Corporate Finance
Leveraged Finance/Europe Through the Looking Glass: Special Report European Mezzanine Revisited
Analysts Executive Summary Pablo Mazzini So it was all just a bad dream. The steep declines in pricing, +44 20 7417 3540 further subordination from Second Lien, weak covenants, lower [email protected] equity contributions and constant pre-prepayments and recycling
Edward Eyerman of the same credits at higher leverage and lower spreads over the +44 20 7862 4056 last three years, were all a bad dream! What a difference a crisis [email protected] makes, as European Mezzanine investors anticipate a return to bank-driven structures with modest leverage, amortising debt, tighter covenants and pricing more in line with the equity-type risk borne by subordinated creditors to risky borrowers. Other Related Research 1. “European Mezzanine Reconsidered” Of course, we are yet to witness the emergence of post-H107 (16 October 2003) trends in the European leveraged credit markets, though once 2. “The European Mezzanine Market in 2003: Still Upwardly Mobile?” transactions trickle through – and they will – Fitch anticipates a (24 March 2004) material pull-back to terms and conditions for Mezzanine more 3. “The Inevitable Rationalisation: The consistent with the bank-driven structures of 2002-2004 than the European Mezzanine Market in H104” non-bank structures that evolved from 2004 to H107. This means (25 August 2004) that together with European regional banks, which remain open for 4. “A Record Year for a Bifurcated business in the senior secured leveraged loan market, European Market: The European Mezzanine Mezzanine funds anticipate considerable structuring and pricing Market in 2004” (22 February 2005) power. While some new CLOs may be printed, and some 5. “Refinancing Wave Fuels European surviving hedge funds will be attracted by the higher yields that Mezzanine Issuance in Q105” (14 April 2005) the new primary market Mezzanine will most likely offer, the days 6. “The European Mezzanine Market in of substitution and compression by these leveraged and liquidity- H105: Eclipsed by Second Lien?” driven investors are over, at least through 2008. (19 July 2005) 7. “2005 Another Record Year for While the market events of summer 2007 represent a healthy re- European Mezzanine” (17 October pricing of risk across the credit spectrum, the crisis may 2005). nonetheless become protracted to the point where it takes longer 8. “European Mezzanine Knows No for new primary transactions to return. Lower leverage levels will Limits” (13 February 2006) no doubt translate into lower enterprise values for LBO target 9. “European Mezzanine - More Risk at companies, leading vendors and sponsors further apart than where Lower Prices in Q106” (12 April 2006) they have been accustomed over the past three years. Add the 10. “The European Mezzanine Market in more immediate concerns that arranging banks have with H106: Raising the Stakes” absorption of Asset-Backed Commercial Paper (ABCP) through (27 July 2006) much of the remainder of 2007, and the estimated USD400bn of 11. “2006 set to be the Year of Jumbo un-syndicated pre-July 2007 deals on their balance sheets, and it is Mezzanine” (10 October 2006) difficult to envisage in the near-term a return to the volumes and 12. “The European Mezzanine Market in transaction sizes the market witnessed from 2004 to H107. 2006: Innocence Lost” (15 February 2007) Finally, while the agency anticipates a return to the kind of lower- 13. “2007 a Test Year for European default risk/higher-recovery characteristics Mezzanine enjoyed Mezzanine” (16 April 2007) 14. “Market Correction – Where Liquidity prior to 2004, the outstanding volumes of post-2004 Mezzanine Matters” (9 August 2007) will continue to haunt the asset class. In this, the latest of our series on bi-annual European Mezzanine market reports, Fitch highlights the challenging state that European Mezzanine found itself in towards the end of H107. Specifically, Fitch reviews how the liquidity bubble in the credit markets extended its reach and eroded many of the attributes of this once – and perhaps future uniquely – attractive asset class.
24 September 2007 www.fitchratings.com Corporate Finance
As the Nightmare Ended: out of the party altogether by voracious senior and Second Lien investors. To the extent that arrangers Reviewing H107 called on Mezzanine investors, it was typically The trends established in H107 can be considered the because a big cheque was required – as in the pinnacle of the liquidity cycle initiated in 2002/3. By unfortunately timed LBO of UK retailer and H107, Mezzanine investors were left with declining pharmaceutical wholesaler Alliance Boots volumes and the worst risk-adjusted terms in the (GBP750m Mezzanine loan). On a last 12-month product’s history. The combination of rising senior (LTM) basis to June 2007, Fitch-rated European leverage as a proportion of total leverage, and added Mezzanine issuance of EUR12.2bn was lower than competition from Second Lien and PIK loans, the EUR13.4bn of Mezzanine capital raised in 2006, resulted in H107 Mezzanine issuance of only and was the lowest annual amount since Q106 (after EUR4.9bn, a 19% decline on the same period of reaching a peak of EUR14.8bn in Q306). 2006, and clearly well below the new record of
Second Lien issuance of EUR8.3bn for the period, which was 165% above H106. The average Chart 1: European Junior Secured Debt transaction size remained slightly above EUR100m, Issuance by Quarter reflecting financial sponsors’ continued reluctance to Warranted mezzanine Warrantless mezzanine use High-Yield Bonds (HYB) to fund LBOs, as Second lien (EURbn) demonstrated by large subordinated debt financings 8 for ProSiebenSat1 and Alliance Boots. The 7 Mezzanine on offer in H107 implied a wide market 6 acceptance of a high PIK coupon (and even a cash 5 element with a PIK toggle option), or low pricing, in 4 which case Mezzanine would frequently resemble 3 Second Lien (albeit with a PIK element). 2 1 In any case, the large share of senior secured debt in 0 H107 structures catered to the substantial demand from CLOs, notably trans-Atlantic investors, in the Q103 Q203 Q303 Q403 Q104 Q204 Q304 Q404 Q105 Q205 Q305 Q405 Q106 Q206 Q306 Q406 Q107 Q207 Source: Fitch process of ramping up European portfolios. To complete the then bleak picture for Mezzanine, prepayments of EUR4.2bn in H107 were well above In H107, Fitch rated 48 new Mezzanine transactions the EUR2.7bn in H106, while the CLOs were also against 69 in H106 and 137 in 2006. maximising their subordinated debt buckets to achieve target yields for their equity investors. All In contrast, HYB issuance, the traditional threat to this translated into increased competition in pursuit Mezzanine, continued to grow in H107, albeit at a of fewer transactions with Mezzanine. much slower pace and largely driven by large cross- over corporate credits (such as Fiat and Rexam). H107 Mezzanine Issuance Dwindled HYB issuance was also boosted by credit-linked Such was the liquidity available in the leveraged notes and loan participation notes issued by financial credit markets and the accompanying de-emphasis institutions and related to emerging markets on risk that Mezzanine investors were frequently left transactions. Overall, corporate-related HY issuance
Chart 2: European LBO Junior Debt Issuance Holdco PIK loan issuance (LHS) LTM HYB issuance (LHS) LTM second lien issuance (LHS) LTM mezzanine issuance (LHS) (EURbn) Sec lien+mezzanine (% of total junior debt issuance) (RHS) (%) 70 100 60 80 50 40 60
30 40 20 20 10 0 0 Q403 Q104 Q204 Q304 Q404 Q105 Q205 Q305 Q405 Q106 Q206 Q306 Q406 Q107 Q207
Source: Fitch
Through the Looking Glass: European Mezzanine Revisited: September 2007 2 Corporate Finance accounted for 80% of H107 HY issuance. The share to shy away from Mezzanine came as no surprise in of HY issued for LBO financings therefore declined a “buyer’s” market where senior debt appeared to to just 20% in H107 from 45% in 2006. This trend know no limits. However, the recent risk aversion as came as little surprise given financial sponsors’ illustrated by the halted syndications of many deals preference for the flexibility afforded by the private in the primary market, as well as the sell-off in the loan market in terms of pricing, lack of public secondary market, will no doubt herald the return of disclosure and reporting, and loose call protection. Mezzanine as transactions re-price and restructure to Table 1 shows the evolution in growth rates by asset cater for the demand from traditional Mezzanine class. fund investors.
Following the normalisation in growth rates for … also by Holdco PIK Loans Second Lien in its start-up days of 2005, Second In addition to Second Lien, demand for deeply Lien issuance grew dramatically in H107, at the subordinated pay-in-kind (PIK) debt remained strong same time as Mezzanine was showing its first in H107. As highlighted in Fitch’s report “European decline year-on-year. Overall, in the last three years, Holdco PIK – Evolution and Formidable Growth” the average growth rate of Second Lien (May 2007), arranging banks were successful in outperformed that exhibited by Mezzanine and HYB. tapping ceaseless demand from hedge funds and other institutional investors willing to take additional Table 1: European Junior Debt: risk down the credit curve. As a result, Holdco PIK loans also became an effective substitution for Growth Rates Mezzanine. Examples include AZ Electronic Second High- Materials, Phadia and Travelex. The response of the (%) Lien Mezzanine yielda Mezzanine market to the competition from Holdco 2004 – 114.0 16.3 2005 204.9 86.0 -16.2 PIK loans was the introduction of PIK toggle 2006 47.2 24.4 47.3 features, as observed in a few examples in H107, an H107 165.2 -19.0 2.8 alternative to introducing a straight PIK instrument CAGR 2004-LTM 120.7 34.4 9.2 in the capital structure (also refer to Mezzanine H107 Pricing section on page 5). a Excluding CLN/LPN issuance related to banking & finance Source: Fitch The Future of Mezzanine While the substitution from Second Lien and Holdco Substitution by Second Lien … PIK represented the final stages of the liquidity The competitive pricing of Second Lien against bubble and the blurred barriers between leveraged Mezzanine (measured as “all-in” cost) made this credit products and investor classes, the Mezzanine instrument the first choice in the seemingly never- product should remain better placed to endure the ending search for tighter pricing among arranging market correction. Specifically, Second Lien and banks and financial sponsors in H107. Fitch-rated Holdco PIK were dependent on leveraged Second Lien issuance had soared in H107 to a record investment strategies from CLOs and hedge funds, EUR5.6bn and, for the first time since its inception, which remain at the mercy of a clogged-up banking LTM Q207 Second Lien (EUR13.6bn) surpassed system and the uncertain outlook towards leveraged Mezzanine, as illustrated in Chart 2 (see also return strategies from institutional end-investors. Appendix 1). Mezzanine, on the other hand, has a committed base of long-term investors with funding in place, which In the market prevailing until H107, Second Lien will remain open for business when new primary was widely used to structure LBOs of any size and, deals emerge. increasingly, for medium- to large-sized deals, not necessarily driven by a committed pool of investors Analysis of Mezzanine Issuance but rather by sponsor demand, as Second Lien was supposed to offer financial sponsors the same Split by Tranche Size flexibility as Mezzanine for a lower margin. Chart 3 highlights two trends: increased polarisation Consequently, sponsors were increasingly reluctant by size of tranche (ie record issuance for jumbo to use Mezzanine in LBO financings, unless it was Mezzanine in H107 and sustained issuance for small required by the size of the transaction as in deals); and a sharp decline in Mezzanine issuance ProSiebenSat1 (EUR405m), Alliance Boots within the EUR100m-200m segment, which was the (GBP750m) and Saga/AA (GBP650m); or in smaller part of the market most exposed to substitution risk. and riskier LBO transactions as in Aliplast (EUR40m), Via Location (EUR25m) and Consolis Fitch rated six “jumbo” Mezzanine deals in H107 (ie (EUR66m). The fact that financial sponsors decided with a facility size in excess of EUR200m): for TI
Through the Looking Glass: European Mezzanine Revisited: September 2007 3 Corporate Finance
Automotive, Molnlycke Health, Mediannuaire example, Alliance Boots’s Mezzanine was launched Holdings (PagesJaunes’ Holdco), Borsodchem, as non-call for three years). ProSiebenSat1, Xsys-Flint and Ferreti (altogether EUR1.8bn with an average size of EUR262m). Split by Purpose Although competition from other products meant Recycled Mezzanine (both for recapitalisations or that jumbo Mezzanine issuance was lower than secondary/tertiary buyouts) remained a key driver of originally thought (eg Kion’s EUR300m was Mezzanine issuance in H107. In volume terms, cancelled and Mediannuaire’s Mezzanine was scaled recycled Mezzanine accounted for 68% of total down to EUR210m from the original EUR524m), H107 issuance (82% in Q2 alone). This was clearly Casema in Q306 and ProSiebenSat1 in Q207 above the average of 57% between 2004 and H107. confirmed a trend towards large Mezzanine tranches. Mezzanine which was used to fund new LBOs, This was further illustrated by the structure for which is a better indicator of the organic market Alliance Boots. growth, was a modest EUR352m in Q207, the lowest quarterly figure since Q205, and a testament to how far the product had fallen by the time the sub-prime Chart 3: Rated Mezzanine Issuance crisis hit the leveraged credit markets in July 2007. 2000–Q207 Split by size
Through the Looking Glass: European Mezzanine Revisited: September 2007 4 Corporate Finance the extent it was employed by arrangers and Chart 7: Mezzanine Pricing sponsors, was less frequently funding the gap Warrantless >EUR100m between senior debt and equity. Despite the smaller Cash pay+PIK coupon (LHS) layer of Mezzanine, the proportion of priority senior Senior leverage (RHS)ª debt approached 60% of EV, which kept recovery (%) Total leverage (RHS) (x EBITDA) prospects for Mezzanine debt under constant 12 8 pressure. Post-crisis, Fitch expects the new deals 10 6 clearing the market to be more akin to those seen 8 pre-2004 – featuring more bank-driven structures 6 4 with modest leverage, lower participation of Second 4 Lien, and increased equity contributions. 2 2 Chart 5: Capital Structure Evolution 0 0 2002 2003 2004 2005 2006 H107 Share of mezzanine at historic lows ª Including second lien debt Senior secured Second lien Mezzanine Equity Source: Fitch (%) 100 level (around 6x), again largely due to the increased 80 sponsor preference for Second Lien financings.
60 Mezzanine Pricing
40 Downward Pricing, Typical of a Buyer’s 20 Market, Comes to an End By the time of the re-pricing that took place in July 0 and August 2007, the average cash-pay coupon for 2001 2002 2003 2004 2005 2006 H107 warrantless Mezzanine (94% of LTM Q207 Source: Fitch issuance) had decreased to 3.79% in Q2, the lowest
quarterly figure ever recorded. The PIK coupon, Leverage Reaches Plateau in H107 whilst also in decline, remained higher at 5.14% in For all transactions with Mezzanine, total leverage Q2. declined to 6x in Q207 from its highest point of 7x in Price erosion was more acute for the large facilities Q306. However, the higher share of Second Lien left (see Chart 7) largely instigated by reverse structural senior leverage stable in the range of 5x-5.5x. flexes. Here, the average cash-pay plus PIK coupon Second Lien and Mezzanine transactions remained reached a low of 8.5% in H107, in spite of average the most highly leveraged in Fitch’s H107 rated leverage which continued to grow to 7.3x. The shift Mezzanine universe. as shown in Chart 6. For such in the risk/reward balance was clear when compared transactions, total leverage declined gradually from with the peak average pricing of 11.7% and 5.0x the record of 7.5x in Q306 to 6.7x in Q207, yet total average leverage in 2003. Fitch also observed senior plus Second Lien leverage stabilised at a high downward pricing pressure for small warrantless-
Chart 6: Quarterly Leverage Ratios Total leverage (deals with second lien and mezzanine) Senior leverage (idem – including second lien) Senior leverage (idem – only first priority debt) Total leverage (all deals with mezzanine) Senior leverage (all deals with mezzanine) (x EBITDA) 8
7
6
5
4
3 Q104 Q204 Q304 Q404 Q105 Q205 Q305 Q405 Q106 Q206 Q306 Q406 Q107 Q207
Source: Fitch
Through the Looking Glass: European Mezzanine Revisited: September 2007 5 Corporate Finance
Mezzanine transactions, which are often more inclusion of a PIK toggle within the terms of some vulnerable to liquidity and business risks, although Mezzanine facilities, following the trend seen in US this trend was accompanied by more conservative Second Lien. In H107, Fitch saw a number of structures in terms of leverage. As a result, pricing European Mezzanine transactions where the cash- reached a low of 8.6% (cash pay + PIK) while total pay element was structured with a PIK toggle feature, leverage declined to 5.4x in H107 (from its highest enabling the issuer to switch the cash-pay coupon to of 6.2x in 2006). pay-in-kind (often with a step-up margin), thereby potentially making Mezzanine an all-PIK instrument in the event of tight cash flow and liquidity Chart 8: Mezzanine Pricing conditions. While traditional Mezzanine investors Warrantless 6 4 to the crisis. 4 2 Prepayment Rates 2 Refinancing activity continued to fuel Mezzanine 0 0 prepayments in H107. Appendix 3 shows that the 2002 2003 2004 2005 2006 H107 total amount of prepaid Mezzanine was EUR4.2bn in ª Including second lien debt H107 out of 26 transactions, 54% above the same Source: Fitch period in 2006. On an LTM basis, prepayments amounted to EUR6.1bn, above the EUR4.7bn Chart 9: Pricing Comparison prepaid in all 2006 yet still below the record of Margin over base rate EUR6.9bn that had been prepaid in the 12-month Senior debt margin (term loan C) (9 yrs) period to Q106 – at the peak of the first dividend Second lien margin (9.5 yrs) recapitalisation wave. Warrantless mezzanine margin (10 yrs) (bps) Holdco PIK margin (9.5–10.5 yrs) 1,200 Chart 10: Mezzanine Prepayment by 1,000 Reason 800 Dividend recap SBO/TBO Debt refinancing Trade sale/IPO 600 Other (EURm) 400 3,000 200 2,500 0 2,000 Q104 Q204 Q304 Q404 Q105 Q205 Q305 Q405 Q106 Q206 Q306 Q406 Q107 Q207 1,500 Source: Fitch 1,000 500 Not only had the imbalance between supply and 0 demand in the Mezzanine market caused downward price pressure, the trend was facilitated and Q104 Q204 Q304 Q404 Q105 Q205 Q305 Q405 Q106 Q206 Q306 Q406 Q107 Q207 Source: Fitch exacerbated by pricing competition from Second Lien (which priced at an average 443bp in Q207, the lowest average pricing since its inception), and Chart 10 shows that the main driver behind Holdco PIK debt instruments, as shown in Chart 9. It prepayments in H107 was the strong refinancing is noted that strong hedge fund demand for Holdco activity not linked to dividend payouts, but rather to PIK instruments caused pricing for this deeply the replacement of Mezzanine by senior secured and subordinated debt instrument (issued outside of the Second Lien and, though less frequently, by Holdco ring-fenced main borrowing group) to drop below PIK loans. In H107, crowding out of Mezzanine by even that of Mezzanine. other debt instruments reached a record amount of EUR3.2bn. Examples of this include Numericable PIK Toggle Feature (EUR510m), The AA (EUR595m equivalent), Elior The latest (and perhaps last) innovation in the (EUR500m), Com Hem (EUR255m) and SSP European Mezzanine market in H107 related to the (EUR100m). Through the Looking Glass: European Mezzanine Revisited: September 2007 6 Corporate Finance In H107, the average time to prepay had declined further to just over 18 months, below 24 months in Table 2: Profile of Fitch-Rated 2006 and the historical average of 25.7 months since European Mezzanine Defaults 2004. However, as the agency has argued, recent Average developments suggest recycling activity will likely Average Time to cease for the rest of 2007 and through 2008. Out of No. of size Min/max default the live LBO transactions currently monitored by defaults (EURm) (EURm) (months) Fitch, 63% are from either a 2006 or 2007 vintage, 2002 4 36.6 5/90 40 2003 5 67.2 35/125 39 with accompanying legacy leverage and structural 2004 4 25.5 11/43 39 characteristics, thereby leaving fewer candidate deals 2005 5 107.7a 32/192a 33 for recapitalisations. 2006 4 85.6 27/180 45 H107 4 30.9 22/52 22 Average 4 61.1 22/114 36 Default and Recovery Rates a Includes Gate Gourmet and Treofan Source: Fitch Few and Small-Sized Defaults in H107 Fitch recorded four payment defaults on its rated small credits, which are inherently more exposed to Mezzanine portfolio in H107 (which names the event risk and limited pricing power, or highly- agency cannot disclose due to confidentiality), two leveraged large credits. In Fitch’s view, large from France and two from Germany. By industry, borrowers benefiting from revenue diversification two were auto-related credits, one consumer will be better placed to forestall default or gain products and one textiles & furniture. The defaults support and new money from investors. As an in H107 were small in size (EUR30.9m average), example, while Belgian consumer product company which is half of the average amount of defaulted Ontex had considered the sale of its healthcare unit Mezzanine on a historical basis (see Table 2). to prepay debt, the company then managed to refinance its debt with the support from Candover The above default activity led to an increase in the and Merrill Lynch which underwrote a large 12-month rolling default rate to around 2% in Q207. preferred equity tranche. However, Fitch notes that While this was higher than the 1.6% at Q406, it was the example of Ontex, and later TMD Friction, is a still in line with the historical average, as corporate reflection of the strong liquidity prevailing until profitability and economic growth continues to H107, something which may not be available in a support LBO performance according to plan. tighter credit environment for other troubled names should they need to refinance or tap the market for Adjusted for two distressed borrowers of which Fitch additional liquidity. is aware, around EUR134m of additional Mezzanine could be added to the reported defaulted volume of Pre-2005 Vintage Deals are the Most Likely EUR464m as of Q207. This would increase the pro- Source of Defaults forma 12-month rolling default rate to 2.6% at Q207. Fitch notes that the volume of Mezzanine debt for The recent trends in issuance and prepayment which the Issuer Default Rating (IDR) is currently activity in Mezzanine have led to a polarisation of ‘B-’/Negative Outlook, or Rating Watch Negative or this market which is largely oriented to LBO below (EUR1.1bn as of June 2007 on 11 borrowers where the risk is concentrated either on transactions), is the likely source of potential Chart 11: Fitch-Rated Default Rates Mezzanine defaulted volume (LHS) Mezzanine adjusted "defaulted" volume (LHS)ª Second lien annual default rate (RHS) Annual default rate (RHS) Annual default rate (adjusted) (RHS)ª EHYB default rate (RHS) (EURm) (%) 800 7 700 6 600 5 500 4 400 3 300 200 2 100 1 0 0 Q401 Q102 Q202Q302 Q402 Q103 Q203 Q303Q403 Q104 Q204 Q304 Q404Q105 Q205 Q305 Q405 Q106 Q206 Q306 Q406 Q107 Q207 ª Adjusted for "distressed" mezzanine deals (IDR rated "CC" or below at time of last update) Source: Fitch Through the Looking Glass: European Mezzanine Revisited: September 2007 7 Corporate Finance Chart 12: Fitch's Mezzanine Recovery Chart 13: Mezzanine "Out-of-the-Money" Ratings as of June 2007 Total leverage (through to mezzanine) Senior leverage (including second lien) Maximum typical distressed EV/EBITDA range RR2 RR3 RR1 Minimum typical distressed EV/EBITDA range RR4 0.7% 2.7% 0.7% EV/EBITDA 3.3% RR5 (x EB ITDA ) 4.7% 10 8 RR6 6 88.0% 4 2 0 H103 H203 H104 H204 H105 H205 H106 H206 Q107 Q207 Source: Fitch Source: Fitch defaults in the foreseeable future. While the confers as a secured instrument, often ranking third historical time to default has averaged 36 months behind Second Lien. This, combined with the since 2002, the average age of the above 11 increasingly aggressive (and creative) financing transactions, is currently just over two years (ie most structures of recent pre-crisis LBO transactions, does are pre-2005 vintage). not bode well for potential recoveries among junior lenders. Not All Doom and Gloom, but Beware Tight Liquidity Conditions Fitch constantly updates its Recovery Ratings In principle, Fitch does not anticipate a material rise portfolio for all debt instruments. The current in default rates over the remainder of 2007 and into portfolio of European Mezzanine (EUR25.9bn) 2008, as these credits have long-term funding in suggests poor recovery expectations, with most place, are early in the life of their plan, and have Recovery Ratings falling within the ‘RR6’ category little amortisation scheduled until 2013. Moreover, – implying expected cash recoveries below 10%. economic growth and corporate profitability remain supportive of even aggressive projections, Chart 13 shows that European Mezzanine remains notwithstanding potential contagion from the credit largely ‘out-of-the-money’. Despite the slight crisis to the broader economy. Notably, the agency reduction in total leverage in H107, further views the dramatic rise in inter-bank short-term subordination of Mezzanine by Second Lien and funding interest rates as a de facto tightening of senior debt has reduced the share of Mezzanine in a monetary policy, which may pose a threat to highly- typical capital structure to around 1x EBITDA in indebted leveraged borrowers over time as H107 from 1.5x in 2006, thereby leaving the refinancing risk builds up. Therefore those borrowers prospects of low recoveries largely unaffected. This with a weak business and financial profile that have is based on the usual distressed EV/EBITDA ranges been able to refinance in recent years will probably of 5x-7x used by Fitch in its recovery calculations be most at risk if market liquidity remains tight (often adopting going concern techniques as opposed beyond 2008, or if they are compelled to return to to traded asset valuation). the credit markets for any reason while the crisis continues. In the near term, however, the agency sees Conclusion and Outlook few credits under pressure, and a material The sub-prime crisis and its contagion to the broader deterioration in business conditions would have to credit markets came just in time for Mezzanine as an transpire before leveraged borrowers are forced into asset class, as the product was under pressure from default scenarios. all corners by the end of H107. With a traditional buyer base that has cash on hand and remains willing Recovery Rates to engage with arrangers and sponsors, Mezzanine is Anecdotal evidence suggests that recent defaulted poised to undergo a rennaissance as a risk-adjusted Mezzanine is achieving poor cash recoveries in debt- asset class. It may not return to pre-2004 levels, for-equity swaps. This is in line with Fitch’s view where equity-like returns from warrants and bank- that recoveries are largely dictated by the distressed like recoveries from conservative leverage were the economic value available for subordinated creditors norm, however it is clear that unwinding leveraged (ultimately a function of business viability and asset strategies and risk aversion will lend greater value), rather than by the rights that Mezzanine Through the Looking Glass: European Mezzanine Revisited: September 2007 8 Corporate Finance negotiating power to the Mezzanine fund investor Chart 14: Global Real Interest Rates and base. GDP Growth Countering the outlook for attractive terms on new Real GDP growth Policy rates primary market Mezzanine are the legacy structures (%) Real interest rates that remain in many portfolios, with their relatively 5 low spreads, weak credit profiles and poor recovery 4 prospects. Many funds may be stuck with these for 3 some time, as refinancing activity will cease for at 2 least the next 12 to 18 months. Moreover, many 1 LBOs have already undergone their secondary or 0 tertiary sale process or have been recapitalised, so the prospect of enhancing long-term profitability -1 therefore appears to rest on driving further consolidation via bolt-on acquisitions which will, in turn, be subject to benign liquidity conditions. ª W/A of US, Euro, Japan and Uk. 2007/8/9 are Fitch forecasts Source: Fitch Default risk will likely remain subdued as long-term providing leverage. This should mean traditional funding is in place and sponsors should have time, at Mezzanine fund investors, together with core bank least for the next few years, to de-lever existing deals investors, will drive structure and pricing for deals towards the primary market levels; reminiscent of that eventually come to the primary market in 2008. 2004, as anticipated by the agency. Legacy deals may therefore ultimately refinance into better In the event of a more permanent market re-pricing – structured and more attractively priced new a potential result of lingering secondary market Mezzanine deals. The crux for such a rosy scenario liquidity, transparency and valuation premia in the centres on sponsors achieving aggressive projections structured credit markets – Fitch foresees the return within a suppportive economic and corporate profit of Mezzanine as the subordinated debt instrument of environment. While the credit crisis may spread to choice for financial sponsors, although potentialy the broader European economy, global growth facing competion again from High-Yield. Price, remains healthy and real interest rates remain low. rather than pre-payment flexibility, may return as the principal concern for sponsors attempting to put the With cash balances building among global estimated USD500bn of globally committed funds to institutitional investors, the outlook for new work in new transactions. For this reason, the agency Mezzanine investments will look particularly does not see warrants returning for large Mezzanine attractive. At the moment, the alternative credit transactions just yet, though large transactions will investors that relied exclusively on leveraged take some time to return in any event. Smaller- and strategies to achieve compensation-driven target medium-sized “club” deals will be the story through returns and gathered assets regardless of risk, will the end of 2007 and into 2008, and a welcome return have to wait for the bank market to digest the ABCP to the good old days for Mezzanine. issues and re-assess their approach to risk and Through the Looking Glass: European Mezzanine Revisited: September 2007 9 Corporate Finance Appendix 1 European Mezzanine, Second Lien and Holdco PIK Loan Issuance Trends Mezzaninea Second Liena Holdco PIKb Amount (EURm) No. deals Amount (EURm) No. deals Amount (EURm) No. deals Q102 264.5 6 Q202 251.6 7 Q302 1,654.3 14 Q402 1,350.2 19 Q103 421.8 6 Q203 388.8 5 Q303 880.0 12 Q403 1,007.1 15 108.0 1 Q104 667.3 13 346.5 2 Q204 1,445.7 18 688.4 2 Q304 1,736.7 22 392.6 2 Q404 1,924.6 19 457.0 3 Q105 1,472.5 18 303.4 5 2,006.3 6 Q205 1,298.5 15 1,845.9 14 922.0 3 Q305 3,732.9 36 2,137.8 19 110.0 1 Q405 4,235.2 30 1,458.7 16 240.8 5 Q106 3,067.7 33 1,877.0 26 100.0 1 Q206 2,953.7 30 1,258.5 18 2,766.0 7 Q306 4,581.4 33 3,040.9 26 862.5 3 Q406 2,756.5 25 2,279.7 21 2,645.0 5 Q107 3,032.4 29 2,671.4 28 3,118.0 12 Q207 1,850.5 19 5,642.7 32 1,737.0 5 a Fitch rated universe b Including both loan/note form Source: Fitch Through the Looking Glass: European Mezzanine Revisited: September 2007 10 Corporate Finance Appendix 2: Mezzanine Issuance by Jurisdiction Fitch notes the lower overall number of Mezzanine transactions across all jurisdictions in H107. However, the average Mezzanine facility size increased to EUR102m in H107, up from EUR94m in 2006, reflecting the concentration around large Mezzanine facilities, such as Kloeckner Pentaplast and ProSiebenSat1 (both in Germany) and TI Automotive and Gondola (both in UK). Mezzanine issued in other jurisdictions accounted for 37% of total issuance. This is above the average of 28.5% between 2001 and 2006, although below the record 41.5% in 2006. The main issuing countries outside the UK, France and Germany were: Sweden (EUR766m), Hungary and Italy (EUR200m each), Belgium (EUR170m), the Netherlands (EUR151m) and Switzerland (EUR142m). Rated Mezzanine Issuance (EURm) Jurisdiction Vintage France Germany UK Others 2001 540 338 1,106 460 2002 860 840 986 835 2003 714 671 505 808 2004 1,006 1,290 2,122 1,356 2005 2,153 1,853 2,698 3,341 H106 1,441 918 1,590 2,073 2006 2,393 1,712 3,711 5,544 H107 1,063 1,007 1,059 1,754 Variance H106/H107 (%) -26.2 9.7 -33.4 -15.4 (By number) Jurisdiction Vintage France Germany UK Others 2001 13 2 18 8 2002 9 11 13 9 2003 11 7 8 9 2004 16 15 19 18 2005 27 21 18 33 H106 17 11 16 25 2006 28 21 41 47 H107 14 5 10 19 Variance H106/H107 (%) -17.6 -54.5 -37.5 -24.0 (Average size) Jurisdiction Vintage France Germany UK Others 2001 41.5 169.0 61.4 57.5 2002 95.6 76.4 75.8 92.8 2003 64.9 95.9 63.1 89.8 2004 62.9 86.0 111.7 75.3 2005 79.7 88.2 149.9 101.2 H106 84.8 83.5 99.4 82.9 2006 85.5 81.5 90.5 118.0 H107 75.9 201.4 105.9 92.3 Variance H106/H107 (%) -10.5 141.2 6.5 11.3 Source: Fitch Through the Looking Glass: European Mezzanine Revisited: September 2007 11 Corporate Finance Appendix 3 Mezzanine Prepayments Statistics Last twelve-month (LTM) rolling data Quarterly data Amount Average Time to Annual Amount Average Time to prepaid No. of facility size prepay prepayment rate prepaid No. of facility size prepay (EURm) deals (EURm) (mths) by volume (%) (EURm) deals (EURm) (mths) Q104 857.7 12 71.5 27.2 8.9 579.7 6 96.6 27.0 Q204 1,232.8 15 82.2 27.7 12.3 431.9 5 86.4 24.8 Q304 1,763.0 22 80.1 27.6 16.1 591.2 8 73.9 28.8 Q404 2,010.9 25 80.4 27.4 16.7 408.1 6 68.0 28.2 Q105 2,155.3 28 77.0 25.9 15.9 724.1 9 80.5 22.4 Q205 3,367.4 42 80.2 26.9 24.4 1,644.0 19 86.5 27.7 Q305 4,560.1 48 95.0 25.4 34.4 1,783.9 14 127.4 22.9 Q405 6,455.5 56 115.3 23.4 42.4 2,303.5 14 164.5 18.7 Q106 6,899.0 58 118.9 24.0 40.6 1,167.6 11 106.1 25.7 Q206 6,808.7 53 128.5 22.7 36.0 1,553.7 14 111.0 24.2 Q306 6,246.2 48 130.1 24.1 30.8 1,221.4 9 135.7 30.6 Q406 4,671.2 41 113.9 25.4 19.7 728.5 7 104.1 20.6 Q107 6,359.9 45 141.3 23.0 25.1 2,856.2 15 190.4 18.4 Q207 6,154.0 42 146.5 21.4 24.2 1,347.8 11 122.5 18.4 Source: Fitch Copyright © 2007 by Fitch, Inc., Fitch Ratings Ltd. and its subsidiaries. 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