Less risky at the mezz level

Roxane McMeeken investigates the ‘mezzanine’ asset class, which falls in the niche between equity and debt. When it comes to private equity, investors nervously dipping their toes into the water for the first time may consider opting for a “mezzanine” approach. Mezzanine investing is less risky than a standard equity investment in the private market, since it falls between debt and equity. A relatively niche asset class in Europe, “mezz”, as its advocates affectionately call it, appears to be growing in popularity as investors search for risk-controlled alternatives to public equities or new ways to diversify their private equity portfolios. London-based specialists in the field Mezzanine Management claim that in the second half of 2002, investment in the asset class in Europe increased by 120 per cent from E1bn in the first six months of the year to E2.2bn. Coupon element Christiian Marriott, director at Mezzanine Management, which has invested E1bn since 1988, explains that private companies are typically financed through a mix of equity investments and senior debt (ie. bank debt). He says that often such companies find they need extra funding, but “they can’t get further bank loans and they don’t want to have to sell half of their company to equity investors, so they go for mezzanine.” Mezzanine investors lend money to the company under a coupon arrangement. They then receive a return on the coupon. However, they also receive a small amount of profit share. In short, mezzanine amounts to private debt with an equity kick. Thus, mezzanine can lead to higher returns than debt, while its downside is that it involves more risk than debt. “The fact is that you can lose all your money”, cautions Mr Marriott. “We have lost our money in five out of 60 investments in cases where businesses failed.” But he stresses that Mezzanine Management emerged unscathed: “We have made one and a half to two times our money on our other investments.” Nonetheless the risk is significant. “People who don’t like mezz say that the risk of disaster is such that you might as well go for equities and get a better return”, says Mr Marriott. Acquired taste “Mezzanine is an acquired taste”, he admits. But he stresses that all the same an increasing number of investors are looking for a more cautious approach within the high risk class of private equity. “More and more investors who were just blindsided by the returns they got from equities are now taking the view that you should risk adjust within private equity.” Mezzanine Management runs two main funds investing in western Europe and plans to launch another towards the end of the year. There is also a small E100m fund investing in Eastern Europe. The average direct investment is E750,000 to E1m. However, Mezzanine is working on generating more retail-friendly routes to its products, including a recent deal with Liechtenstein Bank. Mr Marriott says that mezzanine investments should fit into an investor’s portfolio as a “subset of alternatives”. “If they have E100m and E10m in alternatives they could put 1-2m in a mezz fund.” Wealthy investors able to take more risk might consider another approach to funds. Investec is among a number of banks offering experienced investors the chance to take advantage of particular Mezzanine opportunities. Not for the risk averse Leon Blitz, co-head of Investec Private Bank, says the bank approaches certain clients when such opportunities arise. “Typically it will be a client who has made their own money and who is aware of the inherent risk”, he says. “This is not for risk averse clients, it’s akin to junk bonds.” Investors have to be willing to have their money tied in to the investment for the long term. Furthermore, the investment would not be part of the client’s asset allocation model. “This would be an exotic thing done with advice,” Mr Blitz explains.