LEVERAGED FINANCE SPECIAL(5)

Adam Spence, a managing director in American Capital's sponsor finance group, based in Bethesda, Maryland, is a busy and happy man these days. “Mezzanine is back,” he declares, reflecting on an area of opportunity in North American private equity.

With the second lien and high-yield bond markets effectively closed, mezzanine has a lot less competition in the capital markets and finds itself a sought-after piece of financing. “Mezzanine never went away but it's become more critical,” says Boston-based TA Associates managing director Roger Kafker.

Mezzanine, which has traditionally found its sweetspot in financings below $100 million (€63 million), is now being seen in tranches of $300 million to $500 million, says Spence. For example, Goldman Sachs, which manages the largest mezzanine fund in the world, recently contributed $500 million of mezzanine finance to the recapitalisation of MoneyGram, a deal in which Goldman Sachs also contributed equity alongside Thomas H Lee Partners.

While Kafker notes that “mezzanine players have traditionally wanted to write cheques by themselves,” with deal sizes heading up, clubbing together is an emerging trend in the sector. Spence says he is already seeing clubbed mezzanine deals, often with American Capital as lead or co-lead

At the smaller end of the market, there is still some resistance to clubbing. “We will do club occasionally,” says Neil Marks, managing partner at New York-based Praesidian Capital. However, the strategy does not generally suit a mid-market strategy because the deals are not big enough to require it, he says.

After a long period of cheap debt in the LBO market, rationality has finally returned to deal structures. Spence notes that pricing for mezzanine debt has “crept up into the mid-teens”. However, mezzanine firms have shown “real pricing discipline”, he claims.

In the transformed deal market, private equity firms are rediscovering mezzanine to some extent, Spence asserts, and in some cases firms are bypassing banks and going directly to independent mezzanine providers.

LESS RISKY
The market environment is less risky for mezzanine than it was six months ago because we are in a period of lower leverage, says Kafker. Mezzanine is now “getting attractive returns and taking less risk”

Despite the tide turning in favour of mezzanine, life is not entirely straightforward for the established players. For example, they are not the only ones to spy an opportunity. The arch opportunists in the hedge fund ranks, for example, are beginning to show interest in mezzanine, says Spence. However, he notes a bifurcation between the established players and those “feeding around the edges”.

“There is a higher barrier to entry right now,” Spence notes. His view is that the market is returning to a group of investors that have been doing mezzanine for a long time. In a less certain market, sponsors are disinclined to consider players without a long track record. New entrants are a “harder sell” – other than perhaps in the case of industry veterans.

Kafker sees fundraising as another barrier to entry. “This is an attractive period to raise a mezzanine fund but it's not easy,” Kafker says. “It's hard to raise a mezzanine fund; [they] have not attracted a lot of capital.” It's difficult to return a large multiple in mezzanine, which generally produces multiples between 1.5x and 2x. Large institutional investors like pension funds and insurance companies prefer to target higher returns than that, Kafker says.

Nonetheless, for established players in the North American mezzanine industry, prospects look sunny for the year ahead. There is a “terrific opportunity for all of 2008,” says Kafker. “Then we will see what happens.”

The credit crunch's leveling effect on banks' involvement in the higher risk areas of debt provision is also leaving mezzanine houses in a strong position in Europe – a real contrast with the situation a year ago.

Reflecting on his fortunes 12 months prior, one mezzanine specialist confessed to PEI to sleepless nights, fearing that rapid recapitalisations, covenant-lite loans and highly liquid debt markets would continue without let-up. That same source is now overjoyed at the detailed due diligence and attractive terms he is granted on all deals – and his phone never stops ringing.

His feelings are echoed by peers in the industry. Cécile Levi, head of mezzanine at AXA Private Equity, says: “There were the very large transactions with the highest leverage, which most people experienced and there were many, many recaps.” AXA Private Equity had ten transactions recapitalised in the first half of 2007 due to the highly liquid credit markets, effectively buying them out of credits well ahead of time.

Levi says some of the extremes of the frothy market had not affected AXA specifically. “Banks were able to arrange one-stop financing, although this was generally for larger transactions. It was not the case for mid-size transactions and not so common in France. We had a fairly widespread portfolio in 2006 and 2007.”

GETTING IN EARLY
The banking market effectively monopolised the mezzanine tranche on larger deals, as well as partially moving down into the mid-market, either by providing warrantless mezzanine, second lien or senior debt, all on yields and terms that were unattractive to independent houses. John Clifford, from Investec Growth & Acquisition Finance, says while the senior lender often provided debt financing across the spectrum on deals in the past, now mezzanine providers are being brought into deals at an earlier stage.

Tom Cartwright, a partner in private equity at law firm Taylor Wessing, says: “Most of the banks that have liquidity don't feel there is a big market for mezzanine. They're not finding it as easy to syndicate, leaving independent mezzanine funds, who know what they're putting their money into to do deals.”The banking market has effectively retreated from mezzanine provision, leaving specialist providers to bridge the gap between the equity and the senior debt on deals.

Terms have improved for mezzanine providers. It is becoming increasingly common for them to receive warrants, which allow them to subscribe to the equity on successful deals that achieve high returns. They are also able to demand tighter covenants on deals and be provided with yields that accurately reflect the risk. Levels of leverage are also much lower, with typical provision at the moment being 3 times debt to EBITDA for the senior debt, and 1.5 times debt to EBITDA for the junior tranches. This effectively makes deals less risky for mezzanine providers and increases their involvement.

Improved sentiment in the independent mezzanine market is tempered by knowledge that the banking market may well undercut it again in the future. Clifford says: “It's impossible to say what was going on 12 months ago will never come back. Memories are short and people do strange things from time to time, but for the moment life's easier than it was.”

One thing's for sure: mezzanine providers are now returning to their perch as a vital component in private equity deals. Their model, which relies on successful credit discipline and strict due diligence, is the staple of successful long-term investing. It was arguably a laxity in credit analysis by banks across the spectrum which caused the credit market collapse of last summer – mezzanine providers may justifiably feel a certain sense of schadenfreude.