Not one to mince words, KPS Capital's Michael Psaros offers a ...

20-35_Roundup.qxd 4/6/09 5:39 PM Page 34Debt MonitorWhere’s the Mezz?The mezzanine market, armed with billions of dollars, stillneeds the senior lenders to show signs of life before it canresume its renaissanceBy Danielle Fugazy“ Prior to thechaos thatstarted inSeptember2008, the mezzmarket wasgettingstronger, and itwas startingto shine.”Last year, more than $25 billion was raised byroughly 30 mezzanine providers, according todata from Thomson Reuters. While other lendingsources have effectively dried up amid the credit crisis,one would think the mezzanine market would beenjoying a renaissance as one of the few financing optionsstill available. Such a scenario, however, has yetto materialize.“Very few private equity firms will do a mezz andequity deal; they want senior lending,” says Andy Steuerman,a senior managing director with Golub Capital.“If you can’t get the senior lenders interested, then youhave no transaction. That is the situation today.”Another factor is, quite simply, that the deal markethas effectively stalled. Economic uncertainty, ontop of the credit woes, has both buyers and sellers retreatingto the sidelines until more clarity emerges. Forthe most part, the only deals being pursued are thetransactions that are absolutely necessary for a company’ssurvival. “We are telling our clients to hang on,now is not the time to sell,” says one banker, speakinganonymously. That in turn keeps the private equitymarket stagnant, which effectively idles the mezzanineproviders, even if they’re armed with billions dollarsworth of dry powder.For the few deals that are out there, another factoris limiting the appeal of mezz financing; namely itsprice. The mezz market has become costly, almost tothe point that it rivals the equity portion of the deal.Last year, for instance, mezzanine shops were pricingdeals with IRRs of between 15% and 18%, including apay-in-kind component; rates that were already consideredhigh. Today, mezzanine tranches are being pricedbetween 16% and 20%, according to Ronald Kahn, amanaging director at Lincoln International. He addsthat mezzanine co-investments are now almost alwaysbeing replaced with warrants with most deals also requiringhigher pre-payment penalties, often starting out withtwo-year no-call provisions.Accordingly, sponsors are over-equitizing theirdeals. “Private equity firms are willing to put more equityin transactions,” Steuerman says, noting that the“return profiles [between equity and mezzanine] areconverging.” He adds, “There is also the benefit of [reducingrisk] with less debt.”To some lenders, the current environment bearsresemblance to other periods in the market. “This is thesame thing we experienced in 1999 through 2001,when firms wanted to patch a deal together to avoid thecost of mezz,” says Michael Hermsen, a managing directorwith Babson Capital Management.Hermsen, however, does not reflect any worry aboutthe future of the mezz. “Everyone came back to mezzthen and the same thing will occur again.”Like Steuerman, Hermsen alludes to the role the restof the market will play. “The senior lenders aren’t beingvery aggressive at all; we will be here to fill the gap,”he says, adding “the purchase price multiples are becomingmore attractive and pricing is getting better.”Babson is among those prepared for the market rebound,having closed its Tower Square Capital PartnersIII fund in December with $1.58 billion of capital undermanagement.Mezz is undoubtedly a necessary part of the dealstructure. In fact, it is so important that many equitysponsors have raised their own mezzanine funds. EndeavourCapital, a lower middle market firm, is trying to raisebetween $200 million and $300 million for EndeavourStructured Equity and Mezzanine Fund I LP, whichwould finance deals sponsored by Endeavour Capital andother firms. KRG Capital Partners, meanwhile, is inthe market with a $200 million mezz fund, which wouldbe used to finance its own deals. Other firms such as TheAudax Group, Summit Partners and TA Associates havealways raised mezz funds, although some, such as Audax,won’t invest alongside their equity vehicles.While the mezz market remains stagnant goinginto 2009, it has shown signs of life at times duringthe credit crisis. In the early part of last year, when theMEZZ continued on page 8634 MERGERS & ACQUISITIONS February 2009