Mezzanine debt in South Africa – an attractive proposition for investors

03 November 2017

Interest rates in South Africa are currently close to their all-time lows given the low economic growth environment. Accordingly, it is becoming increasingly difficult for investors to achieve additional yield without assuming greater risk.

What is mezzanine debt?

Mezzanine debt sits between the equity and the senior debt in the capital structure. In the event of default, the mezzanine funder ranks behind the senior lenders but ahead of the equity providers. Given the mezzanine investment’s position in the capital structure, it targets equity-like returns with debt-like risk. The debt-like risk is achieved through the downside protection afforded by its superior ranking relative to the equity investors as well as contractual and other rights that are associated with debt instruments, including financial covenants, step-in rights and security in the form of tangible assets, debtors and share 

Equity-like returns of between 15% and 25% are achieved through a combination of contractual interest, roll up interest and equity participation.

Interest rates in South Africa are currently close to their all-time lows given the low economic growth environment. Accordingly, it is becoming increasingly difficult for investors to achieve additional yield without assuming greater risk, and mezzanine financing offers investors attractive risk adjusted returns when compared to private equity or senior debt. Mezzanine financing offers higher yields than senior debt with less volatility than private equity.

In this paper, we will discuss the various features of mezzanine debt that make it an attractive risk adjusted investment in the current economic environment.

Private equity 

Until the start of the Global Financial Crisis, private equity in South Africa offered tremendous returns given the gross domestic product (GDP) growth and the expansion of South African corporates into other growing regions on the continent. This, coupled with the availability of credit and increase in company multiples, made private equity returns very appealing to investors.

In the current market environment of low GDP growth, poor economic fundamentals, high unemployment rates, increased taxes and multiple contraction being prevalent in South Africa, we believe that an investment into a mezzanine fund will offer better risk- adjusted returns than an investment into a private equity fund that does not offer vintage diversification. A mezzanine investment in the current time frame should however be complementary to an existing private equity portfolio that spans across various vintages because it would enhance the portfolio’s expected risk adjusted return outcome.

A 2013 study by Sankaty Advisors LLC, shows that in an environment of low growth and volatile public markets, mezzanine is less affected than private equity and is more resilient than other asset classes. Although this study focused on the US Middle Market, its findings are also relevant to the South African market, especially given the current low economic growth outlook coupled with lacklustre listed equity returns. 

Because mezzanine is senior in the capital structure to private equity and generates a cash yield, its returns are less sensitive to earning before interest, taxes, depreciation, and amortisation (EBITDA) growth. Figure 1 above shows that in a low 0% - 2.5% growth environment mezzanine returns are more stable at 13% - 14% internal rate of return (IRR), while private equity returns are more volatile at 0% - 7%¹. 

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Secondly, mezzanine is only marginally effected by multiple contraction/expansion. Multiple expansion occurs when a private equity sponsor sells a company for a higher EBITDA multiple than the multiple at which it purchased the company. In the current economic climate, private equity funds are far less likely to sell investments at higher multiples in the near future. Assuming a 2.5% EBITDA growth rate, a 15% contraction in multiples reduces private equity returns from 13% to 7% while mezzanine returns hold at 14%.

 

Thirdly, senior lenders now require the sponsors to write larger equity contributions. This provides a better cushion for mezzanine investors but it also compresses the private equity returns. Figure 3 above shows how private equity and mezzanine returns are affected when the equity contribution is increased from 20% to 35%. Assuming a 2.5% EBITDA growth rate, private equity returns reduce meaningfully from a 19% IRR to a 13% IRR while the mezzanine returns reduce from 16% IRR to 14% IRR.

Lastly, the self-liquidating equity kickers also provide mezzanine debt investors with a definitive exit path as it has a set maturity date which makes mezzanine appealing compared to private equity that is reliant on a sale or an IPO, which can be difficult in the current economic environment where EBITDA multiples are contracting. At such a point in time, it could also be difficult for a private equity investor to find a trade buyer and hence their options for exit might be limited. It is important to remember that a private equity manager has the obligation to establish an exit for its investments before cash returns can be paid back to investors. Mezzanine therefore offers advantages when it comes to timely cash repayment of returns to investors.

Mezzanine debt returns compared to private equity and senior debt returns in a low growth environment. Mezzanine finance in South Africa is still in its infancy when compared to the developed markets and there are very few dedicated mezzanine fund managers with capital to invest.

Senior debt

Mezzanine debt investments are compelling compared to senior debt for two main reasons. Firstly, mezzanine debt can offer a higher return, typically between 15% - 25% compared to senior debt returns of 10% - 13%, which is an attractive premium for the higher complexity and leverage in the underlying transactions. Secondly, mezzanine investors can exercise a lot more control over the investment than senior debt investors.

A senior debt investment is generally syndicated among several investors whereas in a mezzanine debt investment the investor usually controls the mezzanine layer. The investor also takes an active role in monitoring the investment and generally has observer status or directorship on the portfolio company’s board. This allows the mezzanine debt investor greater information rights which include monthly management accounts and reports, participation at board meetings and access to management.

Furthermore, the tight covenants enforced on the company provides the investor with early warning signals of potential defaults and allows for early decisions to preserve their investments.

Thus, while default rates on mezzanine investments are higher than those of senior debt investments, when there is a default on a mezzanine investment, investors in many instances recover a larger proportion of the investment than when there is a default on a senior loan2. Importantly this loss ratio would be applied to a 15% - 25% return range for mezzanine debt investments relative to a 10%-13% return for senior debt.

An investment in mezzanine should therefore not be seen in isolation but complimentary to an investor’s existing senior debt portfolio as it positively adds additional diversification, which improves the investor’s risk adjusted return portfolio profile.

Attractiveness to borrowers

Access to finance is one of the most prevalent challenges faced by mid-market companies in South Africa with banks typically focused on larger corporates. Additionally, the global financial crisis and introduction of capital adequacy requirements have resulted in many banks reducing their exposure to mezzanine debt. While private equity is one viable option, entrepreneurs are sometimes hesitant to go this route due to a reluctance to give up equity. Mezzanine debt on the other hand is attractive to companies requiring capital because it is more flexible than senior debt and avoids the significant equity dilution which accompanies traditional private equity.

For Black Economic Empowerment (BEE) investments, management and leverage buy-outs, and private equity acquisitions, mezzanine debt can also be utilised to reduce equity contributions required by the sponsor thereby enhancing their returns. Mezzanine debt is often the most appropriate form of finance for companies looking to expand existing operations or to fund new acquisitions, or by shareholders to acquire equity in a company, or to do a leveraged recapitalization. Mezzanine debt is further beneficial to the owners because it does not require management control, and with predefined exit arrangements, it avoids conflicting shareholder exit agendas. Mezzanine debt is therefore used by borrowers in various situations and is not a financial tool that is only viable in a set economic environment or type of transaction. This is also particularly useful to the mezzanine investor when constructing a portfolio of mezzanine loans as not only can one craft a diverse industry and company portfolio but the intended use can also be diverse, as one can for example focus on constructing a portfolio of BEE investments, growth capital and acquisition finance transactions.

Mezzanine debt also allows a company to boost its absolute profit and return on equity as well as reduce its cost of capital as one can see from the example below: 

Mezzanine in South Africa

Mezzanine finance in South Africa is still in its infancy when compared to the developed markets and there are very few dedicated mezzanine fund managers with capital to invest. This is compounded by the fact that the credit, capital and private equity markets are also still developing. Per the Emerging Markets Private Equity Association (EMPEA), global capital penetration as a percentage of GDP in South Africa, was 0.26%, compared to the 1.81% for the UK and 1.54% for the US in 2015. Additionally, as at 31 December 2016, there was only R1.2 billion of undrawn commitments available by mezzanine funds in South Africa. 

While on a macro level South Africa is forecasting low growth, Ashburton Investments mezzanine team anticipates that certain sectors will provide ample mezzanine financing opportunities. These include the large number of BEE transactions that will require funding with the implementation of the new Broad-Based Black Economic Empowerment (BBBEE) codes. Additionally, mezzanine funding opportunities exist for mid-market companies looking to fund growth, acquisitions or recapitalizations where the funding can be tailor-made to each company’s specific needs without the dilutionary effect of private equity. In renewable energy transactions, which have been growing rapidly over the last five years, mezzanine financing can help strengthen a project’s equity profile because of its flexibility compared to senior debt finance. Mezzanine finance is also attractive as it can lower the cost of financing a project compared to pure equity financing. Mezzanine financing into infrastructure is attractive due to the stability of infrastructure assets through changing macro and credit conditions.

Conclusion

Mezzanine debt provides investors with an opportunity to earn equity-like returns while taking on debt-like risk due its enforceable downside protection. Since mezzanine investments require periodic coupon payments and capital repayment capability, mezzanine investors have a natural selection bias towards investing in more stable and resilient industries and companies. As such we believe that mezzanine should be an attractive asset for investors alongside their private equity and senior debt allocations.

Ashburton Mezzanine Fund I is looking to raise between R1.0 and R1.5 billion of commitments from investors and has a substantial GP commitment of 6.5%, which is higher than the industry norm of 1% to 1.5%. Ashburton Mezzanine will also leverage off the powerful origination engines of the FirstRand Group and Ashburton Investments as well as the team’s proprietary networks to originate transactions. Ashburton Mezzanine Fund I will be available to institutional and retail investors from November 2017.