Flexibility and Scale

“The mainstream syndicated mezzanine market in Europe has pretty much disappeared… for now.” It’s a bold statement from the head of European mezzanine at one of the European market’s leading firms.

Squeezed by a new breed lender offering private senior debt at one end of the spectrum and private equity firms willing to put more equity in at the other, as well as the proliferation of private debt funds with more than 170 in the market globally,  vanilla mezzanine funds are finding it tough to put capital to work.

Yet ICG has just raised a €2.5 billion mezzanine fund, and it has been deploying capital at a good pace.  So how does he explain that seeming contradiction? First he describes the opportunity for investing in mezzanine today. 

Mezzanine today

The Banks have retrenched, and the European market is slowly shifting towards a US model where institutional capital provides a much bigger role in financing. But that retrenchment has opened doors to new players, including ICG, looking to provide private senior debt, as well as to the high yield bond market.

“These players are looking for slightly higher returns than bank-sourced senior debt would, so structures come to look more like stretch senior or unitranche. That eats away at the gap in the capital structure that mezzanine would normally fill,” Durteste explains. 

The traditional syndicated European mezzanine opportunity this year is vividly illustrated by the data. The overall volume of mezzanine remains a tiny fraction of what it was pre crisis. So far 2013 volumes are significantly down, with investors turning to high yield bonds.

Across all European deal volumes for 1H 2013, the bigger picture for leverage finance shows positive momentum. The second half of 2013 European leverage finance new-issuance volume has reached a post crunch high in excess of €40bn, showing double digit increases each quarter. Leverage loan volumes are at a five year high, up nearly 50% from the early months of 2013. Sponsored transaction volume reached €21.5bn during the first half of 2013, the highest volume in five years.

“There’s a lot private equity money in the system, and relatively few potential deals, which means sponsors are being pushed to accept lower target returns. That again puts pressure on mezzanine,” Durteste says.

During the first half of 2013 private equity sponsors have contributed less equity to buyouts, this is due to new-issue volume increasing for loans and high-yield bonds.   If this early momentum is maintained throughout 2013 it could be the best year since the crisis for debt investing.   So there are opportunities, and ICG has always been adept at finding them.   

There are also technical features of the market which are challenging mezzanine. Banks have become more savvy and risk averse, and are increasingly structuring deals with greater protections and rights vis-à-vis the sponsor. “In many instances, that puts mezzanine in a bit of an awkward position. Clearly mezzanine is a great asset class, but it has to be done well. Done poorly it’s just underpriced equity without the rights,” he says.

Lastly, the European mezzanine opportunity remains limited by its legal framework, some European governments have imposed limitations on the interest tax deductibility meaning the tax benefits of mezzanine investing are reduced.

“That adds up to a situation where it’s difficult to find interesting mezzanine opportunities that offer the right risk / return profile for investors,” Durteste says.

ICG’s mezzanine investing strategy

Against this backdrop, ICG has raised its biggest ever mezzanine vehicle, ICG Europe V, and has already invested 40 percent of the €2.5 billion it raised (meeting its hard cap).

How has it managed it?

“ICG is known for taking a flexible approach to mezzanine investing and evolving our approach to local market conditions. We’ve always taken the view that in order to properly invest in mezzanine, you needed teams on the ground in every country you wish to invest in. Local relationships, understanding of laws and local process have been central to our strategy. It’s the reverse of the model adopted by most others.

The companies ICG invests in value ability to execute complex deals in fast timescales, as well ICG’s ability to provide access to capital for the whole financing (vs club deals) and the possibility of follow on capital for investment. Price is still an important factor but all the factors combined are important.

“Our DNA is more towards developing our own deals rather than buying mezzanine in syndication from banks.  I cannot say we have never done it because it has happened, but that’s not our model today,” Durteste adds.

This means that despite the dearth of ‘on-market’ deals, the firm has been successful at deploying capital because there is still a significant need for flexible capital in Europe.

“Even today, the European market remains quite dysfunctional in that sense,” Durteste says.  “There is a lot of liquidity available, but only for certain deals, and there are many more situations where it’s difficult for companies to access credit or even high yield. That’s where we fit in.”

ICG has also been taking advantage of its geographic reach. “Before Spain became fashionable again, we were doing deals there. Nobody wanted to touch Spain but there were perfectly good deals there, with great return prospects.

“In the UK market, there’s acute need for financing in situations which probably don’t tick all the boxes for an easy syndicated loan. And take Germany too – traditionally it’s been very difficult for private equity and mezzanine to access because it’s very decentralised, with local banks being supportive of local companies. But even the Landesbanks are experiencing difficulties which means they’re lowering their exposure to leveraged loans. We’ve beefed up our German team and are seeing more dealflow there than ever, particularly in situations where ICG is the sole financer.”

There are drawbacks to the ICG approach though, Durteste admits. Sponsorless deals can take longer, for example. “When you are purely focusing on the LBO market it is relatively easy: there’s a process, a timeline. You may slip a bit, but really it is an organised process.  If you are talking to a company and you are offering a type of financing they’ve not thought about before and which they are always going to consider expensive – certainly compared to what they could achieve five or six years ago – it takes time but the risk / return profiles are more attractive.”

When asked if ICG’s return expectations have come down, Durteste gives a contrarian answer: “If anything, they’ve gone up. On a plain vanilla piece of mezz, they haven’t evolved – we’d still look for anywhere between 10.5 to 12 percent over, depending on the deal. But because we are increasingly lending into very complex situations, on average our overall pricing has pushed up; it’s more of a function of the nature of the transaction that we are doing rather than a pricing evolution.”

Critics will point to the fact that some firms are stretching the definition of mezzanine to its limit in a bid to deliver target returns. Durteste agrees, but argues that flexibility is actually a virtue and appeals to investors.

“That has always been the case for us, and that has always been something we’ve put the emphasis on even though it makes our life more difficult when we are fundraising. We have always thought that boxing yourself into a narrow definition of mezzanine was extremely dangerous precisely because the market moves. It may happen that the market is outside of your box. So yes, we have a flexible mandate,” he agrees. 

That mandate has allowed the firm to pursue its own deals very successfully, as well as opportunistically investing in discounted senior debt assets or portfolios, particularly in 2010 and 2011 when prices were attractive. The firm knew the assets in question and had an advantage as a result. “We were able to generate good returns for our investors because we were able to do those deals,” he adds.

Looking forward, the firm expects liquidity to increase in Europe as CLOs enjoy a resurgence and private debt as an asset class develops further. As one of the industry’s longest established firms, it will have a major role to play in that further evolution.