Capital plan for mezzanine deals

THIS week a major capital restructuring went through the market as two private equity houses, Permira and CVC, completed the financing of their recent acquisition of the AA from Centrica.

It was a process that involved, among other things, the biggest issue of mezzanine debt seen in Europe, a landmark deal, therefore, for the private equity houses involved.

But it was also a week that saw some independent mezzanine finance providers express discontent at trends in the buyout market and pressure being put on their margins.

These signs of tension come because the private equity industry is at something of a crossroads. It has a big backlog of money to be spent - witness Charterhouse's willingness to pay £1.35bn for holidays and finance company Saga, a price substantially in excess of what it would have fetched had it been floated on the stock market, and, separately, estimates from McKinsey that across Europe there is a pool of $50bn of private equity money looking for a home.

At the same time there is a big overhang of exits - companies the private equity funds wish to sell on but are stuck with because of the difficulty of floating anything on the stock market.

It means that increasingly the funds have had to resort to the unsettling and, in many ways, unsatisfactory practice of selling to each other to crystallise value.

There is further unease among investors that some former star funds are now producing questionable returns just as some of the biggest names are beginning to bang the drum for more money.

Realistically, however, the difficulties of parts of the industry should be no surprise. Returns of private equity funds depend very much on achieving capital growth, and although the big driver for that is stringent financial control coupled with heavy gearing, it is legitimate to question how sustainable these can be across the board given that in the quoted company sector capital growth is a minor part of the total return of equities.

Indeed, London Business School data compiled by Professor Paul Marsh and his colleagues show that while the 100-year real return on listed equities was approaching 6%, less than 2% of this was capital gain and the larger part came from the re-investment of dividend income.

There is now also a lot of money in dedicated mezzanine funds, so this is leading to pressure for mezzanine only deals where a company is taken private and refinanced but there is no involvement by a private equity house. Such shares as exist are held by the management.

Although this may seem unconventional, there is no immutable reason why current private equity deals are structured as they are with mezzanine finance typically comprising just 15% of the package. Indeed, the private equity marketplace could be considerably widened and deepened if more deals were done with mezzanine finance alone.

Mezzanine-only deals should be popular with pension funds because they could deliver a substantial running yield with much less exposure to the vagaries of the market. It would, in fact, be a high-yield, low-volatility asset at a time when they need some serious but steady catch-up performance. So there should be no shortage of investors.

Nor would there be a shortage of deals. Freed from the private equity house requirement for a 30%-plus internal rate of return, many more propositions could come into the net. For a mezzanine fund, a target return of 20% - a 7% running yield and 13% from the eventual capital exit - would probably be acceptable.

What is needed, therefore, is for some of the big pension houses to break ranks and decline to put money into more of the conventional private equity funds. They should back mezzanine funds and mezzanine-only deals to create financial assets that would make a positive contribution to solving the problems in pension funds.

The opportunity is there. The issue is who will take the chance to seize it?

Oil comfort

IT IS not at all comfortable to see the oil price push through $51 a barrel to its highest-ever price. But neither is it cause for panic. Though the world economy was brought low twice by oil shocks, the price would have to rise above $80 to be the equivalent of the price it hit in 1980 after the Iranian revolution.

There is a second reason for comfort, if not complacency. Oil makes up a significantly smaller proportion of world output now than it did then, so the rise in price directly affects a smaller part of the economy. Even if it got to $80, the effect would be damaging but nowhere near as brutal as last time.

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