Cash in the system

Europe's mezzanine market is flush with capital, and more investors are looking to gain access. Philip Borel finds out what market practitioners make of it all

Most structured finance professionals active in European acquisition finance agree that the market is currently at a peak in terms of competitiveness.

To equity sponsors operating in Europe's increasingly buoyant buyout market, this is obviously good news. They report that although the leading debt providers' credit analysis remains rigid, getting transactions funded isn't the challenge it used to be. There are plenty of reliable sources to choose from.

This ready supply of capital has its dangers though. Sponsors, for one, need to take a disciplined approach, as it is all too easy to saddle a company's balance sheet with more debt than is good for it. According to market sources, such restraint is not always being exercised.

Christine Vanden Beukel, a director at London-based independent mezzanine specialist GSC Capital, says: “Capital structures are typically not built to accommodate much bad luck. You need a bit of wriggle room for when problems occur, otherwise it quickly becomes a downward spiral for the company, management and the investors.”

However, the potential pitfalls of excessive leverage aside, sponsors obviously relish the fact that when discussing terms of a funding package, they often find themselves negotiating from a position of strength, as lenders looking to deploy capital are having to make significant concessions on terms and conditions – for if they don't, somebody else will.

This is why the debt providers tend to be more circumspect in their assessment of where the market is headed. Providers of subordinated debt, or mezzanine capital, are no exception. Their bone of contention is not so much that one particular type of lender, or a certain source of capital, is behaving particularly aggressively and to the detriment of everybody else. Rather, it is felt that the presence of a multitude of players jockeying for position, in a market where dealflow, although decent, is distinctly finite, is what is making life tricky for most participants.

“Cash in the system is our biggest competitor by some way, be it from banks, CDOs and institutions,” says Tom Attwood, a director at Intermediate Capital Group Plc, the London-listed specialist provider of subordinated debt, which in April closed Europe's largest dedicated mezzanine structure to date, a leveraged fund capitalised at €1.5 billion.

The hunt for yield that is presently driving capital into the mezzanine market is changing its underlying characteristics at the same time. As Robin Menzel, a partner at London-headquartered independent investment bank Augusta & Co, points out: “There is too much money in the market at the moment. While the message from mezzanine fund managers is ‘bring us deals, deals, deals’, debt to equity ratios are creeping up, and returns are compressing.” Menzel estimates that in today's environment, mezzanine funds should be expected to return beween 12 to 15 percent, down from approximately 18 to 20 percent in the late 1990s.

Market conditions vary considerably between the different segments of the buyout market in Europe. The large LBO segment, described as ‘hyper competitive’ by a senior professional at a non-captive mezzanine house in London, is essentially controlled by an elite group of banks that the leading equity houses rely on. These institutions are expected to arrange the very large funding packages comprising both senior and subordinated debt that are needed to finance multi-billion euro LBOs.

Able to utilise their large balance sheets and having honed their credit assessment and syndication skills, the leading market makers such as RBS, Barclays Capital, HBoS and others essentially lead a pack of around 30 banks capable of taking meaningful positions in such sizable transactions. Pricing is said to have remained relatively flat in this part of the market, although warrantless mezzanine has largely disappeared from view as a result of the step-up in supply.

The mid-market, where the independent specialists such as ICG, GSC Partners, Mezzanine Management, AIGMezzvest, Hutton Collins and Indigo Capital as well as a number of regionally focused providers such as Helsinki-based Nordic Mezzanine and Euromezzanine in Paris pursue the bulk of their deal flow, is somewhat less crowded. Because the big banks tend to focus on the big transactions, boutiques stand a better chance of securing lucrative arranger mandates here. Furthermore, prepayment protection and equity participation are more common in medium-size deal structures, and leverage multiples are also somewhat less aggressive.

That said, accounts of a recently completed mid-market transaction in the UK where close to a dozen debt houses elbowed in to get a share of a mezzanine strip of just £35 million suggest that competition in this part of the market is also becoming more intense.

Estimates of the subordinated debt market's current size vary, but most participants expect that bar any unforeseen external shocks destabilising the buyout market, between €3.5 and €4 billion will be invested in Europe this year.

BIG DEALS, SMALL DEALSEuropean mid-market transactions offer mezzanine investors attractive risk metrics relative to large LBOs, according to London-based merchant bank Augusta & Co.

Big deals Mid-market deals
(>€25om) (€50-25 om)
Deal flow Auctions Often proprietary
Sponsorless/issuer direct
Placement Syndicate, book building Direct private placement
Leverage Average senior lev 3.6x Max. senior lev 3.25X
Average total lev 4.6x Max. total lev 4.5X
Mezz structures Warrantless mezz the norm Kicker (warrant or
straight equity)
Minimal prepayment protection Prepayment protection
& backstop
Mezz pricing L+10-12 L+13-17
Increasing homogeneity of terms ‘Hair’ and/or complexity
gets paid for
Mezz competition Stretched senior, second ranked loans Smaller high yield
placement will come
High yield is issue size >€125m High yield private
placement need mezz style structure protection
Pref/equity like PIK depending on sponsor No PIK, but preference
shares possible
Minimum equity 25-30% Minimum equity 30-35%

This institutionalisation of the private debt market in Europe, and with it the resulting emergence of a secondary trading environment, are likely to have a profound impact on the market as a whole.

For a start, while potentially adding to the capital overhang that already exists at this point in the cycle, in the long term secondary loan trading will allow investors to risk manage their portfolios more effectively.

Moreover, the emergence of an extra layer of institutional capital with a risk and return profile somewhere between conventional mezzanine investors such as CDOs and distressed specialists is likely to allow portfolio companies and their equity sponsors to build more stable capital structures going forward.

This should be good news to sponsors in particular, who tend to be sensitive as to who invests in their transactions. The presence of CDOs in a debt structure for example is often seen as a mixed blessing, as CDOs tend to look for a way out the moment there are signs that an underlying business might not be performing as planned. Historically in Europe, their paper then didn't have many places to go, so prices would drop quickly until the vulture funds would move in and buy at big discounts. The formation of an institutional market place where more investors participate along a broader risk spectrum is likely to change this pattern.

However, for the time being the amount of uninvested capital looking for a home in Europe's buyout market remains the immediate challenge. Most practitioners agree, however, that supply and demand of capital are likely to return to a state of equilibrium within the foreseeable future. What could help bring this about is news of a leveraged company suffocating underneath an excessive debt burden, particularly if interest rates pick up.

At a London roundtable held by Private Equity International in January (see PEI 22), the leveraged finance professionals attending agreed that despite 2004 promising to be a strong year overall, a ‘big and high profile’ deal was likely to come undone at some point this year. The implication was clearly that for the market as a whole, this wouldn't be a bad thing. Slightly less exuberance is seen as beneficial, provided the market isn't dealt an overly severe blow.

Overall, the expectation is that while an adjustment is both welcome and inevitable, Europe is going to experience a relatively soft landing. Says Vanden Beukel at GSC: “People sometimes forget that credit markets are inherently cyclical. The current cycle in Europe won't last, but there won't be as big a correction as in the US, which is headed for more pain.”