Fitch says mezzanine to ‘reign supreme’

After a tough year in 2007 providers of the hybrid form of debt are likely to capitalise fully on the disappearance of competition to finance leveraged buyouts.

Fitch, the rating agency, has said it expects mezzanine debt to “reign supreme” in the leveraged credit market that emerges from the present financial crisis.

Lenders of the hybrid form of debt were under pressure during last year as they were forced out of deals and faced competition from the banking market. This had been spurred on by the high levels of liquidity in the debt market prior to August of last year. The levels of mezzanine debt rated by Fitch in 2007 fell by 25 percent to €10 billion ($16 billion).It only rated 31 mezzanine transactions in the second half of 2007, the lowest number of transactions rated since the second half of 2003.

But Fitch said because mezzanine providers avoided many of the deals signed in the first half of 2007 they were able to remain open for business. “With a traditional buyer base successfully raising funds and continuing to engage with arrangers and sponsors, mezzanine is poised to undergo a renaissance as a risk-adjusted asset class when the market re-opens on a wider scale,” Fitch said.

Since August mezzanine providers have managed to negotiate better terms for debt, as the liquidity in the debt markets driven by their competitors the hedge funds and CLOs largely disappeared. Fitch compared 13 hung deals to 13 new vintage deals, finding that average total leverage on deals had decreased from 7.7 times to 5.8 times with senior leverage on these deals decreasing from 5.5 times to 4.4 times. Spreads for mezzanine lenders had widened on a cash and PIK basis from 837bps to 950bps, with this widening entirely coming from a change in average PIK spreads from 442bps to 555bps and no change in the 395bps paid in cash.   

Fitch said terms for mezzanine providers may not improve to pre-2004 structures when there were equity-like returns from warrants and leverage was conservative. But it said unwinding of leveraged strategies and an aversion to risk will lend greater negotiating power to mezzanine providers.

Mezzanine providers’ returns will also benefit from the slow-down in refinancings. Rapid recapitalisations were fuelled by debt market liquidity last year with a total amount of prepaid mezzanine of €4.2 billion in the first half of 2007 from 26 transactions, 54 percent above the same period in 2006. By contrast, the amount of prepayments was €1.03 billion from just eight transactions in the second half of 2007. This is the lowest figure for a six-month period since the second half of 2004.