA-MARKET COMPETITION
Yet while the outlook for mezzanine as an asset class seems secure, life within the market has still become more challenging for the dedicated funds.

With its favourable value relative to senior debt, and a better security and pricing compared to high-yield, mid- to large-cap mezzanine has arguably become the most targeted part of the LBO debt capital structure.

Specialist firms – including ICG, Park Square, GSC, European Capital, AIG Mezzvest and captives Goldman Sachs and Lehman Brothers in the midto upper end and Mezzanine Management, Indigo Capital, Hutton Collins, Euromezzanine and Nordic Mezzanine in the mid and lower end – have had to watch as hordes of new investors have charged into their market in the past 18 months.

The bulk of the new investors are institutional, comprising CDOs, highyield, hedge and other credit funds. In addition, many banks have also ratcheted up the amount of mezzanine they can hold. With many more providers active, even the recent buyout boom has been insufficient to meet overall investor demand.

Such strong liquidity has driven pricing down to record lows. As more investors are buying across the capital structure, so pricing between highyield, second lien and mezzanine is converging. While this convergence creates relative value plays for some investors, there is no upside for those that concentrate mainly on mezzanine. For large or popular credits, mezzanine spreads have plunged to 8-8.5 percent, while for mid to lower mid-market LBOs, spreads are just 9.25-9.5 percent, down from over 10 percent a year ago.

Another blow for specialist funds, many of which have always required the inclusion of warrants to secure above-market returns, is the near-total demise of warranted paper for mid to large LBOs. Sponsors have been able to secure warrantless mezzanine due to strong demand from buyers such as CDOs, which are not set up to deal with the uncertainty of warrants.

Of even greater concern to specialist funds is the leap in leverage multiples. A significant change in credit quality is far more serious than falling spreads, as one bad default can obliterate the performance of an entire fund. As the risk-return profile has changed, many specialists are turning down opportunities. For some – especially some older firms, which are not under such pressure to ramp up – this means doing fewer deals. “Our deal completion rate is less than it was a year ago because we have declined more, due to leverage and pricing concerns,” says Kevin Murphy, a director at Indigo in London.

STILL GETTING ENOUGH
With so much competition for assets and the deterioration in pricing and structure, there has been some speculation that the specialist funds have been pushed out of their own market.

Yet the specialists themselves insist this is far from the case. Although there is more demand than supply of deals, they say this is mostly hurting the newer market entrants. “There's been a lot of talk about specialist funds being pushed out by all the new investors. But in reality, sponsors and arrangers are still showing us most of their deals,” says Murphy.

Firstly, the extraordinary growth of the market in the last few years has helped maintain most specialist funds' deal supply – even while they have become pickier. “We are being very selective at the moment, so our market share has no doubt fallen. However the market has grown enormously in the last couple of years, so in absolute terms our deal volumes are holding up well,” says James Davis at ICG.

“With so much competition for assets, no-one is in clover at present. But as the market has grown so much and as many sponsors still want us in their deals, we are getting as much paper as we need,” agrees GSC's Vanden Beukel.

Indeed, many sponsors prefer to have specialist funds as lenders than a large group of new, unpredictable investors. Some sponsors are tempted by the cheap pricing that hedge funds offer, but there is also the perception that many hedge funds are not relationship orientated. “A high proportion of our mezzanine deals are still sold to specialist funds. Their enduring importance to many sponsors – because of their credibility as holders of assets and because they have worked with us in the good times and the bad – should not be underestimated,” says Andrew Golding, banking partner at 3i.

Many sponsors need to have predictable, long-term holders on board – especially if they plan to push through swift recaps. With leverage levels so high and a rise in restructurings expected, having amenable lenders is even more important today. The relationship angle has therefore become a competitive advantage that specialists have been able to play up to great effect.

Specialist funds also say they are still getting enough paper because, unlike many new investors, they negotiate their takes directly with sponsors. Banks have been underwriting mezzanine for the last five years, but the specialist funds still approach the sponsor very early on to discuss distribution, reinforcing their foothold in a way many newer investors cannot. “Specialist funds never just wait for the arranger to sell them paper. We are in constant dialogue with sponsors from day one,” says GSC's Vanden Beukel.

Relationships with banks, as well as the arrangers' strategy, are also crucial, however. While some arrangers like to have diversity, others still prefer to sell large tickets to just a few specialists. Almost without exception, specialists seek a key role in restricted clubs and shy away from syndicated transactions, to ensure they receive sizeable tickets. “Most specialist funds like to have a lead role and are not interested in being one of 10 lenders alongside hedge funds in a very highly levered deal,” says GSC's Vanden Beukel.

Where possible, specialists also avoid the most competitive part of the LBO market – deals with an enterprise value of €1 billion to €1.5 billion. This space has seen the greatest influx of new investors, as hedge funds and CDOs are attracted most by large, liquid deals.

With the exception of the very big ticket firms such as Park Square, which also tend to avoid this space by sticking to deals over €2 billion, most specialists were set up to focus on the midmarket. Large syndicated deals are a new phenomenon resulting from the market's recent expansion. “We avoid large deals and have not followed the market up the size chain. We've left that to newer investors,” says GSC's Vanden Beukel.

DARWINISM
Yet the specialists have not maintained their standing without also adapting strategically to remain competitive and sustain returns. “Specialist firms have kept apace with innovation and in many cases driven it. Most can now provide everything north of and including equity and south of senior debt and have been proactive in delivering what we need,” says 3i's Golding.

Most specialists have broadened their investment criteria significantly. Although most of the older funds – with AIG MezzVest a notable exception – have traditionally required warrants, now all will buy warrantless paper. Most still aim to get some form of equity – be it pure equity or an equity-type component, or junior or senior PIK – but all will now take on genuinely warrantless for the right deal. “Even specialists that were resistant initially have started buying warrantless paper in the past year. They have had to adapt to survive,” says GSC's Vanden Beukel.

Also, although some specialists regard second lien as underpriced mezzanine that does not fit their return hurdles, others will now buy it in a strip with mezzanine and PIK. “Buying a vertical strip of the debt capital structure is one strategy we've seen investors employ in an attempt to persuade arrangers to give a better mezz allocation,” says Michael Small, a founding partner at Park Square Capital.

For some, moving with the times has also meant doing much smaller LBOs than before. As smaller deals still tend to carry warrants and have higher pricing and lower leverage than larger ones, this strategy is deemed increasingly attractive.

Others firms have diversified by creating CDOs that can invest in senior debt and high-yield bonds. One or two of the big funds are selectively attempting a more aggressive approach, going head to head with arrangers by bidding to sponsors to underwrite mezzanine in order to control fees and distribution.

Some funds are also investing away from conventional mezzanine, providing more sponsorless capital for expansion, acquisitions or general corporate financing or entering new regions such as Central Europe. Yet others are considering adding or significantly increasing the leverage in their fund, so as to give them more firepower and enhance flagging returns on equity.

It remains to be seen whether the various tactics employed will remain enduring strategies even after the market has peaked. The downturn, when it comes, should see at least some of the hot money drain away, while leverage will fall and pricing should rise slightly. “The market is tough at the moment, but credit markets are cyclical and current conditions will not persist,” says ICG's Davis

Although most specialists' insist that neither their dealflow nor their returns have been hit too hard by the ultra-competitive market, a more conservative lending climate would be unanimously welcomed by all.

This may be proving elusive, but most firms remain upbeat. Total returns are coming down, but rising interest rates have gone some way to offset the drop in contractual spreads. “Some mezz funds' returns are falling, as pricing has dropped and most are doing slightly fewer deals,” says Murphy at Indigo. “However, rising LIBOR rates have helped counteract the fall in mezz pricing. So although given the point in the cycle, things are a bit tougher for mezz funds, it is far from a catastrophe.”

Crucially, the relative value of mezzanine against other asset classes is still very favourable. Although specialists may not achieve the same returns as two years ago, most are still looking at IRRs in the 14-15 percent bracket, combined with a good security package. Concludes Vanden Beukel: “The risk-reward trade-off of mezz relative to other asset classes is still extremely attractive and the default rate is still very low. The fact that we've just raised a €1 billion fund shows how optimistic we are about the market and our position in it.”