The continual search for yield across the credit markets has driven new investor groups into Europe's traditionally clubby and private mezzanine market. Larger deal sizes, increased liquidity and an ever-more active secondary market have all helped tempt private equity funds, institutional investors and, inevitably, hedge funds into the mezzanine market this year. But for some, notably the large mezzanine players, the entry of new groups into the asset class threatens the safety of the asset class and some say could lead to losses further down the line.

For the average collateralized loan obligation (CLO) manager, hedge fund or institutional investor, getting hold of mezzanine paper is not an easy task. Traditionally, mezzanine transactions were small - less than EURO150 million - and placed privately among a small number of large mezzanine investors. That has changed over the past year with the market experiencing rapid growth in deal size, liquidity and the number of investors participating in the market.

Despite this growth, CLO managers still have a hard time getting hold of mezzanine paper for their portfolios.

"Mezzanine is not easy to get hold of; often a mezzanine piece is swallowed whole by one of the large mezzanine funds," said a UK-based senior CDO portfolio manager. "When it does launch to syndication, CLOs are still lucky if they receive a piece, and when they do, allocations are scaled back considerably." As a result, despite having mezzanine buckets up to 10%, most CLOs are underweight this asset.

The recent 120 mezzanine tranche that accompanied the GBP450 million loan backing Hicks, Muse, Tate & Furst's GBP642 million buyout of UK cereal maker Weetabix changed all that. The large mezzanine funds essentially handed the deal to the CLO, hedge fund and US fund community on a platter, and CLO managers took the opportunity to bulk out their 10% buckets with this household name.

Why didn't the mezzanine funds want the deal? It all came down to pricing. A controversial reverse flex by MLA JPMorgan Securities meant that pricing on the mezzanine tranche was flexed down from 10% to 9.5%, too low to attract mezzanine funds,

"Pricing did not appeal to conventional mezz players, which start struggling with any sub-10% debt," said one UK-based portfolio manager. "Instead, the allocation process was driven towards US accounts, hedge funds and CLOs."

But for the many sizable US funds raising money in Europe and total return hedge funds, the opportunity to invest in such a well-known brand was too good to miss. Copious liquidity, low default rates and the improving economy are all driving these investors to leverage up in order to maximize returns.

Many of these peripheral investors believe that mezzanine offers greater returns for what they perceive to be insignificant additional credit risk. But mezzanine, with its equity-like characteristics, is still a risky part of the capital structure and should be treated as such, warn the more established mezzanine players.

Investors eager

"There are so many people waiting to pour money into the asset class - the current feeding frenzy in the mezzanine market is an accident waiting to happen," said the CDO manager. "When it was just a small club of investors, such as GSC Partners Europe and Intermediate Capital Group, investing in these deals, you could argue that the market was more controlled and safer, but that has all changed. It takes just one bad mezzanine deal to slip though, most likely one passed on by the established players, and these peripheral investors will take the slack for spoiling the party," he said.

Preserving the market's balance is precisely why the large mezzanine players opted out of the Weetabix deal and most hope that by standing their ground, lower pricing will not become the norm. "The big mezzanine guys did not participate in Weetabix because they were scared that a precedent for lower pricing would be set," said the CDO manager.

Sub-10% pricing brings mezzanine more in line with high yield bond pricing and serves to further blur the already confused boundaries between high yield and mezzanine. In fact, the debt supporting Weetabix's buyout was originally going to comprise a GBP200 million bridge to a high yield bond, but the strong demand and cheap pricing available led the borrower and MLA to switch to a mezzanine loan, sources said.

"The ongoing new liquidity entering the market as total return funds chase higher returns and is leading to further convergence between the asset classes," said Robin Menzel, partner at Augusta & Co.

Sponsors play a large part in determining pricing. Previously, many sponsors have paid up on mezzanine debt because they care about who is lending them the money, but with many CLOs and hedge funds prepared to lend at cheaper levels, that could all change. But unlike the larger mezzanine players who are arguably more committed to the market's health, these new investors are just out to make a quick buck.

"You can't blame the sponsors for taking cheap money, but it is not good for the market over the long term, and could lead to losses further down the line," said the UK portfolio manager. "It is hard to believe that hedge fund money will be invested [in mezzanine] for five years. If things start to go badly, or if something else more interesting comes along, they will simply pull their money out."

Copyright 2004 Thomson Media Inc. All Rights Reserved.

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