Investors
are showing a growing appetite for mezzanine, but some industry insiders warn
they should be picky eaters.
Mezzanine
financing is seen as filling the gap between what banks can lend and what
private equity firms want. Banks, together with collateralized debt obligations
and hedge funds, aren't providing enough money now for the average leveraged
buyout, industry executives say.
“In this
environment, strategies such as mezzanine and direct lending should become more
attractive,” a white paper by consulting firm Towers Watson & Co. released
last month said.
A
super-sized amount of loans made between 2005 and 2008 needs to be refinanced,
and mezzanine yields of 12% make an attractive option for refinancing, the
paper noted. Mezzanine lenders are in a position to get better terms for the
loans they extend, making it more likely mezzanine managers and those who
invest with them will both gain current income as well as make money on the
loans.
Pension
funds that have launched searches for mezzanine managers this year include the
$5.1 billion Chicago Municipal Employees' Annuity & Benefit Fund, which
seeks a manager to run $75 billion, and the $3 billion State-Boston Retirement
System, which wants a firm to manage up to $10 million.
Officials
at the $31.3 billion Tennessee Consolidated Retirement System, Nashville, plan
to invest the pension fund's newly increased private equity allocation, doubled
to 10% by May legislation, in mezzanine, among other strategies.
These
investors will have plenty of opportunity. There were 63 mezzanine funds
looking to raise $25 billion in the first quarter, Alex Jones, senior analyst
at Preqin, London, an alternative investment research firm, said in an e-mailed
response to questions.
But the
strategy is not for the faint of heart. Mezzanine relies on a strong pipeline
of buyouts, noted Towers Watson's white paper. Private equity fundraising is
still fairly low and the European sovereign debt crisis could cause LBO
transaction activity to remain low.
“The second
half of 2011 and first half of 2012 have relatively been slow for the large
market LBO deals. However, the middle market continues to be active,” said
Theodore L. Koenig, president and CEO of Chicago-based debt investment
management firm Monroe Capital LLC. Big leveraged buyouts needing large amounts
of mezzanine have not been getting done, Mr. Koenig said.
The result
of the low amount of LBOs is a $40 billion overhang of mezzanine capital raised
for buyouts of all sizes over the past several years that has yet to be
invested, Towers Watson noted.
Still,
there should be enough opportunities for the capital raised and being raised.
“To the
extent that the banks seem to be hesitant to lend, we think there is an
opportunity for mezzanine,“ said Bradley Morrow, a New York-based senior
private markets consultant for Towers Watson Investment Services, a research
subsidiary of Towers Watson & Co., who co-authored the report.
But not all
mezzanine managers are alike.
“From an
investor standpoint, it's important to find mezzanine managers that earn the
high fees that they are charging by producing alpha instead of just being a
lender,” Mr. Morrow said.
They do
that by getting involved with the companies to which they lend to help improve
their performance, he explained.
Thomas
Haubenstricker, CEO of New York Life Capital Partners LLC, New York, agrees
there remains ample opportunity for both existing mezzanine funds and new ones.
“The lack
of senior debt financing, and volatility of the high-yield market, creates
additional demand for mezzanine financing among many buyout sponsors. And so we
continue to see a pickup in attractively priced deals from our sponsors
relationships,” Mr. Haubenstricker said.
Even so,
mezzanine is higher-risk capital than senior secured private debt because it is
unsecured and the historic returns have not been as good, Mr. Koenig said.
Returns
have not been stellar, especially in view of the private equity-like 1.5% to 2%
management fees and 20% performance fees that could cut into the returns,
according to the Towers Watson paper. Towers Watson recommends adding mezzanine
as part of a multistrategy credit mandate, rather than a stand-alone
investment.
All of this
will make it more difficult to raise mezzanine funds in the future, Mr. Koenig
said.
Need for
loans
Still,
there is a growing need for loans for private equity firms and others because
companies are having trouble getting loans.
Indeed, the
second largest private equity fund raised in the first quarter was a mezzanine
fund — Blackstone Group's GSO Capital Partners subsidiary, according to Preqin.
In March, the firm closed the $4 billion GSO Capital Opportunities Fund II, its
second mezzanine fund. It took 12 months to raise the fund, which was
oversubscribed, Beth Chartoff, senior managing director and head of marketing
and client relationships, said at the time.
“It's
extremely difficult for companies to get committed financing to finance
acquisitions and leveraged buyouts,” Ms. Chartoff said.
Investors
in the GSO fund included the $156.8 billion Florida State Board of
Administration, $83 billion State of Wisconsin Investment Board, $24.1 billion
Indiana Public Retirement System and the $50 billion Massachusetts Pension
Reserves Investment Management board.
“There are
so few mezzanine providers that have fund sizes that can comfortably hold $150
million to $200 million of mezzanine debt positions,” Ms. Chartoff said. “We
saw there was a real need for one-stop shopping for upper-middle-market
companies.”
Also in
Preqin's top 10 in terms of private equity capital raised in the first quarter
was New York Life Capital Partners, which closed the $980 million NYLIM
Mezzanine Partners III in April.
Another
manager that closed a substantial mezzanine fund within the last 12 months was
KKR Asset Management, the private equity firm's debt investment subsidiary,
which closed $1.023 billion KKR Mezzanine Partners I in August.
The
fundraising environment for mezzanine funds is tougher than it was before the
economic meltdown, when billions were needed to finance the LBO boom, said New
York Life Capital Partners' Mr. Haubenstricker. Fundraising has fallen
significantly since the heady days of six or seven years ago. But he said he is
not discouraged by the decline in fundraising. “Historically the good mezzanine
funds have generally delivered mid- to- upper teens returns to investors,” he said.
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