Investing in Mezzanine funds to diversify and enhance portfolio returns

There are compelling reasons why investors should consider investing in mezzanine debt funds.

Over the last decade, the local stock market has experienced poor returns and a great deal of investor uncertainty. Investing in mezzanine debt can not only provide valid diversification to a portfolio but can also enhance yield while reducing volatility. 

What is mezzanine debt?

Mezzanine debt sits between equity and senior debt in the capital structure.

In the event of default, the mezzanine funder ranks behind the lenders of senior debt but ahead of the equity providers. A mezzanine investment has two parts to it:

  • A debt component, generally a subordinated loan, which has an interest rate set somewhere in the mid-teens. This instrument has an interest component and provides the investor with regular cashflows in the form of interest payments; and
  • An equity component, which provides the investor with longer term capital gains in the form of equity related upside should the equity in the investee company rise in value.

Mezzanine debt fund managers will generally target gross returns of around a 20% per annum.

Increased volatility in the markets 

There have been two severe stock market declines over the last 10 years and it has been a period of substantially more volatility. Because the core of a mezzanine investment is a loan instrument which generates around 60% - 70% of the total return, even if the equity does not perform, the mezzanine investor should still achieve a 15% per annum return (namely two-thirds of the targeted return) from the contractual interest coupons. Mezzanine investments are therefore less volatile and can outperform equity in a low growth environment.

Portfolio diversification

Diversification investors’ local equity portfolio can be achieved by adding investments in offshore equities, high yield bonds, investment grade bonds, REITs and commodities.

Previously, equities had a low correlation to the other asset classes and hence adding these other assets to a portfolio created diversification. However, because the correlations have increased, investment grade bonds are currently the only true diversifier to equities.

With bond rates close to all-time lows in South Africa, investors are seeking additional yield which can be achieved by investing into mezzanine funds which offer cash yields of around 15% and potential total yields (including the return from equity kickers) of 20% and higher. Additionally, with bond rates expected to rise, bond returns could decrease as capital values fall. Mezzanine funds perform relatively well when rates rise, unlike bond investments. 

Poor growth forecasts

South African equity returns in the future may be constrained by slow economic growth. Growth forecasts in South Africa to 2020 are less than 2% per annum.

Equities are projected to return 12% and bonds 9% per annum over the next three years. A portfolio consisting of a combined 60/40 equity/bond portfolio 10.8% over the same period. This leaves little headroom in terms of what pension funds require to cover their liabilities. Adding an investment into mezzanine debt, which targets 20% returns, to one’s portfolio will not only increase the returns of the portfolio but also add the comfort of diversification.

Access to mid-market companies not traditionally available to investors

Mezzanine investments are generally made in mid-market companies. These investments are originated by the team managing the fund from their proprietary networks and the team is heavily involved in an active analysis and diligence of the company prior to making the investment. The investment is also tailor made to suit the company and the mezzanine lender’s requirements, with the fund manager actively managing the investment.

 

Premium for lack of liquidity

Traditional investments into equities and bonds are liquid and can be accessed very easily at low fees. An investment into a mezzanine fund by comparison is illiquid, has higher fees and can be hard to access by investors seeking to invest less than R50 million. The lack of liquidity and higher fees are, however, compensated for with higher returns. Mezzanine fund managers are additionally less constrained and are very active in their approach to originating transactions that are inaccessible to the ordinary investor. The longer-term horizon of a mezzanine fund is also well suited to pension funds, endowments and sovereign wealth funds who have longer investment horizons.

 

Conclusion

While investors should keep a portfolio of traditional assets, which are liquid, it is important to add an alternative asset such as a mezzanine fund.

A mezzanine investment offers investors regular cash flows in the form of interest and longer-term capital gains in the form of equity upside. Because around two-thirds of the return is generated from the interest component, in a low growth environment in which equities could struggle, mezzanine could outperform equity.

Additionally, increasing interest rates will reduce the value of bonds but increase the return on a mezzanine investment highlighting the low correlation between mezzanine and traditional assets.