Friday Letter: Back to school

As the search for yield continues, can mezzanine rise to the challenge?

There are still a few days left before the summer hiatus ends, but as September begins, thoughts will turn to the challenges that lie ahead in the last few months of 2014. Targets for the year will take centre stage.

On a macro level, it is central bank handling of the continued weakness in the euroland economies that will capture the attention of most when they return to their desks.

Speculation is rife that ECB president Mario Draghi will make an announcement in the first week of September regarding the introduction of quantitative easing, as the two biggest euro economies, Germany and France, flounder.

QE, an asset purchase programme, has been credited with helping the US and UK economies recover more quickly than the euro region. It has recapitalised their banks and both the US and UK markets are buoyant. 

All this makes for an interesting mix. With a lending landscape traditionally dominated by banks distracted with other matters, Europe is seen as a playground from a private debt investor point of view.

One of central bank policy’s most glaringly obvious failures, in Europe, the UK and even in the US, has been its inability to get small businesses, the backbone of the economy, to borrow and finance growth. 

Figures released today from the Bank of England show that net lending by participants in the Funding for Lending Scheme to small and medium-sized businesses (SMEs) has fallen once again in the second quarter of 2014, albeit at a slightly slower rate than previous quarters.

Combine this situation with an increasingly competitive senior lending landscape, tight pricing and a swathe of liquidity chasing yield in a low interest environment and it's easy to come to the conclusion that some dry powder will end up chasing returns higher up the risk curve. And possibly into mezzanine debt.

To be sure, mezzanine lending hasn’t done well over the last few years. Deal flow has fallen off a cliff and dedicated funds haven’t been able to make the returns envisaged.

In its heyday, European mezzanine loan volume syndicated by banks reached almost $10 billion in 2008. There was a steep drop in 2009 of 87 percent and volume has continued to dwindle since. It stood at $584 million in 2013, and has only reached $313 million, as at 29 August 2014, according to data provided by Dealogic.

In the US, equivalent figures, where private debt funds are more established, showed mezzanine syndicated loan volume by banks reached $2.5 billion in 2008 and has dropped off to just $89 million, as at 29 August 2014. 

Only five mezzanine facilities have been issued in conjunction with senior loan debt in Europe so far this year, according to S&P Capital IQ LCD.

When compared to the rise of unitranche and covenant-lite loans, the demise of mezzanine is even starker. Unitranche, offering senior and mezzanine lending in one, has thrived under current economic conditions, offering borrowers more simplicity and flexibility than the traditional banking model. It has been a boon for the larger private debt providers over the last couple of years. 

There are still situations when mezzanine can fit the bill however. It is just a matter of finding those deals. It is suited to companies with growth potential but deemed too risky to carry senior debt.

It is also an option for companies which are willing to dip their toe back in the water in terms of borrowing and not willing to give up a big equity stake in their business, and / or deem equity too expensive. 

Last week it emerged that OVO Energy, one of the fastest growing new power suppliers in the UK, completed an £8 million mezzanine financing with Generation Investment Management, a fund linked to former US vice president Al Gore, in January 2014.

OVO’s founder Stephen Fitzpatrick told The Sunday Telegraph: “The most important thing for us was that we didn’t have to give up any control. We had previously turned down a deal with a private equity investor as we were being asked to give up too much control relative to the stake we were selling.”

Mezz is suited to small businesses that have weathered the financial storm, actually grown market share and that are now seeking to monetise their business, as explained by Aleksander Majewski, investment director at Syntaxis, a mezzanine fund manager in Central Eastern Europe, who has seen a pick-up in activity in the region.

And from an investor point of view, it is suited to companies in that lower mid-market spot between $25 million and $75 million EBITDA, one of the last frontiers in terms of finding relative value post-Lehman, Juri Jenkner, co-head of debt at investment firm Partners Group told PDI, last week. However, a half year report from the firm also cautioned that in Europe, a pan-European approach would be important so as not to restrict deal flow.

Of course, if the opportunity is half as good as some of its flag-bearers state, any absence of competition will soon be a thing of the past. For those already active in the segment, therefore, the priority is to get back to work quickly and capitalise on the advantages of the incumbent. It's back to school for the industry, to get their names onto that deal board.