Stuck in the middle with you

In the first quarter 2007 deals such as KION, PagesJaunes, TdF and Numericable saw senior debt and second-lien replacing mezzanine in post-syndication flexes. Afterwards, primary deals emerged featuring little if any subordinated debt, and where it did persist, dedicated mezzanine also lost ground to public instruments such as PIK notes and secured FRNs, which institutional investors were again happy to buy.

Today, a sizeable mezzanine tranche is a key part of almost every syndication, and far from being flexed out late in the process mezzanine investors are going into deals early and establishing their own terms.

Chris Baines, head of European distribution at SG, said the situation had become stark, adding: “Before the credit crunch, specialist mezzanine investors had difficulty sourcing assets in size as they faced increasing competition from CLOs with mezz buckets or dedicated funds to fill. This was assuming the mezz had neither been flexed out of the structure, nor had its yield reduced to a seven handle, post-syndication.”

The result was pent-up demand for assets from dedicated mezzanine funds, who emerged perfectly placed to pick up a modicum of the slack left as the CLO tide ebbed.

Indications that arrangers could rely on the mezzanine market despite the credit crunch were evident from the third quarter, notably the sell-down of the £750m Alliance Boots mezzanine tranche, still the only sizeable chunk of that deal placed.

Bookrunners Deutsche Bank, JPMorgan, UniCredit (HVB), Barclays, Citi, Banc of America, Merrill Lynch and RBS eventually sold the 10-year facility. As well as raising the coupon from 600bp to 650bp, discounting is understood to have been in line with investor expectations of 10% margins. The deal sold to at that point asset-starved mezzanine investors in a range of ticket sizes.

Since then the situation for mezzanine investors has become ever more favourable. The handful of deals structured and successfully syndicated post-crunch set the template.

The €900m facilities backing the buyout of Firth Rixson featured €250m of mezzanine debt. Lehman Brothers was bookrunner across both the senior and mezzanine tranches, GE Commercial Finance was bookrunner on the senior piece while Lloyds TSB was MLA on the mezzanine debt.

A US$970m debt package backing the Dubai International Capital (DIC) acquisition of Almatis, through UBS, featured US$235m-equivalent of mezzanine and junior mezzanine loans.

Eric Capp, head of leveraged capital markets Europe and Asia at RBS, outlined the changes, saying: “We are seeing strong demand for mezzanine tranches in almost every deal from the smaller mid-market deals up to the US$600m quasi-mezz bridge. The only negative is that deal flow remains low, which means there are still not enough assets for the pent-up demand.”

Ryan McGovern, investment director at Nomura Mezzanine agreed that deal flow remained an issue for some, saying: “Deal flow is obviously affected, there is a lower success rate for buyouts, which means fewer financings in total, but there are still deals being done in the mid-market in particular and investors that can buy smaller assets are still seeing decent deal flow.”

But for deals being done the positives continue. As well as mezzanine forming part of more deals, it constitutes an increased proportion of capital structures.

To win commitments from bank investors there is a requirement that they sit over larger proportions of subordinated debt. Structures currently tend to feature senior debt of 4-1/2 times Ebitda with a turn or a turn-and-a-half of mezzanine below that.

While leverage through total debt has declined, mezzanine pricing has risen. Pricing has gone up from 7.5% over Libor a year ago to 9.50% to 10.5%.

But Capp said margin rises had not been especially sharp, adding: “Margin increases for mezzanine have been relatively modest compared with margin increases on senior debt, partly because the stretching of leverage last year was more aggressive on the senior than subordinated tranches, and also because there is strong demand from investors.”

However, on top of price increases is increased call protection, and on smaller deals warrants. With mezzanine investors having ridden a tiger over the past number of years, call protection is a particularly welcome development, locking in the benefits of the current situation.

According to Baines: “At the top of the market deals were being refinanced quickly, leading to weakened call protection and eroded prepayment penalties to around 101. The boot is now on the other foot, and we are seeing a return of non-call one or two, which mezz investors see real value in.”

Baines pointed out that despite rising margins sponsors are happy to tap the mezzanine market, saying: “For sponsors, the return of mezz makes sense from a cost benefit point of view. They can tap liquidity where it is the most prevalent and increase the gearing of their transaction at a cost that, while obviously higher than senior, is still less than their expected IRR.”

He noted that “mezz investors are stalwarts of the market with whom sponsors are typically comfortable doing business”.

Sponsors are voting with their feet, not only tapping more mezzanine but seeking out mezzanine investors early in the debt arranging process.

McGovern said that suited both sides. “Banks are less willing to hold risk,” he said. “As a mezz investor we are going into deals earlier and earlier in response to direct approaches from sponsors – that means a greater input into the structure regardless of whether the mezzanine is underwritten by banks or by mezz investors.”

Of the €700m debt backing EQT‘s buyout of German power plant builder SAG, a €95m mezzanine loan was pre-placed and underwritten by ICG. Senior debt was underwritten by Commerzbank, BNP Paribas and RBS. Bookrunners Commerzbank and ING launched an early bird investor phase for the mezzanine tranche of debt backing the buyout of CTL Logistics in Poland.

Capp said the trend was especially favourable to the mezzanine houses. “Investors are in deals earlier, and happy to be there, they can access better fees, get larger positions and negotiate higher margins than a competitive auction would yield,” he said. “Some sponsors are pre-placing mezzanine in an effort to de-risk deals, though in fact mezz liquidity means that it is often the easiest, lowest risk piece of the capital structure to place.”

Primary mezzanine syndication has been helped by secondary markets relatively less affected by the credit crunch. A lack of liquidity means secondary is not a real alternative to primary for investors that want to buy in size.

However, McGovern said secondary did provide opportunities. “There is value to be had in secondary, to a lesser extent than is true of senior debt, but in deals where there is a large number of mezz investors in the syndicate buy and hold investors can take advantage of any forced sellers in the syndicate, particularly if they did not get the allocations they wanted the first time around,” he said.

Credit concerns persist of course, but margin increases at least reflect that risk. Sluggish deal flow aside, mezzanine investors are making hay while the sun finally shines.