The credit crisis that slammed the door on bank debt for real estate and private equity deals has opened a new window for mezzanine debt financing.
With less access to leverage to lift returns, investment managers are looking for deals that will offer the double-digit returns they promised investors before the credit crunch. Mezzanine appears to be just such an opportunity, consultants and investment managers say.
Traditional mezzanine managers — lenders of second-mortgage debt usually unsecured by the property — had been shut out over the past few years by banks, hedge funds and other providers of cheap and easy debt. Who would pay higher mezzanine prices when other lenders would finance up to 90% of the transaction for historically low interest rates?
But things have changed. Now, even some equity real estate and private equity buyers who do not normally provide or buy mezzanine debt are in the market for these deals.
Several managers are busy raising mezzanine funds. According to data provided to Pensions & Investments by Private Equity Intelligence Ltd., London, 36 funds are seeking to raise $28 billion, on top of 17 funds that raised $9.6 billion in private equity mezzanine so far this year.
Real estate mezzanine fund figures are harder to isolate because many real estate funds include mezzanine as part of a broader strategy, said Tim Friedman, publications and marketing manager at Private Equity Intelligence. So far this year, four mezzanine-only real estate funds with aggregate target commitments of $800 million are being raised; another four closed with $1.6 billion, he said.
Already in
Some pension funds are already invested in the arena. For example, the $256.2 billion California Public Employees’ Retirement System, Sacramento, had a $186 million private equity mezzanine portfolio, as of June 30.
Other pension funds have just recently decided to augment or add the subasset class. Since late summer, the $2.1 billion Seattle City Employees’ Retirement System and $15.7 billion Louisiana Teachers’ Retirement System, Baton Rouge, began searching for mezzanine managers. And the $11.7 billion Los Angeles City Employees’ Retirement System and the $4.1 billion North Dakota State Investment Board, Bismarck, made commitments to new mezzanine funds.
In the third quarter, three U.S. mezzanine private equity funds raised $787 million. Since then, three more funds close with a combined $1.6 billion, according to Dow Jones Private Equity Analyst data.
Worldwide, five mezzanine funds closed in the third quarter with $1.2 billion in commitments, according to Private Equity Intelligence. This does not include the Goldman Sachs Mezzanine Partners V fund reportedly targeting $20 billion in commitments, which has hit the road just a year after the firm closed the largest-ever mezzanine fund, the $9 billion Goldman Sachs Mezzanine Partners 2006.
Even if all of the funds now raising money close by year end, they most certainly will start making deals as soon as they have commitments. Opinions vary whether there is but a short window for mezzanine or whether this cycle will be longer. It depends on when banks and other lenders clear the backlog of debt they already have, which then will allow them to start making new loans. That backlog totaled $285 billion as of Oct. 12, according to Ed Sweeney, a spokesman for Standard & Poor’s, New York.
“There has been a lot of interest in mezzanine investment opportunities since the repricing and recent disruption in the financing/
credit markets” for leveraged buyouts, said Marc E. Sacks, senior managing director at Mesirow Financial Private Equity, a Chicago-based private equity fund of funds and direct private equity fund manager. “Our view is that it’s too early to make conclusions (or) changes” to the mezzanine portion of investors’ target private equity portfolios.
For the 12 months ended March 31, the most recent data available, mezzanine funds returned 10.8%, according to Thomson Financial, New York. This is up slightly from the 10.1% for the 12-months ended March 31, 2006.
Mezzanine debt’s returns are highly sensitive to whether there are competing pools of capital in the market that can make loans at lower interest rates. Even so, it can perform well in times when returns in other private equity subasset classes falter.
“In our experience, mezzanine has provided strong returns during troughs in the credit cycle, when other private equity strategies have more limited options for liquidity,” Mr. Sacks said.
While there is insufficient data on performance of real estate mezzanine funds, Mr. Friedman said that private equity mezzanine’s money-weighted average returns have been strong — varying between 7% and 20% for funds closed from 1996 to 2004.
As a long-term subasset class, mezzanine can provide fairly stable returns without some of the spectacular highs and lows of the venture capital and buyout sectors, he said.
“Although mezzanine funds are unlikely to provide the astonishing performance of, say, the top venture or buyout funds, which can have IRR (internal rates of return) figures in excess of even 100%, they are also relatively unlikely to perform especially badly, which can be a feature amongst the lower performers in the venture and buyout sectors,” Mr. Friedman said.
On the real estate side, some banks are lining up mezzanine financing from managers who usually are buyers, rather than lenders.
Among the investment managers interested in mezzanine deals are Apollo Real Estate Advisors, New York; Shorenstein Properties LLC, San Francisco; The Blackstone Group, New York; Lehman Brothers Private Equity, New York; and Babson Capital Management LLC, Boston. All were involved in mezzanine transactions in the past, but all are making it a focus while the window of opportunity is open.
While Apollo closed its $625 million debt fund in January, “the current liquidity crisis has expanded the range of debt investment opportunities that are attractive to us,” said Bradford Wildauer, partner.
On Oct. 8, Shorenstein bought a mezzanine loan from Deutsche Bank AG even before the New York office building that was the focus of the financing was sold, said Robert S. Underhill, managing director, in Shorenstein’s New York office.
“Lenders that had given 70% loan to value are now down to 60% loan to value and the other 10%” has to be filled by mezzanine, said Joseph Azelby, managing director and global head of real estate and infrastructure for JPMorgan Asset Management, New York.
But the plum opportunities will go to the swift, many investment managers say.
“The window is about six to nine months,” said David K. Christensen, executive vice president, Jones Lang LaSalle Inc., a Chicago-based real estate manager. Once the debt glut clears, banks will be back to originating loans to real estate and private equity dealmakers, he said.
Other industry insiders won’t predict the length of the window.
“Once there is more transparency and more confidence in the bond markets, bond buyers will return,” said Rob Noeldechen, principal at Ernst & Young LLC, New York. There is already more transparency in the bond markets than there was six months ago, he said.
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