INTELLIGENCE

EUROPEAN MEZZANINE REPORT 2010

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 Expect a strong vintage

1
Editor by David Wilmot, Babson Capital Europe
Emanuel Eftimiu Guest author David Wilmot of Babson Capital assesses the role of
emanuel.eftimiu@incisivemedia.com mezzanine in a post-credit crunch world.
Page 2
Contributor
Mareen Goebel
mareen.goebel @incisivemedia.com

Mezzanine in restructuring

2
Publishing director
Catherine Lewis
catherine.lewis@incisivemedia.com
by Mareen Goebel
During the market slump of the past two years, mezzanine has felt
the heat in countless restructurings.
Production
Chris Morrish Page 4
chris@cypressdesigns.co.uk

Marketing
Helen Longhurst
Roundtable

3
helen.longhurst@incisivemedia.com
with Emanuel Eftimiu
Advertising & Sponsorship In early May 2010, five leading industry professionals debated the
Stephen O’Sullivan state of the private equity market and its implications for mezzanine.
stephen.osullivan@incisivemedia.com
Steinar Liverud
Page 6
steinar.liverud@incisivemedia.com

All rights reserved. No part of this publication may

be reproduced, stored in a database or electronic
Statistical Commentary

4
retrieval system, transmitted in any form or by
any means, electronic, mechanical, photocopied, by Emanuel Eftimiu
recorded or otherwise, without written permission A collection of graphs and tables mapping trends within the
from the publishers. No statement in this journal is mezzanine market.
to be construed as a recommendation to buy or sell Page 12
securities.

Incisive Financial Publishing ltd

Haymarket House
28-29 Haymarket Acknowledgements
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United Kingdom
Page 16

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INTELLIGENCE 01
 The macroeconomic and financial market
Expect a strong vintage
BY DAVID WILMOT, BABSON CAPITAL EUROPE
turmoil of the last 18 months has brought
about some radical changes to the financing
environment for European buyouts and
created a highly attractive risk/return
environment for mezzanine providers.
The burst of the sub-prime mortgage bubble
in the US and ensuing global credit crunch
saw banks retract from their broad senior
and mezzanine debt underwriting strategy
during 2008 and 2009. Instead, banks opted
to provide senior debt on a take-and-hold
basis as part of a financing club of lenders,
mirroring a new, highly risk-averse approach
to deal structuring. What is more, despite the
easing of some of the credit policy strictures
that a number of banks have had to operate
under, the level of senior debt offered has
presented a significant obstacle to deal
execution. In mid-market transactions, for
example, senior debt has often been limited
to 3-3.5x EBITDA, which is generally not
sufficient when sponsors are contemplating
entry multiples of 7x and above.
The mezzanine product stands to benefit
in the current environment as not only
can it provide solutions to help companies
withstand economic downturns, but at the
same time it can drive increased value for
private equity sponsors. Mezzanine serves
the shared objective of borrowers and private
equity owners of businesses to establish
a debt structure, which can be serviced
by expected cashflow patterns and with
sufficient flexibility to cope with a period at
underperformance. For sponsors, mezzanine
provides additional funding capacity at a cost
of capital, which is set to enhance private
equity returns upon a successful sale of the
business (see box).
A favourable risk and return adjustment
As illustrated in the example (see box), the
use of mezzanine is to generate a win-
win situation for sponsors and mezzanine
02 INTELLIGENCE
purpose providers alike. Well structured
‘The mezzanine deals enable sponsors to benefit from higher
product stands returns, while mezzanine providers can take
WREHQHÀWLQ advantage of an attractive combination of
the current risk and return. Firstly, spreads have risen to
environment 1200-1300bps compared with the S&P LCD
as not only estimate of a market low of around 780bps
can it provide in the third quarter of 2007. Secondly,
solutions to the advent of two- and three-year non-call
help companies protection has increased expected investment
cash multiples that had been undermined in
withstand
the past by the use of minimal prepayment
economic
fees – effectively amounting to free call
downturns, but options for borrowers. Thirdly, the up-
at the same front and running cash element of returns
time it can has also been recently strengthened
drive increased by increased arrangement fees and the
value for private establishment of LIBOR floors on a number
equity sponsors’ of transactions. The use of equity warrants
on some transactions provides the latitude to
participate in added returns at exit alongside
the sponsor.
Beyond the improving returns there has
also been a clear risk correction, leverage
multiples have further contracted to
4-5.5x EBITDA, compared to 6.5-7.5x
and higher seen at the top of the market.
To some extent, leverage multiples are
being pushed up on larger ‘marquee’
transactions, but this is having far less
of an impact upon mid-market credits.
Additionally, equity contributions have
increased, thereby adding to the buffer
protecting the mezzanine position. Given
the cautious approach demonstrated
by banks in the current market and the
reduced number of institutional funds,
such as CLOs, with available ‘dry powder’
to invest in the primary mezzanine space,
such favourable conditions are set to
continue for some time.
Opportunities abound, even in restructurings
The positive outlook for mezzanine is
further buoyed by the increased buyout
activity recorded since the end of 2009. In
COPYRIGHT © 2010 INCISIVE FINANCIAL PUBLISHING LTD
addition, there will inevitably be increased activity in balance sheet
restructurings that lie ahead in the leveraged buyout arena. Many
high quality businesses have inappropriately structured debt packages
with a high level of debt that will mature over the next few years
and mezzanine has a clear utility here in reducing banks’ exposure
while providing companies with breathing space to execute recovery
strategies.
Although every situation is unique and there can be situations in
which the mezzanine lenders face legal and practical obstacles,
as illustrated by the IMO Car Wash case, European mezzanine
benefits from some important downside protection features. The
interplay of maintenance financial covenants and asset security
provides the opportunity to engage with financial sponsors at a
relatively early stage in the case of performance downturn. In most
cases this enables mezzanine providers to have an influential seat
at the table in restructuring discussions. Naturally, this position
is at its strongest when mezzanine is at least partly covered by
reasonable corporate value estimates, which are enhanced in the
current low-leverage environment. Moreover, in some jurisdictions
mezzanine creditors can, if the situation demands it, address more
radical solutions to restructuring situations such as an equity
control strategy which brings with it the potential for an above-par
return at exit.
Back to roots
The surge in institutional liquidity during the last decade drove high
levels of LBO activity and large syndicated mezzanine tranches.
While some of these proved to be successful, it also led to mezzanine
in large-cap deals becoming a capital markets product for a few
years instead of its original purpose of being a tailor-made financing
solution. The current market environment presents an opportunity
for mezzanine to return to its roots of adapting itself to solving
specific financing problems and generating additional returns, while
reintroducing the partnership concept to financing transactions. This
vintage therefore promises to be a strong one. N

Bridging the financing gap

The example below sets out two debt funding scenarios – the first
being an all-senior structure, and the second including mezzanine debt
and a corresponding reduction in the equity contribution. Assuming
that the sponsor acquires a business making `20m in EBITDA for a
price of `160m plus `10m in fees (see Fig 1), and exits after 3 years
at an EV of `256m (reflecting a flat transaction multiple of 8x, with
EBITDA at `32m). Assuming senior debt costs of E+500bps,
mezzanine debt pricing at E+1300bps and allowing for corporation
tax and capex outflows, the respective cash proceeds realised by
the equity providers are `190.1m in the senior-plus-mezzanine
case and `218.3m in the senior-only case. Clearly the lower equity
contribution in the senior-plus-mezzanine case drives a higher
multiple of 2.38x and IRR of 33.4%, compared to corresponding
levels of 2.2x and 29.7% in the senior-only case.

Fig 1: LBO Company - Debt structure Fig 2: LBO Company - Cashflow

35
180
30
160
25
140 €70m €70m 20
120
Value (€m)

Senior debt 15
100 Mezzanine
10
€20m Equity
80 5
60
€100m
40 €80m 5
20 10 2011 2012 2013
0 15
Excluding mezzanine Including mezzanine
EBITDA Senior Interest Mezzanine interest Capex Tax Net Cash Flow

Source: Babson Capital Europe Limited (illustrative example) Source: Babson Capital Europe Limited (illustrative example)

COPYRIGHT © 2010 INCISIVE FINANCIAL PUBLISHING LTD INTELLIGENCE 03

 During the market slump of the past two
Mezzanine in restructuring
BY MAREEN GOEBEL
years, the holders of mezzanine paper, which
was often structured as part of ‘one-stop-
shop’ financing packages, have clearly felt the
heat, especially in the countless restructurings
that have been necessary. True, falling
company valuations hit equity holders first,
but mezzanine investors followed closely
behind. In cases where the value was seen
to break in the senior, some mezzanine
investments have been completely wiped out.
Valuation is at the core of any restructuring
talks – but in a market with little future trading
visibility, coming up with sensible numbers can
become a highly contentious issue between
the various lender classes. While restructuring
talks are kept strictly behind closed doors, the
public got a glimpse of how fierce negotiations
can get when the dispute between the senior
and mezzanine lenders of British car cleaning
company IMO Car Wash spilled over into the
courts. The ruling went the way of the senior
lenders, but many junior lenders took heart
from the fact that the UK courts were at least
willing to look at value in detail, therefore
dismissing the notion that senior creditors
could opportunistically steal the company by
undervaluing it at a point in time.
This of course is just one example of senior
and mezzanine lenders clashing during
restructuring negotiations as the size, shape
and terms of each party’s contribution can
be hotly contested. Recently the German
gas springs manufacture Stabilus GmbH was
taken over by Triton Beteiligungsberatung
– normally an equity investor – in a debt-for-
equity swap. Triton, along with the hedge
fund Anchorage Advisers and Goldman
Sachs, had opportunistically bought into the
senior and subsequently pushed for a financial
restructuring process. As its contribution to the
restructuring, Triton stated it would provide
`20m to Stabilus – which fell well short of the
demands of the mezzanine lenders, led by AXA
Private Equity and representing `70m in debt.
04 INTELLIGENCE
In an alternative proposal, the mezzanine side
‘Senior backers
had suggested a different packet that would
sometimes require Triton to inject `40m in the company.
ignore the
fact that the When the time comes to restructure, senior
mezzanine lenders must be tempted to exploit their legally
lenders can play strong position to push out the mezzanine
a constructive lenders, if the documentation permits it.
role in Indeed, many feel their position is so strong
restructuring they don’t need to talk to the mezzanine
the company’s lenders at all. But there may be an upside
to negotiating even from a strong position:
balance sheet by
“In our view, the senior backers sometimes
providing fresh
ignore the fact that the mezzanine lenders can
liquidity’
play a constructive role in restructuring the
Frank Grell company’s balance sheet by providing fresh
Latham & Watkins liquidity, and this is a strong argument in a
debt landscape that is characterised by many
black holes left over from debt providers that
have vacated the space, many permanently,”
explains Frank Grell of Latham & Watkins.
Furthermore, disputes between lender groups
can jeopardise the success of a restructuring,
with foreseeable dire consequences for the
company, making this a no-win situation for
all parties. On the other hand, if both sides
are willing to negotiate, they will typically
comb through the documentation to clarify all
ambiguities and potential sources of conflict,
for now and for the future. This will also affect
the expectations of the invested parties – a new
understanding of a part of the contract will
have an impact on returns expectations and
the perception of one’s own legal position.
Nevertheless, one has to remember the senior
lenders are so named for good reason and
mezzanine providers are in the game for a
different set of reasons. As Grell concludes:
“While parties should keep a measured
approach and senior lenders should bear in
mind that subordinated debt can greatly
contribute to the restructuring, in the end,
mezzanine lenders are mezzanine lenders.
They do have rights, but their risk/reward
profile has the risk of loss priced in”. N
COPYRIGHT © 2010 INCISIVE FINANCIAL PUBLISHING LTD
 After another year of falling figures in the private equity space and a substantial drop in the number
Roundtable
WITH EMANUEL EFTIMIU

of deals involving mezzanine financing, unquote” brought together five industry representatives
in May 2010 to discuss the issues facing mezzanine and its future prospects.

Emanuel Eftimiu: Looking at the 2009 statistics, private equity

The Panel activity dropped significantly with only 257 buyouts worth £23.4bn
completed during the year. To put this in perspective, that’s down
55% in volume terms from the 2008 figures, which were already
quite dreadful compared to the 819 deals seen in 2007. The value
contraction has been quite staggering, with 2009 overall buyout value
Graeme down 87% from the 2007 total of £187bn. In terms of mezzanine
Delaney-Smith supplied to those buyouts, around 200 buyouts involved mezzanine
Head of financing in 2007 – equivalent to a 25% share. In 2008, the number of
mezzanine mezzanine deals fell to 113, or 20% of activity, while 2009 has slumped
Alcentra to roughly 20 European buyouts involving mezzanine, which is less
than 10% of dealflow. How do these figures bode for 2010?

Jason Block David Whiteley: 2010 feels more positive for primary deals whichever
Head of investor way you look at it. We saw real signs of improvement in the primary
management market from late summer last year and this has continued into this
Intermediate year. Private equity houses seem keen to invest and have written some
big equity cheques recently with some businesses going for up to 13x
Capital Group
earnings, which wouldn’t have happened a year or so ago. The work
in progress list is longer now than it has been for 18-24 months. We
David Wilmot currently have about 20 transactions in progress, compared to say half a
Joint head of dozen last summer. Vendors are encouraged by the purchase multiples
mezzanine & being achieved and this is helping with the pipeline. Liquidity has
private equity increased as well – last summer we thought there were a dozen or so
MLAs prepared to underwrite, but now we think there are more like
Babson Capital
20-25. Similarly, the number of participant banks has increased from
Europe
around 6 to about 15 over this period. Institutional investors have
received repayments through IPOs and bond refinancings and many
Daniel Morland now have cash to put to work in primary, which was not the case last
Managing director, summer. So overall, we think the market feels much improved albeit still
European debt fragile, and in particular if the IPO pipeline and bond refinancings were
to slow, then fund liquidity could dry up quite quickly because very few
advisory group
of these investors are raising any new cash.
DC Advisory Partners
David Wilmot: The picture is now secure from an institutional
David Whiteley standpoint. Existing CLO vehicles and other non-bank sources of
Managing director, debt provide some liquidity for deals, which would increase if there
leveraged loan was a slew of IPOs. The issue will be once you get to the end of the
investment period for existing CLOs. You can’t buy an asset that goes
syndicate
beyond the term of the CLO, so once you get into next year and
Lloyds TSB
more and more of these vehicles go beyond their investment period, it
Corporate Markets
remains to be seen where liquidity is going to come from.

06 INTELLIGENCE COPYRIGHT © 2010 INCISIVE FINANCIAL PUBLISHING LTD


Eftimiu: So how much of this liquidity is there to support deals?
Whiteley: For an attractive mid-market deal with say around £300m
of senior debt, you now see strong appetite for underwriting from
arranging banks. Previously, deals in this range such as Survitec, BCA
etc, were clubbed. The mid-market deals are the easiest to put together
but it’s the larger transactions, such as RBS World Pay, that require say
`1bn of senior debt, which are more challenging. You can sit down
and prepare some liquidity analysis based on a group of MLAs at the
top and then some participant banks, and funds and maybe you can
raise up to `1bn from European investors for a strong multinational
deal. However, a month later you may come up with a different figure
if in the meantime funds have put their cash to work in the secondary
market, which can sap liquidity quite quickly.
Graeme Delaney-Smith: It’s that activity in the secondary market
that has really changed. The statistics for primary deal activity don’t
really matter because of the relative pricing points for a new deal versus
secondary. Those who had liquidity last year were thinking “well here’s
a new deal with this pricing or I can put it into something that I’ve
been in for a couple of years, know the management team, have a bit
a background with and it’s trading massively below where we think
it should be”. I think that opportunity is pretty much gone. People
who have been active in the secondary market have probably filled
their quotas for different credit names and are now looking at what is
coming down the pipeline. If a deal got sensible leverage and pricing
it would attract a lot of liquidity. But timing plays a significant role,
because liquidity is changing from week to week.
Daniel Morland: And that makes larger underwriting positions quite
difficult to take on because you don’t have that much visibility of what
is going to clear where and when.
Whiteley: Public-to-private transactions are more difficult because
COPYRIGHT © 2010 INCISIVE FINANCIAL PUBLISHING LTD
“It’s activity in
the secondary
market that
has really
changed.”
Graeme
Delaney-Smith
you sign docs but then need to wait for a couple of months before
the deal funds. A couple of non-public-to-private deals that we have
underwritten recently have launched immediately on signing, with a
view to getting investors into the deal within the month. You don’t
want to be exposed to much more market risk than that at present.
Jason Block: We’re not chasing primary deals as leverage is still high
and pricing is unattractive at times. However, we still see a secondary
opportunity. It’s not buying off a run but actually working with a bank
or sponsor in their local market with a name that they’re stuck with
but want to exit. We know the sponsor and we know the structure
is not right but the company is fundamentally sound, which gives us
the opportunity to take the piece off the bank so we can restructure
the company and support its recovery and growth plans. And we still
think there is every opportunity to do this for the foreseeable future.
The issue of strong companies with broken balance sheets has not been
solved just because the capital markets have rallied.
Eftimiu: But is the value on the secondary market still there though,
because prices have risen so sharply.
Block: We bought a piece of paper a month and a half ago at 75c, first
lien. It was a L+250bps that was done over two years ago. But at 75c
for first lien with an implied leverage of 3.75x, we solved the problem
for a bank and we solved the problem for the sponsor, because now
they can go about growing the business with a supportive lender who
wants to see growth.
Wilmot: And this is very different to a trading desk getting a call that
something is available at 90 – do you want to buy it, fill or kill? This is
a bespoke solution for a bank that is long in a position and a sponsor
who can’t do anything more with the financing of that credit. And this
is at the front of a big change to the market. We’ve all heard about the
maturity wall in a few years time, which is going to keep everybody in
INTELLIGENCE 07

“It’s a different
environment, but a
better one. I’m very
comfortable with a
smaller market with
fewer players”
David Wilmot
business because there is so much to do to sort out those transactions
and give the sponsors more runway.
Block: We have seen more primary deals in the last quarter than all
of last year but we haven’t chased many of those deals. The pricing
isn’t great, the leverage is up to where it was in 2006/7 and there are
people who have a fund with its clock ticking and are chasing deals that
simply do not fit our strategy. Our strategy has always been to lead the
mezzanine tranche or own it with a friend. We want to structure it the
right way and we want to make long-term returns.
Eftimiu: So who is supplying the leverage to the primary deals then at
the moment?
Whiteley: we think that currently, there is plenty of appetite for
primary deals from both banks and institutional investors. For a couple
of the deals that we have underwritten recently, around 60-70% of the
debt has been sold down to banks. There are plenty of funds out there
that are keen to play but we’ve also seen the return of a number of
participant banks which is welcome. There are a number of deals over
the past few months that we’ve looked at that have been structured at
about 4x total, which for a strong credit seemed about right, but we’ve
seen leverage starting to creep up on some more recent deals which is
making some investors nervous.
Delaney-Smith: But that kind of multiple is taking a lot of
comfort from the 12.5x multiple paid by the equity isn’t it? What
I’ve found surprising is that multiples and debt multiples have
rebounded very quickly.
Morland: If you look back over time there haven’t been many
points when the maximum senior debt has been at 2.75x. Ultimately,
financial sponsors need to buy and sell assets. Although they are
long-term strategic investors they still need to sell, and when selling
08 INTELLIGENCE
you’re going to start with the good assets because you’ll get a good
price for them. And there is a big wall of buyers out there that will pay
high multiples for the right asset if they can find a way of justifying it.
They only get 4x debt into the structure, which means their base case
returns are not going to be exuberant and that makes it difficult for
mezzanine because it is too expensive. If private equity is only going
to make 20% why are they going to pay mezz 18%?
Wilmot: I don’t buy into that “mezzanine is too expensive across the
board” argument. Some sponsors will always tie themselves to that
notion but if you compare where mezzanine is now in terms of cost
of capital to the early noughties, there is not a lot of difference in total
cost of money. At the end of the day, mezzanine is value-enhancing
for them and there are plenty of sponsors out there prepared to work
as partners and buy into mezzanine as part of the overall financing
solution. Particularly if they look to finance platform acquisitions,
mezzanine can help them bridge the financing gap and buy into
a market consolidation play. So the utility of mezzanine here goes
beyond a financial engineering exercise and provides the means for the
sponsor to get the deal done and start to pursue the upside.
Delaney-Smith: If you are justifying a mezzanine fund return vis-à-vis
an equity fund return, then mezzanine has to be priced in the mid-
teens. It shouldn’t come at 10%+ EURIBOR that is at 75bps.
Whiteley: I think you’re right and one thing that we’ve learnt from
the past couple of years is that in a default situation, mezzanine is very
close to equity and therefore should have reasonable returns. But when
we pitch a senior / mezz structure on a deal, sponsors often argue
that 12% over cost of funds is too rich for them. I’m not saying that is
right or wrong but this is the feedback we are getting. Another reason
for going all senior at the moment is that a lot of these deals could be
refinanced fairly quickly, so many private equity houses say they don’t
want mezzanine in their deals if it has strong non-call protection.
Block: This whole pricing discussion depends on the type of private
equity investor. There are those looking just for capital and others who
are looking to develop strong relationships with their lenders. The
latter entails paying more but if we are 200 bps more and we take 25%
of the capital structure, which changes their equity IRR by 50bps – and
that’s just maths. They don’t mind paying us the extra because they
have us at the table as part of the structure. And that’s what mezzanine
is supposed to be: a tailor-made financing solution when there’s no
capital markets solution. For a few years it became a capital markets
syndicated piece of paper but that is not the way we view mezzanine.
Eftimiu: Fundraising in general has been very difficult over the past
COPYRIGHT © 2010 INCISIVE FINANCIAL PUBLISHING LTD

two years. How do you see institutional appetite for mezzanine in the
current market?
Wilmot: We’re in the relatively early stages of marketing a fund for
mezzanine- and sponsor-backed credits in Western Europe and thus far
it’s been very encouraging. There aren’t many new private equity funds
around at present so investors are by default looking at mezzanine.
And if you are a habitual private equity investor and are looking for
cash, then mezzanine can offer that as it distributes on a quarterly basis
instead of the back-ended cashflow you get from a private equity fund.
Of course, the proof in the pudding will be whether the encouraging
conversations will lead to LPs actually coming to the table to invest.
Delaney-Smith: Getting cashflow from their investments will be
important to LPs as there is uncertainty surrounding the private equity
world in terms of the existing portfolios and how they are going to be
exited. A lot of LPs had issues to sort out last year and with the private
equity return of capital drying up completely, they are looking for
instruments that yield cash. Now, on an unlevered basis, mezzanine is a
cash-paying asset. When it’s a levered fund and you’ve got a collapse in
Euribor it uses up a lot of cashflow, so going forward I think LPs will
look more closely at the returns of levered vs. unlevered funds. And if
they look at the mark-downs that happened across their private equity
books and compare that to the returns generated through mezzanine
funds, then they have to ask themselves what is actually a better
diversified strategy? Maybe a more diversified portfolio where you get
some of the money back pretty quickly might help them to revalue
their positions.
Block: LPs are certainly thinking more about risk-adjusted returns. In
the past their benchmarking revolved around absolute returns. There
was a study about LPs investing in managers and apparently 68% of
all LPs had invested in top quartile buyout managers. If they did that
and got it absolutely right all the time they would beat mezzanine
COPYRIGHT © 2010 INCISIVE FINANCIAL PUBLISHING LTD
“If private equity
is only going
to make 20%
why are they
going to pay
mezz 18%?”
Daniel Morland
returns and the reality then is they don’t need mezzanine. But if they
look at their portfolios and realise that some of them picked some
second quartile every now and then – and someone must have picked
the bottom half – they will realise that mezzanine has helped them
through cycles. And no, in the best vintages we’re not going to ever
deliver anybody a 3x fund – if we do that we’ve done the wrong thing
and took the wrong risk. But in the worst funds we’re not only going
to return the money, we’re going to meet the hurdles and we’re going
to deliver a return that outperforms everybody.
Delaney-Smith: I would say that the universe of mezzanine investors
has probably grown because of what has been going on in Europe.
The use of mezzanine in Europe, the size of the deals that were
taking place, has been far greater than it has ever been in the US. The
European market has really exploded, for good and for bad, but at
least it has opened investors’ eyes to the product.
Eftimiu: What are your views on restructurings that happened last year,
where in many cases mezzanine was left out of the structure?
Delaney-Smith: A lot of restructurings last year were knee-jerk
reactions to what went on. You had the banking market in a bit of
disarray with a lot of fear about liquidity and a lot of restructurings
were done in double quick time because people thought there were a
lot of opportunities. I think last year proved that in a crisis there often
is not a lot of sense spoken. How can you restructure a business when
you’re in a trough and you’re not sure about trading visibility and
things of that nature? And if you look at some of the businesses that
were restructured last year they’ve outperformed their business plans
massively. So it seems to me there was a massive rush to write off debt
last year that probably caused issues for people that didn’t need to
happen. I think this year you can have more sensible conversations as
one has a better idea what the actual sustainable level of EBITDA in a
business will be.
INTELLIGENCE 09

“Dealflow has
improved and we
are a lot more
optimistic then
we have been in
a long time”
David Whiteley
Morland: Absolutely right. If the lending group is in a situation
where no one had the faintest idea what’s going to happen next week,
never mind next quarter on the trading front, surely the most sensible
thing to do last year would have been to put in place an 18 months
standstill and suspend all covenants till we see what’s going on. But
the reality is that never happens from the senior lenders as nobody
wants to find themselves in a worse position in a year’s time through
lack of activity. And panic itself inevitably drives the processes and in a
few cases shareholders used the opportunity to pursue quite successful
disruptive strategies within debt syndicates.
Delaney-Smith: It’s the lenders at that stage that really hold the
power though and if there’s no categorical cash need in the business it
surely makes more sense, if everybody is willing, to sit back and wait.
Morland: And in smaller deals people can do that but in bigger
transactions when CLOs are involved, with their own leveraged
structure and covenants, it’s impossible to do that.
Block: It all comes back to what you consider is mezzanine. If you’re
doing deals where you and your friends are controlling the tranche
of debt, you know the five senior lenders, you know the sponsor well
and it’s a local business and it’s not widely syndicated, you are aware
of any issues well in advance. So you act early and start having the
conversation with the sponsor that he’s going to break covenants in
a year’s time. By the time you reach the point of something going
wrong you have all the right people at the table thinking about it and
trying to create a solution for a business. And the value may break in
the mezzanine and it may break in the senior, but there is something
to talk about and be done, and you can avoid going through a process
like IMO Car Wash.
Delaney-Smith: I agree, our better restructurings are the ones with
the least number of parties involved and where the paper is not trading
10 INTELLIGENCE
left, right and centre. Even some sizeable deals can be of that nature
but it comes down to being able to sit around the table like we used to
10 years ago, when there were five or six participants in the market.
Eftimiu: Would you say there is a noticeable change in terms of
restructuring dynamics so far this year?
Morland: Compared to the beginning of 2009 when, broadly
speaking, no one had any money apart from sponsors and the senior in
theory, we now have a situation where either par investors or some of
the more opportunistic funds are in a position to fall back on liquidity
and that changes the dynamics.
Delaney-Smith: Yes, and I also think some of the sponsors have
woken up to that fact as they have lost some businesses they never
imagined they could lose. All of a sudden either the existing lenders
were able put cash in, because of the government safety net, or they
sold out to other types of funds who were happy to own a business at
4x because they think it’s going to be worth 7x or 8x.
Eftimiu: How do you see the competition for mezzanine from the
reopened high yield market?
Morland: It all comes back to size and if we stick to the theme of mid-
market, high yield is not applicable to the mid-market at the moment.
Whiteley: And sponsors are looking at mezzanine even on some larger
deals, like RBS World Pay, Siemans Audiology etc.
Block: High yield goes through cycles but generally it comes in at the
larger end of the market so has an impact on the fringe of dealflow.
The real impact is on pricing though, because whether high yield is an
option or not, the sponsor refers to the high yield pricing.
Delaney-Smith: Back in the late 90s there was this belief that
mezzanine was dead because high yield bonds were coming into the
market. It’s 2010 and only now are we thinking that the high yield
market is coming to actually take us out of deals that we’ve been in for
far too long.
Block: Given the wall of refinancings coming up in the next few
years, there’s going to be a need for a lot of capital to come into
the market and I see high yield as more of a help than competition
for mezzanine.
Eftimiu: So looking ahead, how do you see the mezzanine market
developing in the next 6-12 months?
COPYRIGHT © 2010 INCISIVE FINANCIAL PUBLISHING LTD

Delaney-Smith: We have confidence in the resilience of the mezz
market for sponsored and sponsorless transactions. Corporate
mezzanine across Europe is probably more exciting than in the UK.
Some people are becoming alive to the fact that equity isn’t coming
without a cost and maybe some of the equity providers are realising
that their cost of capital may be 2% against our 15% but actually, as an
equity holder your dilution is far greater. We’ve been through a few
cycles since the mid-90s and I think mezzanine has always come out at
the other end as an instrument that has longevity for finding a flexible
solution to the funding needs – be it a sponsor deal, a restructuring or
a refinancing opportunity. And that’s where we would like to focus.
Block: There are plenty of opportunities for us out there. Many
companies have capital structures that don’t work because of the way
they were originally financed. Many of them are still inside corporates
and families and whether it’s a primary buyout or a refinancing, there
are enough deals to do that will generate 1.5x-2x money multiples
for the right risk for our LPs. And I think sponsors’ attitude towards
mezzanine has changed – yes there will always be a discussion about
price – but ultimately they and the senior lenders have learned their
lessons, some of them the hard way, about who their partners are and
who they want in the deals.
Wilmot: It’s a different environment, but a better one. I’m very
comfortable with a smaller market with fewer players and the current
availability of quality transactions and good terms. This is a franchise
defining period for private equity sponsors as they need to show that
they can buy and sell well. There wasn’t great dealflow last year but
there has to be this year, because private equity players won’t have
their money sitting in their funds forever. This is a positive driver for
continued supply of opportunities for mezzanine, because you can’t
build a business as a private equity sponsor on 60% equity contribution
to deals. We’re an investor in several private equity funds in Europe and
we won’t be buying their funds if they’re producing 17-18% returns.
COPYRIGHT © 2010 INCISIVE FINANCIAL PUBLISHING LTD
“It all comes
back to
what you
consider is
mezzanine”
Jason Block
Block: The question will be whether private equity funds will be
able to negotiate extensions on the investment periods of their
funds. If they have more time then they may be more disciplined
with their investments and there will be more opportunity for us. If
they can’t get more time they either invest it or lose it. I don’t think
they are going to make rushed investments but they are likely to buy
companies and probably over-equitise them. Regardless, the deal
environment is likely to be a very different one going forward, where
deals are far less vanilla or straightforward. Relationships will matter
again and creativity has become important again.
Morland: I expect the buyout market to improve although not at
a huge pace, and this outlook could change in the highly unlikely
event that global banking regulators agree on some fundamental
reform. Looking a bit further out, there is talk about the huge
opportunity the wall of refinancing is going to bring from next
year onward, but I think it’s way too early to call how that is going
to play out. If you take one small example in YELL; at the end of
the day a large number of investors were more comfortable with
kicking the ball down the field than facing some hard choices today
and I can’t see any fundamental reason why they won’t make a
similar decision in due course again. There will be other technical
reasons that argue against this, such as fund maturities etc, and in a
number of situations businesses’ capital structures will be properly
reorganised, but there will be a large number of situations where
this won’t happen.
Whiteley: We see more and more deals in the pipeline and so
hopefully we will see more deals completing. Liquidity seems to be
coming back quite strongly and we will continue to pitch all-senior
and senior and mezz structures because as we said, 60-65% equity
cheques can’t last forever. Dealflow has improved over the last couple
of quarters and we are a lot more optimistic then we have been in a
long time. N
INTELLIGENCE 11
 2009 saw the European buyout total Volume of mezzanine deals and `bn mezzanine invested
Statistical commentary
Article title
EFTIMIU
BY AUTHOR

involving mezzanine drop to its lowest

Volume Mezzanine Invested (`bn)
level in over a decade. Only around 20 250 12
transactions were structured with the

Mezzanine Invested (`bn)

instrument, equivalent to less than 10% of 200 10
dealflow last year. This is a far cry from the
8
peak seen in 2007, when 200 deals or 25%

Volume
150
of all buyouts recorded were financed with 6
BY EMANUEL

junior debt. Total amount of mezzanine 100

supplied to buyout transactions fell even 4
more dramatically, with less than `500m of 50 2
mezzanine invested in buyout transactions
in 2009. 0 0
2005 2006 2007 2008 2009*
Source: unquote”/Private Equity Insight

High liquidity in the debt markets had led to Development of EBITDA Multiples since 2006
rising entry multiples being paid by private
Equity/EBITDA JD/EBITDA SD/EBITDA
equity firms throughout the middle of the
10x
decade. While overall average valuation
multiples hovered around the 8x EBITDA level
8x
before dropping more significantly in 2009, it is
the share of total debt supplied to transactions
6x
Volume

that reveals the changing market environment.

Not surprisingly, leverage multiples have
4x
contracted since the onset of the credit
crunch, with the lack of financing leading to a 2x
proportional increase of equity tickets. As such,
the average equity ratio in buyouts has risen 0x
from just under 30% to almost 50% in 2009. H1 2006 H2 2006 H1 2007 H2 2007 H1 2008 H2 2008 H1 2009*
Source: Cepres

Substitute products such as second lien had

Mezzanine Pricing 2001 – 2009
significant impact on average mezzanine
pricing and average achieved IRR during the
buyout boom. The credit crisis relieved some Avg Current Interest Avg PIK Avg Base Case IRR
of the competitive pressure on the product 20
and the projected profitability of mezzanine
investments increased substantially in 2008 and 15
2009, due to a higher portion of warranted
Percent (%)

loans including equity kickers. It should be

noted that current interest and payment 10
in kind (PIK) here are calculated as capital
weighted average across all interest bearing
5
tranches within a mezzanine transaction. Thus,
average PIK pricing levels are not a reflection
of average PIK values on the market at the 0
2001 2002 2003 2004 2005 2006 2007 2008 2009*
time, but show the average pricing of PIK per
deal related to the total invested capital. Source: Cepres

12 INTELLIGENCE COPYRIGHT © 2010 INCISIVE FINANCIAL PUBLISHING LTD

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unquote
Returns for sponsorless mezzanine investments have clearly European sponsored vs sponsorless transactions
outperformed sponsored transactions, with the former achieving
an IRR for realised transactions of 22.4%. At the same time the Equity / EBITDA IRR realized transactions
loss rate of investments in sponsorless transactions is also higher, JD / EBITDA SD / EBITDA Loss Rate realized transactions
8 25
with mezzanine failing to recover its capital on 14.8% of cases. This
7
is mainly due to the different characteristics of these investments.
6 20

Rate times Ebitda

Besides involving larger buyouts, sponsored transactions involve lower

Percent (%)
risk as the deal is undertaken with a buyout investor, therefore adding 5

an equity cushion beneath the mezzanine tranche. Therefore the 4 15

equity exposure that makes sponsorless deals more lucrative on the 3

upside leads also to higher loss rates on the downside. 2 10
1
0 5
sponsored sponsorless

Source: Cepres

The bubble caused by the abundant availability of leverage during European buyouts 2003- 2009
the 2005 to 2007 period, becomes evident when the value of %2bn Total Value
European buyouts, excluding `2bn+ transactions, is plotted
%2bn %2bn
against overall buyout value. In 2006 and 2007, 3% and 2% of 1000 200
total recorded transactions, respectively, accounted for a staggering
46% and 31% of total deal value. The market exuberance reversed 800
150
through 2008 with total volume dropping by 28% and value by

Value (%bn)
600
Volume

60%. Consequently, unquote” recorded only four buyouts above

100
`2bn, representing just 12% of the total deal value in 2008. In 2009,
400
buyout volume and value contracted to the lowest levels seen in
more than a decade. 50
200

0 0
2003 2004 2005 2006 2007 2008 2009
Source: unquote”/Private Equity Insight

#YKPPKPIUQNWVKQPHQTNGXGTCIGFƆPCPEG
#UCVVJGGPFQH#RTKN.NQ[FU65$%QTRQTCVG/CTMGVU#ESWKUKVKQP(KPCPEGJCUDGGPQPGQH
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OGCPUQWTCRRGVKVGHQTUWRRQTVKPI'WTQRGCPRTKXCVGGSWKV[TGOCKPUCUUVTQPICUGXGT

14 INTELLIGENCE COPYRIGHT © 2010 INCISIVE FINANCIAL PUBLISHING LTD

With larger, more heavily leveraged deals being completed through Average `m Value of Mezzanine Deals and Tranche Sizes
the middle of the decade, average value of mezzanine deals peaked
at approximately `390m in 2006, with an average tranche size of Average Deal Value Average Tranche Size
400 60
`56m. Following the onset of the credit crisis and the subsequent
drop in buyout activity, especially at the top end of the market, the 350
50
average value of deals involving mezzanine financing fell by more 300

Value (`m)

Value (`m)
than half in 2008 to just over `180m, while average tranche sizes 40
250
dropped to around `27m. Although the small sample size in 2009 200 30
makes it difficult to draw any sound statistical conclusions, the few
150
transactions structured with mezzanine were significantly smaller 20
than averages in previous years, while the average tranche size
100
10
dropped to around `10m. 50
0 0
2005 2006 2007 2008 2009*

Source: unquote”/Private Equity Insight

Over the sample period, capital raised by mezzanine managers for Capital raised by Mezzanine Funds 2004-2009
European investments has been patchy. Following the `2.9bn capital
raised in 2004, the fundraising environment for the product cooled 2004 Closed (%m)
considerably in 2005. Since then though, mezzanine fundraising went
2005
from strength to strength, with substantial vehicles closed along the
way. That said, although 2008 was statistically another record year for 2006
mezzanine fundraising, more than three quarters of the `7.8bn raised
was due to the $20bn Goldman Sachs Mezzanine Partners V fund, 2007

which as a global fund is considered to have a 50% allocation reserved

2008
for European transactions. 2009 is considered one of the most difficult
fundraising environments. Against this backdrop mezzanine funds still 2009
raised `2.3bn, which is roughly in line with previous year fundraising 0 1000 2000 3000 4000 5000 6000 7000 8000
averages, implying rather stable LPs appetite for the product. Capital raised (%m)
Source: unquote”/European Fundraising Review 2010

*Please note that 2009 figures are based on a limited amount of observations for that year.

+CP5CNGs/CPCIKPI&KTGEVQT#ESWKUKVKQP(KPCPEG
Tel: 'OCKNKCPUCNG"NNQ[FUDCPMKPIEQO

.NQ[FU65$%QTRQTCVG/CTMGVUKUCVTCFKPIPCOGQH.NQ[FU65$$CPMRNEYJKEJKURCTVQHVJG.NQ[FU$CPMKPI)TQWR.NQ[FU65$$CPMRNEoUTGIKUVGTGFQHƆEGKU)TGUJCO
5VTGGV.QPFQP'%8*0CPFKVKUTGIKUVGTGFKP'PINCPFCPF9CNGUWPFGT0Q.NQ[FU65$$CPMRNEKUCWVJQTKUGFCPFTGIWNCVGFD[VJG(KPCPEKCN5GTXKEGU#WVJQTKV[

COPYRIGHT © 2010 INCISIVE FINANCIAL PUBLISHING LTD INTELLIGENCE 15

 Thank you to the following contributors
Acknowledgements

who helped with the research of this

intelligence report:

Jason Block Graeme Delaney-Smith Daniel Morland

Head of investor Head of mezzanine Managing director,
management Alcentra European debt
Intermediate advisory group
Capital Group DC Advisory Partners

David Whiteley David Wilmot Frank Grell

Managing director, Joint head of mezzanine Partner
leveraged loan syndicate & private equity Latham & Watkins
Lloyds TSB Babson Capital Europe
Corporate Markets

16 INTELLIGENCE COPYRIGHT © 2010 INCISIVE FINANCIAL PUBLISHING LTD

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