Mezzanine investing usually takes the form of a subordinated loan and an equity piece, such as warrants or preferred stock. Several trends have converged in the last few years which have diminished the flow of high- quality transactions to mezzanine investors. These changes in financial markets have made it more difficult to achieve targeted returns and have increased the risk of mezzanine investing.
The first trend is one that is well known and is common to capital markets of many types: there is too much money chasing too few deals.
A number of new mezzanine funds have been created and established mezzanine funds have raised additional funds. Mezzanine funds raised $2.2 billion in 1995, an 84% increase over the amount of funds raised in 1994.
In 1996, the fund-raising activity continued on a similar pace with some funds becoming oversubscribed. For example, TCW/Crescent Mezzanine LLC targeted a $300 million close and, in fact, closed with $482 million. In addition, several banking institutions have recently established divisions or subsidiaries to make mezzanine investments.
The second trend has also been around for several years: the willingness of senior lenders to make riskier loans by increasing the amount of their term loans.
The result is that senior lenders dip into the part of the capital structure usually serviced by mezzanine investors and debt-oriented mezzanine investors are left with only equity-oriented investments (usually with debt-oriented pricing). This also pushes down the equity-oriented mezzanine investor into a class of investment that is priced as a mezzanine piece but which carries with it equity risk.
A third trend is the increase in the purchase price of the assets. The purchase multiples for acquisitions have increased steadily and dramatically over the last few years.
Higher acquisition prices usually mean more highly leveraged deals and greater risk.
Thus, the mezzanine investor faces greater competition from other sources of mezzanine money and greater competition from senior lenders and equity investors. What's more, the credit quality of the available transactions has been degraded because of high purchase prices. How can the mezzanine investor engage in a prudent pursuit of its targeted returns?
There are some measures mezzanine investors can take to protect themselves.
First, it is important to balance the pressure to deploy money allocated for mezzanine investing against the risk of loss of principal. While limited partners, management, or whoever oversees the investment activity may exert intense pressure to close the deal, the pressure resulting from a failing investment will ultimately be much more severe.
Maintaining underwriting standards is an essential element for success in a highly competitive environment.
Second, preparation for troubled situations will permit the mezzanine investor greater freedom to monitor the investment through the default and workout.
Most of the preparation can be accomplished in the initial negotiation of the terms of the investment, the mezzanine investor's relationship with the senior lender and equity investor. The best arrangements usually allow the parties to maintain as many options as possible through the workout process.
The primary issues that arise in a negotiation with a senior lender are:
*Can payments to the mezzanine investor be blocked after a default has occurred? If so, for how long and for what kind of default?
*Can the senior lender prevent the mezzanine investor from exercising its remedies after a default has occurred? If so, for how long and for what kind of default?
*Does the mezzanine investor have covenant levels and defaults that are as strict as the senior lender's? If not, how much further must the company's situation deteriorate before the mezzanine investor has remedies?
*Can the mezzanine investor amend its documents in order to permit the company to operate without experiencing an event of default? (This becomes particularly important if the senior lender has a cross default.)
*Can the senior lender amend its documents without the prior consent of the mezzanine investor? (If so, the terms of the senior debt to which the mezzanine investor is subordinated can become significantly more burdensome on the company and the mezzanine investor.)
*Can the senior lender increase the amount of senior debt without the consent of the mezzanine investor? (If so, the mezzanine investor may find itself much lower in the capital structure than it originally bargained for.)
Successful negotiation of these issues will permit the mezzanine investor greater influence over the restructuring of a defaulted company's debt and equity structure as well as greater ability to monitor its credit.
Finally, given today's competitive conditions, traditional mezzanine investors may need to reassess the rate of return they can realistically expect from traditional mezzanine transactions. If mezzanine investors need to maintain their rate of return, they will need to become comfortable with increased risk.
Mr. Stromberg is a partner in the Los Angeles office of the national law firm, Heller Ehrman White & McAuliffe.
