Warrantless mezzanine, along with second lien, are now accepted instruments in any mid-to-large buyout and their prevalence will no doubt continue given current market conditions. Many investors in these products are new entrants to the European LBO market, and whilst the extra liquidity is beneficial to leveraged deals, there is a concern that these investors are more focused on return rather than relationships with the private equity houses in whose deals they are investing.
Warrantless mezzanine is a pure debt instrument and there are signs that co-operation with the equity houses in distressed or value-accretive circumstances is not always so forthcoming as may have been the case when warrants created more of a partnership approach in such circumstances. As debt now contributes such a large part of any capital structure, will the changing nature of the mezzanine investor base prove detrimental to equity returns?
Mezzanine’s original roots lay in the substitution of equity in a capital structure, and the warrant component aligned the interests of the mezzanine lenders and private equity investors. This was extremely valuable to both parties during difficult times or restructurings as there was a shared conviction to work together on the best long-term solution for the investment to help protect equity value. This remains the case today and partially explains why default rates for long-term mezzanine investors are impressively low. The incentives to maintain such low default rates are, however, not so obvious for investors in warrantless mezzanine given the ability to trade out of difficult credits.
The growth of warrantless mezzanine has been prompted by three factors: the desire of private equity houses to retain equity in a falling returns environment; the lack of credit defaults in recent years; and the growth of alternative asset holders. The first factor is only possible as a result of the second two factors. These latter two are very much linked, to the extent that low credit default levels have allowed asset managers to invest heavily in a range of assets, safe in the knowledge that, on a portfolio basis, their losses will be minimised and returns protected. The spectre of increasing credit defaults is not yet upon us, but should the current benign financial environment change, and portfolio losses mount up, nobody is quite sure how these asset managers will react.
Recent experience suggests they will trade out of their impaired positions, either to a distressed debt specialist, or, in extreme examples, to a vulture fund. Neither is well regarded by private equity investors. This is not to suggest such specialists are Machiavellian, but they are less likely to promote consensual restructurings and adhere to the informal London Banking Code for the simple reason that they have no relationship, or need for a relationship, with the PE houses. Ownership of the distressed company is ultimately what they desire and they will use controls in the debt documents to enforce control rather than allow the business any breathing space to effect a potential recovery. Increasingly, such investors are happy to take on highly leveraged loans confident that they will have the keys to the business in a few years – such “loans to own”, as they are called, give an indication of where the future balance of power may lie.
In most mezzanine deals, the transfer clauses allow trading between financial parties, however PE houses are slowly awakening to the implications of such actions and the potential adverse impact on their businesses. Active syndication management, restrictions on transfer and “yank the bank” clauses are all designed to prevent debt falling into the wrong hands. PE houses are also looking to place more of their debt with LPs, confident as they are in this long-term relationship. These measures are undoubtedly going to reduce the transfer of debt ownership, but trading will never be completely eradicated and even if it could be, may it all be too late?
Since 2003, about 140 European deals with a total value of about €12 billion have incorporated warrantless mezzanine. A portion will already have been repaid but this still leaves a sizeable amount in issue. By the time of any credit default crisis, undoubtedly a further element will have been repaid upon exit but the popularity of secondary buyouts suggests this debt will just be recycled. Of course, we have no way of knowing how different investor types will react in a downturn but it would be ironic if the very financing product designed to improve private equity returns was a major contributor to the industry’s future malaise.
Mike Anderson is a director in the UK and Ireland team at Intermediate Capital Group, a fully independent UK public company listed on the London Stock Exchange and dedicated to providing mezzanine capital in Europe and Asia Pacific. Intermediate Capital Group PLC is authorised and regulated in the UK by the Financial Services Authority.