In recent years, mezzanine finance has been eclipsed in Europe by the vigorous profusion of unitranche debt. Yet fans of mezzanine argue that the case for investing in it remains strong.

The simultaneously precarious but attractive properties of the market are asserted by Cyril de Galea, managing partner of Paris-based mezzanine specialist Indigo Capital. “Mezzanine has always been a niche, or ‘niche-y’, market in Europe, even though it is relatively large in the US,” he says. “I’m trying to achieve an equity-like return that can reach as high as the upper teens, but at low risk.”

Jeffrey Griffiths, principal at London-based placement agent Campbell Lutyens, echoes de Galea’s assessment that mezzanine is not wildly popular. For corporate deals, he says, “mezzanine is now a smaller piece of the pie than it was, though it still attracts interest from a group of investors”.

However, sceptics might ask just how attractive mezzanine can be if it has so signally failed to grow in Europe over recent years, whether for corporate or real estate deals.

When it comes to the property market, Martin Wheeler, co-head of Intermediate Capital Group’s UK real estate arm ICG Longbow, has an answer. Wheeler says that even now – or perhaps especially now – many lenders are wary of mezzanine, because of what has gone before. “The perception is that we are again getting towards the peak of the market after an extended period of recovery,” he says. “So lenders who have a memory of last time around – which is most lenders out there – are wary of high leverage, and they are also wary of mezzanine. That is, I think, a healthy sign.” When the last credit downturn hit, a number of mezzanine commercial real estate loans went bad.

Potential funders of corporate mezzanine are also wary at this point in the credit cycle. Muzinich, the credit specialist, has a mandate from its investors to make some mezzanine and second lien loans, as a minority of its overall book. Yet it has not fully invested this junior debt quota. Echoing Wheeler, Kirsten Bode, Muzinich’s co-head of private debt in Zurich, explains: “We appear to be at the end of the credit cycle, and are therefore obviously very cautious, and not too aggressive, about where we play in the capital structure.”

However, mezzanine was never particularly popular at any point in the current credit cycle, so fear of cyclical distress cannot be the only reason it has remained such a niche. Analysts need an alternative explanation of why corporate mezzanine has not enjoyed the same meteoric growth as many other parts of the private credit market. Many have cited structural factors to do with the supply of debt that have little to do with comparisons of relative risk-return.

Applying for uni

The most important of these factors, say many market observers, is the growth of unitranche. This market was given a boost by the credit crunch, which forced banks to cut lending to all but the most blue-chip corporate borrowers. Seeing a gap in the market, direct lenders stepped in with loans to cover corporate funding needs that had previously been met by banks providing senior debt in co-operation with funds providing mezzanine. For lenders, unitranche offered the attraction of slightly higher spreads above risk-free rates because the debt was, in effect, lower down the capital structure than senior loans. On the other side of a transaction, private equity sponsors loved it because, unlike for mezzanine deals, banks were rarely involved – and, for some restless sponsors, banks take too long to decide deals. “I believe the beginning of the unitranche market, which has effectively combined senior and mezzanine into one instrument, has reduced the opportunity set for mezzanine on the demand side,” says Bode.

Another dampener on European mezzanine growth is the investor profile. Many investors in European private debt are at the wrong stage of the investor journey, says Bode: “Most of our investors were not invested in any private debt at all six or seven years ago.”

Until then they focused on investment-grade bonds, but it progressively dawned on them that, since these no longer paid very much, “they needed to go into something that was reasonably secure, but still offered a bit more return”. Because of its lowly place in the capital structure, mezzanine does not meet this investor requirement for security, says Bode.

But for investors prepared to keep the faith and continue doing mezzanine deals, returns can sometimes be attractive. In real estate, “rates vary between 6 and upwards of 12, or even 15 percent”, says Martin Farinola, co-manager of GAM Investments’ real estate finance team in London. “It just depends on what kind of risk you’re taking.”

Wheeler says the mezzanine deals he is aware of that are large and offered across Europe, rather than just in their respective home countries, are often placed with investors from Asia, “on interest rates that are in our minds pretty poor in terms of risk-adjusted returns: spreads of between 400 and 500 basis points, that are just a little bit higher than senior debt at 200 to 300 basis points”. Wheeler regards this rather small premium above senior debt as rather miserly: “It’s a very different piece of risk, and we don’t think that’s a particularly good return.”

When it comes to corporate deals, however, de Galea sets out high projected returns. He says that Indigo offers both senior and junior mezzanine debt, “according to the requirements of the deals”. Senior mezzanine assumes a return of around 11-13 percent, based on a mix of cash coupons, payment in kind and warrants. Junior mezzanine carries returns of up to 18 percent, based entirely on warrants and payment in kind, with no cash coupon.

Lower leverage

Projected returns are of course pie in the sky if they are unlikely to be met. However, advocates for mezzanine suggest that, counterintuitively, the risks can be lower than for unitranche, even though the projected IRR is higher and even though mezzanine is lower in the capital structure.

In the first place, observers argue that there has been little erosion of mezzanine’s covenant terms, in contrast to those for unitranche. This is partly because competition among debt funds is less severe, and partly because the banks lending senior debt insist on strong covenants, which are then applied to the mezzanine debt too.

In the second place, leverage is often lower, as de Galea notes. This means Indigo is typically not lending to companies with risky business models designed to achieve high multiples for private equity sponsors. Instead, its typical borrowers are, as he puts it, “robust companies with reasonable growth prospects”. He gives a typical example: X, an outdoor wear company targeting the middle-aged, which sells its products online and by catalogue and is gradually expanding into new European countries. Once men of a certain age have found a brand, he notes, they tend to stick with it – and this leads to the high recurring revenues that lenders prize above everything else. These revenues should provide some comfort to junior mezzanine holders whose interest payments are being rolled up and saved to the end, rather than being paid as regular cash.