Australia mezzanine: Compromise solution

Wind the clock back three years and there was little or no consensus as to how mezzanine providers could participate in Australian leveraged buyouts. Westpac had put forward a set of intercreditor principles intended to act as a model for managing the interests of senior and junior lenders in a deal. The mezzanine specialists had rejected it.

Now, though, mezzanine is back in vogue. In the absence of hard data, anecdotal evidence suggests that PE firms are becoming increasingly comfortable with a particular kind of structure - holdco PIK. Initially the preserve of refinancing and recapitalization situations, it is now also creeping into proposed acquisition packages.

Holdco PIK is a way around the intercreditor impasse. While senior debt provided by the likes of Westpac and its domestic peers is typically held at the operating company level of the acquisition target, holdco PIK is secured against the holding company used as a vehicle for the PE firm's equity interest in the business. There is no need for an intercreditor agreement because senior lenders see the holdco PIK tranche of debt as being more akin to equity.

The rise of holdco PIK isn't just about expedience; there is an economic rationale too.

"There is definitely more interest among sponsors, firstly because valuations are full and sponsors are looking for other ways to generate returns," says David McWilliam, executive vice president at Sankaty Advisors. "Secondly, in the past people shied away from mezzanine because it was seen as expensive, but with lower cost of debt across the credit spectrum it is now more accretive to returns."

Sankaty is one of the major players in the space, alongside Babson Capital, Intermediate Capital Group (ICG) and KKR. It has been involved in half a dozen advanced holdco PIK proposals in the last 12 months, each worth more than $50 million. Two thirds of the deal flow tends to be driven by PE activity, the rest by family-owned businesses that are unable to get all the capital they need - to support growth or a bolt-on acquisition - from banks and are unwilling to give up equity to third-party investors.

"It's a fairly competitive space and a lot of mezzanine is available," adds an executive from an Australian PE firm. "We have not used it of late. In some businesses the cash flow profiles or the acquisition profiles make it attractive to put in that extra turn of leverage. In other cases it is not appropriate for the capital structure."

What rights?

At the heart of the disagreement over intercreditor principles was the question of when and how subordinated lenders should be able to enforce their rights. Another issue was to what extent senior lenders could amend loan documents without the consent of their subordinated counterparts.

With holdco PIK the mezzanine provider's rights to receive cash are limited. The product will continue to accumulate interest until sufficient senior debt has been paid down that distributions can be made to the holding company and from there to the note holders. Often returns don't come until an investment is realized, with liquidity generated for the note holders through an exit.

However, Shawn Wytenburg, a partner at Ashurst, observes that sponsors initially held off using this structure for acquisitions because they were concerned that a default would see equity handed to the holdco PIK investors. A refinancing, by contrast, is a more certain affair; by this point the sponsor has a strong understanding of the cash flows. Other potentially contentious rights include the appointment of board observers.

Private equity firms' comfort with these terms is facilitated by pricing. Holdco PIK tranches are said to come with interest rates of 10-15%, depending on the underlying risk of the asset and the amount of leverage in the capital structure. Three years ago senior lenders were complaining that mezzanine providers wanted returns in the high teens and low twenties. As a result, it made more economic sense to stretch the senior debt portion and exclude mezzanine.

"There is very little mezzanine or subordinated debt volume in Australia - I can recall only 4-5 deals of any size in the last three years," Wytenburg says. "Given the risk-return view of traditional mezzanine players from North America and Europe and their pricing expectations, they haven't found the Australian market of much interest. Also, Australian sponsors have a lot of cash committed to spend so they haven't needed to seek operating company subordinated debt funding, particularly as senior lenders in Australia have been keen to deploy their balance sheets."

It could be argued that the presence of holdco PIK actually helps the banks get deals done. This is of critical importance because the large number of exits over the past 18 months has brought down the net size of the banks' leveraged loan books, while a number of large transactions have been lost to the US markets.

Australia syndicated loan volumes slumped to $8.9 billion in the first quarter of 2015 but the three-month average for 2014 was $31.4 billion, the highest level since before the global financial crisis, according to Thomson Reuters LPC. This was preceded by a bumper last quarter of 2013 when $50.9 billion was transacted. A large chunk of this went to the US markets as PE and other sponsors found they could obtain packages featuring "covenant lite" and little or no amortization at competitive pricing.

The Big Four Australian banks, not wanting to lose out, have become more amenable on terms. Holdco PIK can play a role in this. Indeed, one of the earliest holdco PIK deals in the current phase is said to have been a refinancing of New Zealand-based biscuits producer Griffin's Foods for which Pacific Equity Partners obtained senior debt from the Australian banks rather than go to the US because it was the cheaper option.

"These Holdco PIK notes sit outside of our lending group and have no real ability to be called during the tenor of our loan, so have little impact on us," says Russell Sinclair, head of acquisition finance director of leveraged and acquisition finance at Westpac. "Holdco PIK can therefore be used to reduce the senior gearing and this lets the banks senior lenders give more borrower-friendly terms."

More amenable

For example, banks may insist on strict covenants to finance a deal in a volatile sector and so the private equity sponsor submits a counter proposal suggesting the leverage multiple for the senior debt be set at 3x EBITDA rather than the industry standard 4x. This de-levering is compensated for by inserting a larger mezzanine tranche, perhaps 1.5-2 turns of leverage for an overall package close to 6x. In ordinary circumstances the mezzanine piece might generate additional leverage of 0.75-1x.

Given the risk of default on the senior tranche has been lowered, the banks are willing to give more ground. Ashurst's Wytenburg claims to have seen senior lending proposals with less than 20% amortization over a five-year term - not the zero amortization bullet payment seen in US financing packages, but better than what has been available domestically in recent years. Meanwhile, covenants can be looser, with greater headroom and larger permitted baskets, giving the borrower greater scope to incur debt or make investments without triggering a breach or less stringent maintenance tests.

A larger holdco PIK tranche also opens up a variety of options. The pay-if-you-can clause in the structure means a company at the bottom of an industry cycle is not obliged to make regular repayments unless it has free cash distributed to the holdinc company to do so; the pay-if-you-want clause could see no capital returned to note holders until maturity if the sponsor prefers to deploy the cash elsewhere.

"We can structure it whatever way works for the sponsor," says Sankaty's McWilliam. "The weighted average cost of debt with the holdco PIK will make it more expensive but often the sponsor will say it is a price they are willing to pay. We are seeing quite a bit of holdco PIK usage from a flexibility standpoint rather than a financial returns standpoint."

Admiration for the structure is not universal. One international banker describes holdco PIK as "punitively expensive" given the limited rights, adding that it will largely remain a last recourse for sponsors unable to raise enough bank debt. Concerns are also raised about the volume of debt available and the complications that would come in dividing up a large tranche among multiple relatively small-ticket investors.

But one of the virtues of holdco PIK is its versatility. Some industry participants claim to have seen deals as small as A$15 million. The absence of intercreditor agreements also means transaction costs can be lower.

It remains to be seen what happens to private equity firms' appetite for mezzanine financing when pricing becomes less favorable. Holdco PIK is not a new phenomenon in Australia. It featured in a number of deals before the global financial crisis, often in addition to a layer of subordinated debt at the operating company level. That disappeared when the senior debt market became less comfortable with mezzanine in the wake of some challenging post-crisis workouts.

The structure has emerged as solution to the intercreditor problem - and it may appear in PE acquisitions as well as refinancing situations - but the future of holdco PIK is likely to be characterized by variations in size, usage and prevalence.

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• Topics
• Financing
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• Australasia
• Mezzanine
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• Australia
• buyout
• Mezzanine