The Blackstone Group has joined rival firms Kohlberg Kravis Roberts and The Carlyle Group in raising huge funds to take advantage of mezzanine opportunities in an environment that is increasingly more capital constrained.
Blackstone’s debt affiliate GSO Capital Partners has collected about $2.1 billion for its second GSO Capital Opportunities Fund. Sources expect the vehicle to pull in more than $3 billion by final closing in the first quarter next year.
While the vehicle does not have an official target, documents from the New Jersey Division of Investment show the firm wants to raise between $3 billion and $3.75 billion. New Jersey committed $150 million to the fund. Park Hill Group is working as the placement agent for the fundraising.
The fund has “solid commitments” for about $2.6 billion, according to a person with knowledge of the fund. Blackstone did not return a call for comment.
GSO’s first mezzanine fund closed on $2 billion in early 2008 and has been producing a 15.98 percent internal rate of return since inception, as of 31 March 2011, according to performance information from the California State Teachers’ Retirement System.
Blackstone acquired GSO in 2007 for almost $1 billion to expand its credit strategies. GSO was formed by former DLJ and Credit Suisse colleagues Bennett Goodman, Tripp Smith and Douglas Ostrover. The group also uses a distressed investment strategy through its Capital Solutions Fund, which closed on more than $3.25 billion last year.
Mezzanine gets hot
The mezzanine investment strategy has emerged as a popular one with limited partners. KKR was able to haul in about $1 billion for its debut vehicle that it closed earlier this year. The firm has participated in roughly $1 billion of mezzanine financings since 2005.
Carlyle has been raising a mezzanine fund focused on the energy sector, and Park Square Capital closed its second mezzanine fund earlier this year focusing on the European mid-market on €850 million.
Earlier this year, placement agency Probitas Partners revealed that about $2.8 billion had been raised for mezzanine funds in the first quarter, compared to $8 billion for all of 2010. The record year for mezzanine funds was 2008, when $27.6 billion was raised, according to Probitas.
The strategy has been attracting LPs because of its return potential, with expectations that internal rates of return will fall somewhere in the range of mid-to- high teens. But investors also like the “risk profile”, meaning in the case of a default, mezzanine has some protection in the capital structure.
“Typically, you have 30 to 40 percent equity in front of you [in the capital structure], so the business would have to lose roughly a third of its value before our investment starts getting impaired,” according to Marc Ciancimino, a member of KKR’s mezzanine team, who spoke to Private Equity International in a prior interview.
“While equity valuations can move around a lot, especially levered equity, you have to have a big underperformance for mezzanine to move in the same way,” he said.
There is also a “current income” aspect of mezzanine investments, in that investors received quarterly or semi-annual distributions on the interest. This helps reduce the j-curve effect of private equity on their portfolios, since investors start seeing returns right away, Ciancimino said.
In the volatile markets, companies in the small and mid-markets have a tough time finding credit, being too small to attract the interest of the larger institutions, which are themselves tightening credit standards for even big borrowers.
It’s in volatile and tight credit markets that mezzanine stands out, with the potential to reap equity-like returns. With the numerous funds that have been raised around the strategy, mezzanine lenders should see a lot of competition going forward.