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Hewitt Investment Group May 2001 In Brief Mezzanine Debt Executive Summary Mezzanine debt is a niche component of the private equity market. Mezzanine securities are junior subordinated debt with equity warrants, and generally are used to finance leveraged buyouts (“LBOs”). The importance of mezzanine securities declined with the growth in the “junk bond” market, but high-yield underwriters increasingly have focused on larger issues. Long-term returns are not compelling relative to other forms of private equity, but the available universe is incomplete. In addition, mezzanine debt funds have a lower risk profile than do LBO partnerships. The currently tight credit market environment increases the importance of mezzanine debt, and therefore increases the return prospects. Institutional investors with significant LBO commitments should consider diversifying their programs with the addition of third-party mezzanine debt funds. Definition Historically, the term “mezzanine” has been used in two very different ways to describe components of the private equity market. Both descriptions are inspired by financings that are “in the middle,” similar to the mezzanine section of a theatre. Mezzanine has sometimes been used among venture capital investors to describe “bridge” rounds of financing, or those that occur shortly before an initial public offering. This paper outlines the second (and now more common) definition, which concerns mezzanine debt. Mezzanine debt is the part of the capital structure “in the middle” of senior loans and equity in an LBO transaction. Mezzanine securities are junior subordinate debt instruments that carry a sizable coupon (currently between 12% and 14%) and equity warrants. Mezzanine debt often is referred to as debt with equity “kickers,” because of the warrants. Mezzanine debt ranks junior to bank loans and (usually) high-yield bonds, but senior to the equity. History When mezzanine securities were first formed in the early 1980s they often were part of a “strip.” Banks acquired these strips, which combined junior debt and warrants, as part of their funding package supplied to a buyout target. Mezzanine debt predated the development of the “junk bond” market, and therefore accounted for a significant portion of the capital structure of the typical 1980s buyout. Before the advent of the high-yield bond market, mezzanine debt accounted for a larger portion of an LBO’s capital structure. In the 1980s, the LBO industry generalized both junk bonds and the privately placed mezzanine securities as http://www.HewittInvestmentGroup.com Hewitt Investment Group May 2001 the mezzanine portion of the capital structure, and generally it accounted for 40% to 45% of a deal. Senior bank debt accounted for between 50% and 55% of the purchase price, with equity sponsors providing the balance (generally around 15%, but as low as 10% during the 1980s). Because of the subordinated position of mezzanine debt, and the warrants required to entice buyers, the securities represent the most expensive form of debt. The creation of the original issue high-yield market significantly reduced the importance of the mezzanine market, but it has increased as the high-yield market has become focused on large issues. During the last year the reliance on mezzanine debt has increased at the expense of the high-yield market. Examples Obviously, the best return potential for mezzanine debt instruments lies in the warrants. When the issuer performs successfully and is able to eventually sell stock to the public, the warrants attached to mezzanine debt can garner large returns. However, credit losses can result in significant downside for mezzanine investments. In March of 1996 Texas Pacific Group sponsored a $350 million leveraged buyout of Beringer Wine Estates. The financing for the deal included $35 million in mezzanine debt. The senior subordinated note carried a cash coupon of 12%, and the issue included warrants that amounted to 3.5% of the company if exercised. The company grew its EBITDA (earnings before interest, taxes, depreciation, and amortization) by 17% in 1996 and by 23% in 1997. Beringer filed to go public in August 1997, and floated its stock in October of that year. The mezzanine debt was retired shortly after the offering, and the combined gain on the income and warrants amounted to an IRR of more than 40%. In January 1997, Advent International sponsored the leveraged recapitalization of Homemaker Industries, a rug manufacturer founded in 1945. The financing included $57.5 million in senior bank loans, $2 million of redeemable preferred stock, and $18 million of senior subordinated debt with warrants (the mezzanine tranche) carrying a 13.3% coupon. The company came under pressure from its debt load as well as competition from machine made rugs. Homemaker was forced to file for bankruptcy protection in October 1999, listing assets of $27.2 million and liabilities of $75.7 million. The company eventually was sold for $7.5 million. The total of interest received and the meager recovery on the sale of the company totaled about $3.5 million, producing an IRR of -93%. http://www.HewittInvestmentGroup.com Hewitt Investment Group May 2001 Mezzanine Debt Funds There are two primary types of mezzanine debt funds, but only one with which we are concerned. Captive mezzanine funds are created by large LBO firms in conjunction with their equity buyout vehicles. Typically, the limited partners of the LBO fund also comprise the investor base for the captive fund. The purpose of the captive mezzanine fund is to supply capital to the LBO sponsor’s deals with prearranged terms. The equity sponsor benefits from having a ready source of capital, while limited partners receive a blended debt and equity return. Third-party mezzanine funds provide subordinated debt to a variety of buyout sponsors. These lenders compete with other mezzanine suppliers to fund buyouts that they deem to be credit worthy. The principals of these funds must have strong contacts in the buyout community (and Wall Street), and have strong credit evaluation skills. The resulting portfolio is more diversified than a captive fund (because it spreads risk among many equity sponsors), and the primary goal of the fund is to achieve strong returns (rather than to fund the deals of a particular equity sponsor). Largest Mezzanine Debt Funds Fund DLJ Investment Partners II GS Mezzanine Partners II Blackstone Mezzanine Partners II ML Mezzanine Investors Lehman Brothers Mezzanine Fund DB Capital Partners Source: Venture Economics, HIG Vintage 1999 2000 1999 2000 2000 2001 Size ($mm) $1,600 $1,600 $1,140 $1,100 $1,000 $1,000 Return History Overall returns for mezzanine debt have not been compelling, and do not compare favorably to other forms of private equity. The pooled average of 11.9% trails both venture capital and (the more comparable) buyout sector by a substantial margin. The pooled average for mezzanine funds has trailed that of buyout funds by 6.6% (annualized) cumulatively. However, the sample size for mezzanine debt is relatively small, and captures only a portion of the total market. Venture Economics counts 184 mezzanine funds with total committed capital in excess of $36 billion. However, the return sample includes only 46 funds with a capitalization of about $14 billion. In addition, the Venture Economics database includes captive funds along with third-party funds. These captive funds comprise a significant portion of the assets in the database, and may skew the returns to the downside. http://www.HewittInvestmentGroup.com Hewitt Investment Group May 2001 Private Equity Annualized Returns December 31, 2000  Private Equity Sector Number Venture Capital Buyouts Mezzanine All Private Equity Source: Venture Economics 962 461 46 1420 Pooled Average 19.5% 18.5% 11.9% 19.1% 75th Percentile Median 28.3% 21.4% 16.0% 25.4% 11.4% 10.2% 11.3% 11.0% 25th Percentile 1.8% -0.6% 5.9% 0.8% The return data demonstrates that mezzanine is not as positively skewed as the other major segments of private equity. The pooled average return for all mezzanine funds (11.9%) is very similar to the median return (11.3%). Both venture capital and buyout funds have a pooled average return well above the median fund for their respective universes, indicating significant positive skewness. Mezzanine debt has a lower risk profile than either venture capital or buyouts, so the returns are not directly comparable. The distribution of returns demonstrates the tighter return spread of the segment. The dispersion (the spread between the 75th and 25th percentiles) is 10.1% for mezzanine debt, versus 22% for buyout funds and 26.5% for venture capital (presumably, survivor and selection biases reduce dispersion for all private equity segments). Finally, the past returns for mezzanine debt must be placed in their historical context. The pricing structure of mezzanine securities has not changed significantly during the last decade. However, the risk profile of this portion of the capital structure has declined over time. As credit standards have tightened, the portion of the capital structure funded with subordinated debt has declined, and the equity portion has increased. Historical returns seem to indicate that investors were not “paid” for the excessive risk associated with funding LBOs that had 10% to 15% in equity funding (but it is difficult to draw conclusions from the limited return data). HIG’s View Hewitt Investment Group does not consider mezzanine debt to be a “core” portion of the private equity market. This is due to the relatively small size of the thirdparty mezzanine fund market, the episodic nature of fundraising, the long-term characteristics of the asset class, and the spotty return data. By most estimates, mezzanine debt fundraising accounts for about 3% of all private equity fundraising. While this is roughly the size of the distressed debt market, unlike that asset class mezzanine investments do not diversify buyout fund commitments. Although risks are lower for mezzanine funds (than for LBO funds), they take on the same basic deal risk as buyout funds. http://www.HewittInvestmentGroup.com Hewitt Investment Group May 2001 The Venture Economics database counts 184 mezzanine funds. The 172 funds with asset data have total commitments of over $36 billion. Almost $18 billion of those commitments (about 50% of the historical total) have been raised since 1998. Since 1986, there have been five years when the market raised less than $1 billion. In addition, these totals include significant commitments to captive funds. For example, in 1987 (a year where total funds exceeded $1 billion), 45% of total commitments were accounted for by one large captive fund. We believe that the overriding goal for institutional investors who invest in private equity should be to achieve higher returns than those afforded in public markets. Thus, the asset in question should provide a “private equity-like” return. In general, we believe that buyout investors simply should take the equity risk associated with buyout investments, and therefore employ LBO funds for this core exposure. In addition, it is difficult to judge the relative merits of mezzanine debt as a strategic (i.e., long-term) component of a private equity program due to very limited return data. Mezzanine Debt Fundraising $8,000 $6,000 Millions $4,000 $2,000 $0 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 Although we do not consider mezzanine debt to be a core component of the private equity market, we do believe that investments in the sector may improve a program on a “tactical” basis. During the last decade, the development of the high-yield market has diminished the importance of the mezzanine market. However, when mezzanine instruments become relatively important to LBO equity sponsors the mezzanine market warrants consideration. http://www.HewittInvestmentGroup.com Hewitt Investment Group May 2001 Current Environment While LBO managers have had an abundance of attractive targets, deal flow has been stunted due to a lack of available financing. The credit crunch that began in late 1998 has not abated as far as the buyout market is concerned. Credit standards have continued to tighten during the last two years, with senior lenders limiting total leverage to about four times cash flow, down from five times only two years ago. Pricing also has increased, with spreads to Libor and up-front fees rising. In addition to declining risk tolerance, consolidation in the financing sector has reduced the number of available lenders. There have been two mergers among the top five members of the 1997 league tables for leveraged loans (the belowinvestment grade loans employed by LBO sponsors). Last year’s merger between J.P. Morgan and Chase combined two perennial leaders in the league tables, who together accounted for as much as 50% of originations. Meanwhile, the high-yield market has become more difficult to access. Two years ago the minimum threshold for a new high-yield offering was about $100 million. Market participants have seen that threshold rise to about $150 million. According to estimates by Oaktree Capital Management (see chart at right), 90% of new high-yield issues are above the $150 million mark. This has left a funding vacuum for small and medium sized buyouts. Through mid-April, only three leveraged buyouts this year have employed highyield debt as part of their financing. High-Yield Offerings $150mm or Less 40% 34.6% 30.5% Percentage of Total 30% 24.9% 20.1% 20% 10.0% 10% 0% 1996 1997 1998 1999 2000 LBO Subordinated Debt Sources 20% Percentage of Total Sources 15% 10% 9.3% 10.3% 3.9% 9.5% 4.5% 1.8% 2.0% According to Portfolio Management 5% 8.4% 8.3% Data, high-yield bonds accounted for 5.5% 5.2% 4.2% 4.5% 4.1% less than 2% of average buyout during 0% 1995 1996 1997 1998 1999 2000 LTM the last 12 months (ended March 2001 2001). By contrast, mezzanine debt Mezzanine Bridge High-Yield accounted for an average of over 8% of the purchase price during the same period. The use of high-yield debt dominated that of mezzanine from 1996 through 1998, while high-yield accounted for between 9% and 10%, and mezzanine for about 4%. However, the capital market disruptions of 1998 increased the importance of mezzanine financing, and the segment has outweighed high-yield since 1999. Anecdotal evidence also suggests that the pricing (from the perspective of the mezzanine debt buyer) has improved in terms of both coupons and warrants. http://www.HewittInvestmentGroup.com Hewitt Investment Group May 2001 ATLANTA 3350 Riverwood Pkwy Suite 80 Atlanta, GA 30339 770-956-7777 CINCINNATI 1710 PNC Center, 201 East Fifth Street Cincinnati, OH 45202 513-621-3300 LINCOLNSHIRE 100 Half Day Rd Lincolnshire, IL 60069 847-295-5000 ROWAYTON 40 Highland Ave Rowayton, CT 06853 203-852-1100 Summary While the term “mezzanine” has been used to describe multiple forms of private equity, its standard meaning is the debt with warrants that is used to finance leveraged buyouts. Mezzanine was a particularly popular form of debt financing in the 1980s, before the advent and growth of the original issue high-yield market. Public high-yield bonds are a cheaper form of financing for LBO sponsors, and as the importance of high-yield has grown, the significant of the mezzanine debt market has waned. Return data for mezzanine funds is spotty, and the figures that are available are not compelling. From the sample available, it appears that mezzanine debt suppliers were not adequately compensated for underwriting the highly leveraged buyouts of the past. Due to this, the episodic nature of mezzanine fundraising, and the market’s relatively small size, HIG does not consider mezzanine debt to be a core segment of the private equity universe. However, we do believe that mezzanine funds provide an opportunity to add value opportunistically, and the current environment is particularly favorable to mezzanine debt. Tight credit markets have reduced the amount of bank debt that LBO equity sponsors can raise. At the same time, there is little investor appetite for relatively small high-yield bond issues (i.e., those under $150 million in size). These conditions have made mezzanine debt more important to equity sponsors, and therefore have raised the “price” of mezzanine funding. In addition, the average leverage used for buyouts has declined, improving the credit position of mezzanine debt-holders. Hewitt Investment Group, a division of Hewitt Associates LLC, is a fullservice investment consulting firm. Since 1974, we have helped our clients develop asset allocation strategies, select money managers, and evaluate performance. Recognized as one of the “Top Five” investment consultants in the U.S., Hewitt Investment Group consults with over 150 clients including blue-chip corporations, endowments, foundations, hospitals, and public funds. 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