Is mezz in a mess?

Logic suggests that things should be looking up for mezzanine finance providers around the world. Senior debt dries up; mezzanine demand goes up. Unfortunately, however, the situation has become more complicated than that.

Towards the end of 2007, banks reined in their senior lending and it did indeed look like mezzanine would step into the breach as a ready, willing – and crucially – able source of leverage. “When the syndicated second lien market fell apart, mezzanine was the sole form of junior debt available,” says Adam Spence, managing director in the New York office of American Capital, a Nasdaq-listed provider of private equity and sponsor finance. “First lien lenders became less tolerant of second lien in the structure; mezzanine became more palatable.”

In the six months following August 2007, while the number of private equity-backed deals involving mezzanine fell by 30 percent year-on-year, the total amount of mezzanine finance issued jumped by over 50 percent for the same period, according to data provider Dealogic.

For a time, the rumble in the credit markets looked like a cause for muted celebrat ion among mezzanine players. In the overheating buyout market of the prior years, mezzanine funds had slipped out of fashion. From an investor perspective, limited partners were lured by the spectacular returns being generated by the large buyout funds. Meanwhile, questions were raised as to the need for mezzanine funds in a market where senior debt was so cheap and plentiful. Some mezzanine managers began to wonder whether their area of lending had a future.

“The expected resumption of significant mezzanine lending and investing did not occur because the credit and equity booms went on and on,” says Joseph Ferrigno, managing partner of Asia Mezzanine Capital Group in Hong Kong.

YOU'RE DEAD
“Your type of mezz is dead,” is what one seasoned mezzanine fund manager was told by LPs during the credit bubble, referring to relatively expensively priced debt in conservatively leveraged deals. So it would have come as a relief to mezzanine practitioners when the debt market suddenly became less crowded. But now the financial crisis has become an economic reality for almost everyone – and mezzanine providers are being dragged down along with everyone else.

The reason? Not all mezzanine providers were as conservative as those who were told they had no future. A lot of mezzanine money went into buyouts during and immediately after the credit boom. With the dramatic fall in market valuations, it is inevitable that plenty of mezzanine tranches will, like the equity sitting above it in the capital structure, now be underwater. “There is a fallacy that mezzanine is a very safe place to be,” says John Clifford of Investec Private Bank's Growth and Acquisition Finance team, “but if you were doing deals at the top of the market sitting on four or five times senior debt, you will quite possibly have had your legs blown off.”

And while a scarcity of senior debt boosted mezzanine use to a certain extent, it has now slowed deal flow to a virtual standstill. Add to the lack of senior a highly unpredictable business environment, and mezzanine providers are faced with a problem putting their money to work. “Making new investments remains our biggest challenge,” says Martin Stringfellow, managing partner at European mezzanine fund manager Indigo Capital. “Deal flow is fine but right now backward-looking analysis tells us nothing about the short-term future.”

Globally there is a significant amount of mezzanine capital awaiting deployment: managers of mezzanine funds corralled more than $27 billion worldwide in 2008.

Without a ready flow of deals, mezzanine managers are looking elsewhere for opportunities to put their money to work. “In the nearer term, buyouts are going to play a much less prominent part in what we do,” says Ben Edwards, managing partner of Central Europe-focused mezzanine specialist Syntaxis Capital, pointing to two areas which are starting to dominate his firm's thoughts: acquisition finance and capital restructuring opportunities.

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