Cash & Liquidity ManagementInvestment & FundingCapital MarketsThe Inevitable Rationalisation: The European Mezzanine Market

The Inevitable Rationalisation: The European Mezzanine Market

In the first half of 2004 the European market was awash with liquidity and demand for Mezzanine paper, with its floating rate coupon, was at unprecedented levels. This is despite a European High Yield (“HY”) market that was very much open for business with issuance of EUR21.9bn in 1H04 compared with EUR12.6bn in 1H03. However, this did not negatively impact Mezzanine issuance. In 1H04, the agency rated EUR2.2bn of Mezzanine, compared with EUR810m in 1H03 and EUR2.7bn in the FY 2003. The market remained highly competitive and Mezzanine facilities of quality issuers were significantly oversubscribed. Newer classes of investor, including US investors and hedge funds, have demonstrated interest in European Mezzanine whilst European CDOs are chasing Mezzanine assets in the search for yield and following high levels of prepayments. Inevitably, such high levels of competition will serve to depress Mezzanine pricing. The recent reverse flexing down of the Warrantless Weetabix facility took Mezzanine pricing below the 10% threshold.

European Mezzanine has been an extremely attractive subordinated debt instrument from a relative value perspective for a number of years and market developments in 1H04 reflect a natural rationalisation of the product. Is Mezzanine increasingly converging with HY? Certainly, falling Mezzanine pricing removes one of the historic differences between the two asset classes. However, other historic advantages of Mezzanine over HY are being eroded; the introduction of new classes of investors that are unlikely to be committed to the Mezzanine market over the longer term challenges the “buy-and-hold” approach of traditional Mezzanine investors. With an increasingly diverse investor base and further downward pricing pressure considered likely, many future Mezzanine syndicates will no longer comprise a small number of players with homogeneous interests. The agency believes that these factors may have a negative impact on future Mezzanine recovery rates. Furthermore, the market for Mezzanine may become cannibalised by the increasing use of second lien debt – essentially Mezzanine debt on much cheaper terms.

However, the agency acknowledges that these developments only impact future Mezzanine supply for facilities that are large enough to consider HY as a viable junior debt option. The majority of Mezzanine facilities are of less than EUR100m and therefore the supply of issuers who can take the either the Mezzanine or the HY route are not plentiful.

Mezzanine Issuance in H1 2004: Heading for an All-Time High?

Following a quiet 2003, particularly in the first half, Fitch rated more than double the number of Mezzanine facilities in H104 than in 1H03. The agency rated 11 transactions in 1H03 (and 35 in the FY 2003), compared with 27 transactions in 1H04 as shown in Chart 1.

Chart 1: Number of Transactions with Mezzanine
Number of Deals. Split by Country


Source: Fitch Ratings

Indeed, in 1H04, 64% of Fitch-rated LBO transactions contained Mezzanine, up from 58% in 1H03.

Fitch rated EUR2.2bn of Mezzanine in 1H04, compared with EUR810m in 1H03, representing an increase of 167% year-on-year.

To put this growth rate in context, in 1H04 the amount of rated Mezzanine already accounted for 90% of the 2003 level. As a result, 2004 may herald a new record for Fitch rated Mezzanine issuance, surpassing the 2002 record of EUR3.5bn.

Chart 2: Rated Mezzanine Issuance (1998-1H04)
Split by Country


Source: Fitch Ratings

Issuance From Non-Core Jurisdictions Continues to Increase

French Mezzanine issuance was active once again. In 1H04, the agency rated six French Mezzanine transactions compared with just two in 1H03. Germany also registered an increase with four facilities, up from just two in 1H03. UK levels, however, remained relatively stable with five transactions compared with four in 1H03.

As noted in previous reports, jurisdictions outside the core key issuing countries of the UK, France and Germany continued to increase their contribution to total Mezzanine deal flow. In 1H04, 12 facilities from non-core jurisdictions represented a material 44% of all Fitch-rated Mezzanine facilities. This is substantially higher than the 27% represented by such facilities in 1H03 (three facilities).

In line with the increased number of facilities, the volume of rated Mezzanine increased substantially in France between 1H03 and 1H04, as outlined in Table 1. However, UK volume also registered a major increase despite no material change in the number of transactions. Conversely, German volume declined by 26% despite an increasing number of facilities coming to market. With one exception these facilities were small – and issuance in 1H03 had included the EUR197.5m facility of Viterra. Additionally, a number of German corporates raised funding by way of HY in 1H04.

All “other” jurisdictions recorded increases in the volume of their rated Mezzanine issuance in 1H04. Fitch highlights the steadily increasing level of Mezzanine issuance in the Netherlands, Sweden and Finland, which accounted for 47% of the volume of Mezzanine in non-core jurisdictions in 1H04 (35% in 2003).

Table 1: Rated Mezzanine Issuance

  Jurisdiction
Vintage France Germany UK Others
2001 540.3 337.8 1,106.4 459.9
2002 876.8 840.1 878.9 880.4
2003 713.7 670.5 448.5 864.9
1H03 125.0 276.5 172.2 237.0
1H04 398.0 202.5 437.4 1,124.3
Variance (%) 218.4 -26.8 154.0 374.4

Source: Fitch Ratings

“Jumbo” Facilities – Making Their Presence Felt…

Three jumbo facilities (facilities > EUR200m) came to market in 1H04, as illustrated in Table 2. Both in number and in volume, 1H04 was materially up on 1H03, notwithstanding the favourable conditions in the HY market. The first half of the year also saw a number of other large Mezzanine facilities in excess of EUR100m, such as Weetabix (GBP120m), New Look (GBP100m), Saeco (EUR135m) and Demag (EUR100m).

Table 2: “Jumbo” Mezzanine Facilities

Vintage Issuer Country Facility Size (EURm)
1H03 Viterra Germany c. 200
2H03 Linpac UK 207
  Materis France 210
  Springer Germany 265
Total     882
1H04 Vetco International Norway 240
  Vivarte France 225
  Yellow Brick Road Netherlands 275
Total     740

Source: Fitch Ratings

…But the Average Mezzanine Size Remains stable

Chart 3 highlights that the average Mezzanine facility size remained roughly unchanged at EUR74.6m as of June 2004 (1H03: EUR73.7m).

Chart 3: Mezzanine: Average Facility Size

* EURm equivalent at deal date
Source: Fitch Ratings

Fitch rated 14 Mezzanine facilities that were below EUR50m in size in 1H04, representing 52% of total Mezzanine facilities rated in the period. As illustrated in Fitch’s previous reports and again in Table 3, the majority of Mezzanine facilities rated by the agency are less than EUR100m in size. At 1H04, 55% of all rated facilities were of less than EUR50m and a further 24% were between EUR50-100m.

Table 3: Mezzanine Issuance by Facility Size (1999 – 1H04)

Facility Size (EURm) No of Issuers Av. Facility Size
<50 116 25.3
50-100 51 73.7
100-200 29 125.4
200+ 14 254.1

Source: Fitch Ratings

However, with so many investors chasing yield, the average proportion of Mezzanine in the capital structure of new deals rose to 15.2% in 1H04, up from 14.2% in FY2003.

Composition and Drivers of Issuance

By number of issuers, 44% of the Mezzanine facilities rated by Fitch in 1H04 related to recapitalisation transactions or secondary/tertiary buy-outs (together “recycled issuance”). Within this recycled universe, 67% of facilities related to SBOs and the remainder to recapitalisation transactions. By volume, recycled issuance amounted to EUR587m in 1H04 and represented 27% of total Mezzanine volume. This is materially higher than EUR179m in 1H03, which accounted for 18% of total issuance.

The average Mezzanine facility in SBOs declined to EUR41m compared with EUR59m in 1H03 and EUR66.5m in FY 2003, reflecting the small size of many recent SBOs, such as Together-For-Leather, IMO Car Wash, Convenience Food Systems and Refresco.

Recapitalisation transactions in 1H04 included Condor Group, Cable Satisfaction and, at the end of 1H04, Picard Surgeles. It also included the EUR100m Mezzanine addition to Demag Holdings. The average facility size for Recapitalisation transactions was EUR66.4m (EUR59.3m for the FY 2003).

A number of new Mezzanine funds came to market in 1H04. Lehman Brothers completed a European Mezzanine fund that closed in May totalling EUR750m. ICG raised a EUR650m fund in May. Summit Partners, a US private equity group, raised a EUR380m fund. Notable among forthcoming issuance is Robin Doumar, formerly of Goldman Sachs Mezzanine Partners, who is reportedly raising a fund through his new independent investment vehicle and GSC Partners is raising a EUR500m Mezzanine fund.

A significant number of European CDOs are chasing Mezzanine paper. The agency notes that several recent CDO transactions have minimum Mezzanine buckets, which is an interesting extension of the traditional concept of maximum investment buckets within CDOs. Typically, the size of such buckets is 10%, although some deals have a maximum investment bucket of 25%.

Mezzanine Pricing: Heading Downwards

Table 4: Warrantless and Warranted Mezzanine in 1H04

Type Av Fac Size (EUR) Av Cash Pay (%) Av PIK (%) Av Warrants (%) Av Transaction Multiple Av Senior Leverage Av Total Leverage
Warrantless 77.0 5.0 5.8 n.a. 7.1 4.0 5.1
Warranted 71.6 3.7 5.6 6.6 7.5 3.7 4.9
Total Market 74.6 4.4 5.7 6.6 7.3 3.9 5.0

Souce: Fitch Ratings

Mezzanine pricing must be examined on the basis of whether or not it has Warrants attached. The recent examples of reverse flexing have both occurred on Warrantless Mezzanine facilities. Pricing on both the senior and the Mezzanine debt of the Weetabix transaction was reverse flexed down following heavy oversubscription. Pricing on the Mezzanine facility was reduced twice – from 10.5% to 10% and then to 9.5%, whilst 25bp was cut from the margins of the senior B and C tranches. Many traditional Mezzanine investors baulked at pricing below 10% (as did some “non-traditional” CDO investors). In principle, the agency believes that greater differentiation of pricing is appropriate in a mature market but that this should ideally be based on credit fundamentals, rather than opportunism in a liquid market.

The agency understands that CDOs and US hedge funds comprised the Weetabix Mezzanine syndicate at closing. It is unclear which party or group of investors has the controlling stake. This is a very different syndicate from those hitherto experienced in Europe and the agency believes that syndicates such as these are likely to be more difficult to manage than the traditional Mezzanine syndicate, particularly in distressed situations when new money may be required. With a new class of investor in the market, the dynamics of future syndicates will change depending on the approach of the financial sponsor. For example, the presence of hedge funds in the Weetabix transaction is reflective of the fact that US private equity sponsors, in this case HMTF, are more comfortable and familiar with this type of investor than European sponsors.

In recent weeks the market has experienced another example of reverse flexing. The EUR120m Mezzanine facility of Balta, the Belgium rugs and carpet maker, was recently reverse flexed down from 11.5% to just above 10%. For some investors a one percentage point movement in pricing is not especially significant and if the credit is sufficiently strong this is a market practice many are prepared to accept. Currently, the main issue concerning Mezzanine investors are the high levels of financial leverage in certain recent transactions and the ability to source Mezzanine paper of quality issuers.

Notwithstanding these examples of reverse flexing, there were many other deals in the market in 1H04 that attracted typical Mezzanine pricing. The average pricing cited in Table 4 has not evidenced any material downward movement from the FY 2003 average pricing outlined in Fitch’s last report – in fact, the average pricing of Warranted Mezzanine increased in 1H04 from the FY 2003 level.

The use of dual tranche Mezzanine continues. Recent examples include Vivarte which had a EUR150m Warrantless tranche and a EUR75m Warranted tranche and Vaasan & Vaasan (EUR35m and EUR10m, Warrantless and Warranted respectively).

In 1H04, EUR1.2bn of Fitch rated Mezzanine was Warrantless. This represents 57% of total rated volume, slightly lower than the 60%, or EUR1.6bn, seen in FY 2003.

Mezzanine Ratings Remain Stable

The average Mezzanine rating remained unchanged at “B” as shown in Chart 4. Jumbo Mezzanine facilities continue to be rated higher. The average Mezzanine rating for “Jumbo” transactions was ‘B+’.

Chart 4: Average Ratings by Vintage

Source: Fitch Ratings

Much Higher Prepayment Rates

European Mezzanine continues to experience a high level of prepayments, with EUR793m of Mezzanine prepaid in 1H04, mainly driven by refinancing activity. Fitch recorded eight issuers that had their Mezzanine prepaid in full in 1H04. The volume of prepayments in 1H04 represents 35% of the total volume of Fitch recorded prepaid Mezzanine, which stood at EUR2,231bn at 1H04. This is because in 1H04 two large Mezzanine facilities were prepaid; Coral Eurobet EUR210m (equivalent) (by way of a recapitalisation) and Linpac’s EUR207m facility (from asset disposals). Excluding these, the amount of prepaid Mezzanine falls dramatically to EUR417m. However, this is still far higher than FY 2003, when three issuers prepaid Mezzanine totalling EUR359m.

The average number of months to full repayment has been reduced to 21 months in 1H04 from 25 in FY 2003. Indeed, Almatis recently issued a USD150m High Yield Bond and used part of the proceeds to prepay its USD33.2m Mezzanine facility just five months after closing.

Table 5: Prepayments in 1H04

  Prepayment in Full
No. of Issuers 8
Amount of Issued Mezzanine (EURm) 793.0
Average Number of Months to Full Prepayment 21
Average Initial Facility Size (EURm) 88.1

Source: Fitch Ratings

The agency expects further prepayments in 2H04, including ATU’s EUR150m facility which is being taken out by way of a SBO.

As mentioned in previous reports, certain Mezzanine investors have argued that Mezzanine, especially the Warrantless variety, requires call protection. The weighted average life of Mezzanine continues to fall, as do Mezzanine prepayment fees, from 103/102/101 of principal in years one, two and three respectively, to 102/101. However, advocates of call protection are likely to find their pleas falling upon deaf ears – in such a competitive environment many investors are prepared to invest without any prepayment fees. Mezzanine Default Rates

Two issuers known to the agency defaulted on their Mezzanine debt in 1H04, producing a total defaulted volume of EUR95.6m. Christie Tyler, a UK furniture manufacturer, defaulted on a EUR35m Mezzanine facility of a 2002 vintage in March 2004. The other issuer was French, with a 2000 vintage transaction. The two transactions had an average time to default of 32 months. In early 2H04, the agency learnt of the Mezzanine default of another UK issuer.

By way of contrast, there was only one HY default in the European market in 1H04. Refer European High Yield Defaults down 90% in 1H04 vs 1H03 (August 2004).

Recovery Rates

In July 2004, Christie Tyler completed a consensual debt-for-equity restructuring whereby Mezzanine lenders agreed to equitise EUR33.5m of the EUR35m Mezzanine facility. The EUR1.5m of outstanding Mezzanine will remain under the new structure, reflecting a pro-forma recovery rate of just 4.3%. Senior lenders experienced a 20% loss on principal.

Second Lien Facilities: A Threat to Mezzanine?

In its review of the Mezzanine market in 2003, the agency highlighted the introduction of second lien facilities: please refer also to the agency’s report entitled Creative Structures in European Leveraged Finance (May 2004). Initially designed to appeal to a largely U.S. investor base in the pursuit of enhanced yield, second lien facilities resemble European Mezzanine in that they are second secured, largely buy and hold instruments that are subordinated to senior secured debt. Typically, such facilities benefit from minimal prepayment fees and/or call protection. However, second lien facilities diverge from European Mezzanine in terms of pricing – this is debt provided on substantially cheaper terms than Mezzanine despite having similar maturity profiles. In an environment where Mezzanine pricing is on a downward trend but still considered expensive by many parties, second lien facilities are becoming increasingly common.

The recent recapitalisation of the Springer transaction came to market with a EUR278m Mezzanine facility and a pre-placed EUR100m second lien facility. This transaction has served to highlight that European investors are also hungry for second lien paper. The investor base of the second lien facility was entirely European, comprising funds and CLOs. The Mezzanine lenders gave permission for the inclusion of an additional layer of debt above them, presumably fearing prepayment of the Mezzanine facility if they did not do so.

The introduction of a new layer of debt in the capital structure creates a degree of uncertainty as to how the investor class may act in a distress scenario and may serve to potentially complicate distressed restructuring negotiations.

So far, no EUR500m Mezzanine Facility but What About GBP400m?

At the start of the year there was speculation that 2004 would be the year of the EUR500m Mezzanine facility. At the end of 1H04, this had not occurred – unsurprising given the buoyant conditions in the HY market. Notwithstanding this, there will always be sponsors and issuers who will prefer Mezzanine over HY whatever the market conditions, attracted by the inherent flexibility of the Mezzanine instrument and the ability to control the composition of the syndicate.

The forthcoming transaction for the buyout of the Automobile Association has taken the Mezzanine route. Reportedly, the transaction will come to market within the next few days with a Mezzanine facility of GBP400m. This would make it Europe’s largest Mezzanine facility to date.

Outlook

The agency expected the environment to remain highly competitive for the remainder of 2004. Accordingly, it anticipates that downwards pressure on Mezzanine pricing will continue, reflecting an inevitable adjustment to the traditionally attractive risk/reward profile of the asset class over recent years. Indeed, as there has yet to be a large, high profile Mezzanine default transactions will keep on pushing out the leverage boundaries in the knowledge that the demand is there. Some disciplined investors have been consistently declining what they consider to be excessively aggressive structures, but transactions are still being syndicated successfully. This lack of discipline could prove to be dangerous – and the agency warns that it might take a high profile default for the market to self correct.

Note: Pablo Mazzini was co-author of this report and it was first published by Fitch on 25 August 2004.

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