Bloomberg News

Mezzanine Funds Grow as Falling Defaults Spur High-Teen Returns

June 06, 2011

June 6 (Bloomberg) -- Mezzanine loans, which may earn as much as 18 percent this year, drew fresh investment last week with Intermediate Capital Group Plc announcing plans for a 2 billion-euro fund ($2.9 billion) as the market rebounds.

The 16.9 billion-euro market is increasing its appeal as defaults fall and investors use floating-rate debt as a defense against rising interest rates. ICG is seeking 1.5 billion euros in third-party funds for ICG Europe Fund V and will supply the remaining funds out of its own balance sheet, it said June 1. Park Square Capital LLP raised an 850 million-euro mezzanine fund in April.

Falling mezzanine defaults are tempting investors back after a 47 percent drop in first-quarter volumes, allowing U.K. noodle bar chain Wagamama and Paris-based online travel agency Karavel-Promovacances to raise 75 million euros of mezzanine loans in the second quarter to fund their buyouts.

“The absolute return is still attractive,” said Klaus Petersen, a partner at Park Square in London. “Expected returns for mezzanine today are in the mid-teens on the debt and in the high-teens including equity co-investments. Its risk is lower than equity.”

ICG is targeting returns of about 18 percent with its new fund expected to close next year, said Mike Anderson, a director in London-based ICG’s investor management group. Mezzanine debt is used to finance leveraged buyouts, ranking behind senior debt and sometimes offered with equity stakes.

Refinancing Gap

Mezzanine defaults have declined at the same time as borrowers seek to fill a potential funding gap in the leveraged loan market as $280 billion comes due in the next five years. The floating-rate debt can also help investors hedge against rising interest rates as central banks around the world act to curb inflation.

New mezzanine funds will help replace about 50 billion euros of lost capacity as collateralized loan funds, once the biggest leveraged loan investors, start to wind down from next year, according to ICG.

“In the medium term, the high levels of European buyout debt maturing over the next four years at the same time as CLO reinvestment periods expire will create demand for new sources of capital to fill the gap,” ICG said in its annual earnings report on June 1.

CLO issuance evaporated in the wake of the financial crisis as investors blamed the hard-to-value assets for contributing to $2 trillion of losses and writedowns. Since 2008 just one CLO for 1.4 billion euros from ICG has been raised in Europe.

Default Rate Falls

The default rate for mezzanine loans fell to 6.09 percent in the first quarter, the lowest since the second quarter of 2010, according to Fitch Ratings. The lagging 12-month default rate for the S&P European Leveraged Loan Index rose to 2 percent in April from 1.7 percent a month earlier, according to Standard & Poor’s. High-yield bonds and leveraged loans are rated below Baa3 by Moody’s Investors Service and BBB- by S&P.

Holders of the debt typically receive more than double the interest margins of senior leveraged loans to compensate for a higher level of risk. The average return for European buyout mezzanine financing ranges from as little as 10 percent in 2007 to as much as 21 percent in 1991 and 1996, according to CEPRES Mezzanine Research, part of Deutsche Bank AG’s DB Private Equity.

Endemol Breach

Mezzanine defaults peaked at 8.12 percent in the third quarter, mainly as a result of U.K. gaming company Gala Coral Group Ltd. and European Directories BV which accounted for more than 1 billion euros of the debt with no cash recovery, according to Fitch Ratings.

“In the height of the credit bubble we had structures where the company couldn’t pay the interest out of its cashflow,” said Petersen from Park Square. “Many of the guys who didn’t understand mezzanine were wiped out - they had all the defaults and they’re gone.”

Endemol NV, the Dutch producer of the “Big Brother” television show, said last week it’s exploring options to restructure its debt as widening losses will cause it to breach covenants on 2.8 billion euros of loans, including 325 million euros of mezzanine debt used to fund its 2007 buyout, according to data compiled by Bloomberg.

As new rules from the Basel Committee on Banking Supervision are introduced, requiring banks to hold more capital to deter them from taking risky bets on credit, mezzanine providers will also be able to pick up assets in the secondary market, according to Petersen.

“New regulation will force banks and other debt holders to look at their balance sheets and to sell some of the assets because the new risk capital allocation is too high to make the returns work, which means there’s opportunity again for a mezzanine investor to acquire assets from banks,” he said.

Full-year issuance of mezzanine debt will be at least 1 billion in 2011, according to a forecast by Ipes U.K. Ltd., which administers funds for private equity and mezzanine managers. At the peak of the market in 2006, 13.4 billion euros of mezzanine debt was sold, according to Fitch.

--Editor: Cecile Gutscher, Paul Armstrong

To contact the reporter on this story: Karen Eeuwens in London keeuwens@bloomberg.net.

To contact the editor responsible for this story: Faris Khan at fkhan33@bloomberg.net.


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