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).