The Problem with Mezzanine Funds

 

This week a high profile German group launched another mezzanine fund to fill the growing capital needs of “Mittelstand” companies who previously worked with traditional banks.  Although this new fund focuses on mezzanine lending for operating businesses rather than for buildings, the real estate story is the same.  The ‘funding gap’ in German real estate is estimated to be €150 billion.  No wonder there is a massive increase in the number of European real estate debt funds.  

 

Misunderstood Mezzanine

The German mezzanine debt market lags the US, and historically mezzanine lending has been provided by banks.  Mezzanine financing can be a useful tool to finance real estate developers and corporates in need of growth capital.  Mezzanine funds will put a dent in filling the growing funding gap.  We know this first hand.  At Activum we were asked to provide a mezzanine loan to a successful re-development project in Frankfurt early last year.  Our participation provided needed development capital.  This will be a win-win situation for Activum and the developer.

 

Welcome 2013, enter the funds and exit the banks.  Sadly, there is a reason we have completed only one loan and not more.  Mezzanine and debt focused fund strategies are fraught with difficulties.  Here are some of the roadblocks.

 

  • The Goldilocks Principle.  At Activum, we call it the Goldilocks principle which dictates that the size of a deal can´t be too big or too small, but just right.  Inherently, the mezzanine loan holder needs the ability to take over the senior loan should the project go awry.  This requires a capital reserve at the fund level which can be managed for one or two deals, but becomes more difficult to get right when the entire fund is predicated on this strategy.  
  • Timing.  Most mezzanine loans are short term arrangements that bridge the transformation from ‘fixable’ to ‘fixed’.  The loans will provide great returns, but are short lived. So, getting your money back in 1-2 years with a reasonable multiple is tough to fit into a fund structure that is long term.
  • Inter-Creditor Agreements.  Mezzanine loans require strong inter-creditor agreements which are difficult to structure in Germany. Thus, mezzanine loan often end up looking more like a preferred equity investment than a classic loan.  
  • Borrower vs Lender Expectations.  Traditionally, German banks have provided subordinated loans at cheap rates.  Because the risk weightings at the banks were relatively low, this equity-like instrument was far cheaper than the actual risk incurred. Finding a deal to work for both parties is challenging. Since a mezzanine loan is debt sandwiched between the senior loan and the equity, theoretically mezzanine interest should also sit somewhere between the debt return and the equity return.   This range can be huge and finding the ‘right’ spot is hard.  
  • Bank Licenses.  Lending is lending.  So, what doesn’t require regulation and a license in some countries may require a license elsewhere.  While it may be possible for mezzanine funds to get a lending license or structure instruments that legally work, the overall framework for mezzanine is lending.  So, to fill the ‘lending gap’ and be scalable, investors will have to sort out this puzzle.

What does all this mean for Activum? 

While mezzanine loans can be quite lucrative these can be difficult to execute in Germany.   At the end of the day, a diversified fund strategy with the flexibility to make investments across the entire capital stack – is the soundest strategy.

8th February 2013

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