It may seem as if any analysis of the European mezzanine market that begins by looking at the US is immediately taking a wrong turn. However, the US credit market is, as Declan Canavan, head of alternative investment strategies EMEA at JPMorgan Asset Management in London, notes, “the elephant in the room”.
This is pertinent because the country is, in Canavan’s baseball analogy, in the seventh inning of the credit cycle. As he puts it, “it would be foolish to say that the European market is not indexed to the US market”. Insurers and other institutions that have increasingly entered European mezzanine as limited partners in recent years would do well to remember that a baseball game has only nine innings. To return to his zoological analogy, elephants do not easily stumble, but when they do, the effect is often spectacular.
European mezzanine lenders have tried to cushion themselves against the sometimes spectacular vagaries of the credit cycle through prudent lending.
“We like boring companies,” says Jaime Prieto, London-based founder and managing partner at Kartesia, a manager that lends across the capital structure as well as buying secondary loans. He is not looking for fast-growing businesses, but those that “in the bad times” can cut costs and generate sufficient cash to pay off loans.
“Often they are second- or third-generation family businesses that have owned the same real estate for years and years,” he says. Family businesses appeal partly because they will make financial sacrifices and “die in the ditches” to retain ownership rather than selling the business to the senior lender – an event that often causes problems for mezzanine lenders.He also likes sectors where there are reasonably high barriers to entry and which are not prone to extreme technological disruption.
An example of a Kartesia mezzanine investment that meets these criteria is its 2016 deal with Babcock Wanson, a French company that services industrial boilers. Many mezzanine lenders also have a preference for family-owned businesses, because of the combination of knowledge and grit that they often show. Mike Birch, chief executive of Europa Capital Mezzanine, the London-based UK debt subsidiary of Europa Capital Partners, lends mainly to property companies outside London.
They also tend to know their tenants very well. Birch gives the example of a property company and prospective borrower to which he did not lend – a decision he made upon meeting the chief executive at the station. The man arrived in a Rolls-Royce – hardly a sign of a cost-conscious mindset keen on maintaining a healthy cashflow – and had to input the address of the first property they were visiting into his satnav because he did not know where it was.
But just as general partners are keen to know that their mezzanine borrowers are able to cope with any downturn, limited partners also need to know that their general partners have the resources to do so, too.
Mezzanine lending can, after all, be an extremely labour-intensive business when things go wrong. One special situations specialist remembers that during the credit crunch he bought the mezzanine debt of a company in financial trouble. He became the chief financial officer, a colleague became a treasurer, and another colleague became the employee liaison. Every Friday they had to go through the process of releasing the money to pay the wages of the company’s workers.
“If one company goes bad, it takes multiple members of your team to deal with that situation,” he says. “What happens if you have two, three or four companies that go bad?” Limited partners must know that their fund managers have the capacity to deal with this, he advises.
The ability to provide the necessary time and expertise when a company faces a downturn is all the more important for non-sponsored borrowers, which lack the guiding hand of a private equity backer. Mezzanine lenders often say that they have always lent to non-sponsored as well as sponsored businesses. However, the growth in the amount of capital chasing sponsored deals has increased the incentive to lend into the non-sponsored market. So, too, has the growth of unitranche in Europe for sponsored deals.
“With the arrival of unitranche debt, which didn’t really exist 10 years ago, the trend has gone away from mezzanine a bit,” says Kirsten Bode, co-manager of the pan-European private debt fund of Muzinich, the corporate credit manager, in London. “For smaller deals in particular it’s more efficient to have one piece in the capital structure, and it’s all just done more quickly and more efficiently.”
“At this point in the cycle, the majority of what we do are sponsorless transactions,” says Benoît Durteste, chief executive officer of ICG.
The firm provides debt across the capital structure but relies on mezzanine – in Europe, this is predicated on target internal rates of return in the upper teens – for much of its overall return. ICG typically provides unsponsored businesses with a combination of debt and quasi-equity, and often acts as a private equity fund, with an ICG executive on the board of the business who helps them through a new phase in their history, such as making and digesting a major acquisition.
Another consideration, as mezzanine providers gird themselves for the next downturn, is the extent of legal protection.
This is an unusually high-profile issue for them, because of what happened to some lenders during the credit crunch. A number of mezzanine lenders lost all their money when sponsors agreed with senior lenders to sell businesses and then repurchase them. This left mezzanine lenders high and dry because the original holding company that owed the debt to the mezzanine lender had dissolved. The senior lenders, however, were fine because they agreed on this course of action with the sponsors only if the capital they had loaned was safeguarded.
The rights of mezzanine lenders have, in fact, improved in recent years because of such incidents. Annette Kurdian, banking and finance partner at Linklaters, the law firm, in London, says that most agreements between creditors that regulate junior debt these days include “some form of value protection mechanism” that prevents junior debt holders from losing out. For example, the senior lenders selling the business might be forced either to conduct a competitive auction or to obtain a fair value opinion to ensure that the business is sold at a level that maximises recovery rates for both junior and senior creditors.
She adds that although a restructuring can also be implemented through a statutory “cram-down procedure” which requires the junior creditors to write off all or part of their debt, in most European jurisdictions any such proposal would currently require the consent of the junior creditors in some form.
But such safeguards may not last forever. Kurdian adds that in November 2016 the European Commission published a draft directive on restructuring frameworks, which requires each member state to have a statutory restructuring procedure to enable “cross-class cram-downs”. This may sound like a wrestling move, but it means that junior creditors’ objections to cram-downs could be overruled.
The directive would still prevent the more egregious cases of the past where mezzanine lenders were frozen out – junior creditors could, for example, only be crammed down without their consent if they received under the plan at least what they would have received on a liquidation. But it still might make for some sleepless nights for mezzanine lenders.