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Thursday, 25th April 2024 |
| Irish mezzanine market looks set to follow European growth trends |
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| Mezzanine financing continues to grow in popularity due to its relative cheapness and its ability to be tailored to the needs of the client. Antoinette Flynn and Catherine Davis give an overview on the European market, which is ripe for further growth. |
Mezzanine finance is a relatively new and progressive means of lending money as hybrid of debt and equity financing. Its purpose is to bridge the gap in the capital needs of companies where traditional bank debt and equity fail to cover its capital transactions. Its emergence as a financial vehicle has been prompted by the need to fund growth opportunities such as acquisitions or plant expansions. As an additional layer of debt (on top of senior debt), it carries a much higher risk for the lender and is therefore more expensive. Nonetheless, it is still widely considered to be relatively cheaper than equity and as such has grown in popularity.
One of the primary reasons for growth in the hybrid mezzanine financing market is its ability to be tailored to the needs of the client. Mezzanine allows clients to alter repayments to suit the cash-flow/liquidity of their business, to be warranted or warrantless and it also offers flexible refinancing and the potential to roll-over into senior debt. In addition, the hybrid nature of mezzanine permits it to be treated as equity on a company’s balance sheet. These features coupled with the ease with which it could be set-up, resulted in a European mezzanine market value of E4.684 billion by 2003.
Given the attractiveness of mezzanine finance as a subordinated debt vehicle and the burgeoning growth in providers, a review of this niche market is long overdue. This review necessarily involves a comparison of banks versus independent finance houses; the dominant providers of funding in the mezzanine market.
Development of the mezzanine market
Historically, the growth of mezzanine was driven by higher values being attached to the high-yield market, which opened up a niche sector. A prime example of escalating values in the high-yield market was the record-breaking deal by RBS of E700 million tranche of senior notes for Heidelberg Cement in 2003. More middle-market companies then began to seek out relatively cheap, quick and flexible mezzanine finance in preference to the lengthy arduous and expensive equity finance vehicle. While equity could provide the additional financing required, the perceived future growth in the business may restrict a private equity investor from increasing their equity stake without conflicting with existing shareholders, who do not want further dilution in their own stakes.
Another driver of the development of the mezzanine market was the newfound outlet in the shape of the buyout market (Management Buyin (MBI), Management Buyout (MBO) or Leveraged Buyouts (LBO)). In the 1990s, the buyout market grew to become a major component of the European private equity industry. EVCA estimated that between 1998 and 2002, buyouts accounted for approximately 49.7 per cent of all private equity investments.
Mezzanine soon became the ideal debt vehicle for buyouts, as previously managers/ investors could only afford to purchase a significant share of the company and afford the purchase price in the most limited of cases (basic, small buyouts). By filling this market gap, the demand for mezzanine finance grew despite providers requiring returns of 20 per cent or higher. Senior multiples stand at approximately 70-80 per cent LTV (Loan to Value) but pricing often goes above these multiples. Mezzanine therefore, facilitates larger buyouts becoming the standard rather than the exception, by allowing a company to increase the lending leverage or EBITDA multiples. Evidence of this is borne out by the astonishing jump in total values of buyouts of some E8 billion between 2002 and 2004.
The growth in mezzanine has followed similar growth trends in the buyout market and it is interesting to note that when one suffered a downturn, the other did too. Between 1995 and 2003, many of the mezzanine transactions were linked to transactions occurring in the buyout market, 78 per cent compared to non-buyouts at 22 per cent. In terms of the value, the rate of mezzanine involvement in buyouts is slightly higher at 86 per cent (non-buyouts 14 per cent). In 2002, the value of buyouts without mezzanine stood at approximately E200m, whereas the value of buyouts with mezzanine valued at approximately E420m, which highlights the use of mezzanine to achieve higher price multiples.
This trend was mirrored in the leveraged buyout market with mezzanine facilitating larger deals. By 2005, leverage multiples with mezzanine increased to a high of 5.8 times in comparison to a smaller growth in leverage deals without mezzanine to 5.2 times.
The structure of both the European buyout market and mezzanine market further bears out the close relationship between the two. Initially, both developed in the shadow of the UK market. However, the economic slowdown in 2001 saw European values overtake that of the UK market, the latter weathering that slowdown badly. CMBOR figures showed that Continental Europe was out-performing the UK market in terms of buyouts by 66 per cent, reaching E50.2 billion compared to E30.1 billion respectively. Similar patterns were observed in mezzanine sector with Continental Europe dominating UK with a total of E783.5 million worth of transactions in the former compared to E399.3 million in the latter.
Market suppliers
When banks became more prudent about their lending procedures and regulations (in response to the Basel Accord and the economic downturn) a gap appeared in the funding marketplace, as senior debt failed to cover capital requirements of firms seeking large amounts of capital. Independent providers of mezzanine took advantage of the prudence shown by the banks and began to fill that market niche. As the mezzanine market began to grow and more companies sought this type of finance, banks then realised that they needed to adapt their offerings to a growing and dynamic market.
In an effort to recapture some of that niche market, banks began to offer mezzanine as a supplementary package to their other products. In essence, banks sought to deliver a one-stop-shop whereby companies could source all their financial needs within one finance house. Although many new operatives have appeared on the scene in recent years, there are still two prominent categories that lead the sector; these are banks/financial institutions (for example, Royal Bank of Scotland, HBOS, Allied Irish Bank) and independent finance houses (for example, Intermediate Capital Group, AIG Mezzvest and Goldman Sachs).
A typical mezzanine deal by banks would include approximately 40 per cent senior debt, 40 per cent equity and 20 per cent mezzanine. When a certain level of senior debt has been repaid (i.e. enough to include the mezzanine strip in the security of the senior debt), the mezzanine debt is then rolled-over into senior debt.
On the other hand, independent providers differ from banks in that they hold only the mezzanine strip, the senior debt is usually still held within banks or other finance houses. They also do not have the luxury of the financial security enjoyed by banks. Instead, they opt for warrants which are highly lucrative credit tools to compensate them for any additional risk they face. Warrants provide them with the option to buy equity of the funded company at a lower price than the market price and then sell when the market rises. As a feature of their mezzanine deals, there is usually a penalty on early re-payment of the funding facility, which generates substantial fees. The final differentiation between the two is that independent providers do not require the mezzanine finance to be repaid in full over the agreed term. Instead, they seek an attractive growth rate for their investment and have a planned exit route through an IPO, trade sale or in some cases senior debt re-financing.
Conclusion
In the USA, the number of mezzanine finance providers has increased significantly through time; by 2002, there were 113 providers with pension/hedge/leverage public funds representing 65 per cent of all providers. This increase in number of providers has also seen an increase in the amount of funding available in the market, with $5 billion funds raised in 2001 alone. Analysts predict that the flexibility of mezzanine and its market development will provide ample opportunity to companies to make strategic investments that facilitate growth and expansion, on a scale previously beyond their reach. Similar market expansion is evident in Europe.
Although the UK is a relatively mature market, continental Europe is still growing in terms of its offering for mezzanine finance. France and Germany have rapidly increasing numbers of mezzanine deals. In fact, France remains the dominant leader with approximately 150 deals in 2004. Despite a growth in providers of mezzanine to include pension/hedge funds, mezzanine is still showing growth in both number and value of deals. Indeed with increased competition, the pricing for mezzanine is being driven downwards, making this debt vehicle even more attractive to users. The expansion of mezzanine into larger value brackets now means that mezzanine can partake in all but the largest of deals, which would still require some element of equity. Year-on-year growth to date and the growth in the buyout market afford ever new opportunities for mezzanine funding. At present, the Irish deal values are below that of the other European countries, most notably the UK. The main providers of mezzanine come from the leading Irish banks, AIB and BOI. There is a threefold explanation for the small number of mezzanine deals in Ireland; the market size, the prominent presence of FDI in Ireland, and the significant number of SMEs that make up the Irish industrial structure. In particular, FDI companies utilise their domestic countries’ debt vehicles to their advantage, and it is estimated that only 16 per cent of entrepreneurs have high growth aspirations for Irish SMEs. In the current climate, mezzanine finance in Ireland is a slowly emerging debt vehicle, which no doubt should follow worldwide trends.To sum, the European mezzanine niche is an attractive growth market, operating in a stable environment and overall, the outlook is very positive for the future. |
Catherine Davis is a research student and Antoinette Flynn is a lecturer in the Department of Accounting and Finance at the University of Limerick.
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| Article appeared in the November 2006 issue.
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