Mezzanine level is restricted area for many senior lenders

Past problems make many banks keen to limit mezzanine providers’ rights, reports Lauren Parr

Senior lenders are taking a firm line on the rights that mezzanine providers are entitled to within the capital stack, if they will allow a junior tranche to sit behind them at all. Some French and German banks are thought to be uncomfortable with debt structures that include mezzanine, having been scarred by poorly documented deals in the past.

This is having all sorts of effects, including creating an opening for one-stop-shops that offer both senior and mezzanine, or junior debt, on a pre-negotiated basis. Those spotting the opportunity for this type of property lending include Eurohypo, via the soon-to-be-launched Cairn Property Debt Fund; Deutsche Bank with GIC; and M&G Investments, which has mandates to invest in senior debt and a mezzanine fund that can provide leverage up to 80%.

Jean-Maurice Elkouby, a director of syndicated finance at ING Bank, believes simplicity is the name of the game and, for many lenders, mezzanine is proving to be too complex right now. “The presence of B loans and C loans in previous deals has caused frustration and made restructuring talks complicated,” he says. “B loan lenders had a lot more power and they needed to be consulted or to give their consent, and that has put people off working with different classes of investors or doing new deals.”

Reluctant mezzanine users

Even though some banks may not like a mezzanine tranche in their deals, it doesn’t necessarily mean they won’t do it. Santander falls into this camp. Susan Geddes, the bank’s head of real estate finance, told Real Estate Capital last month that two out of more than 15 loans completed this year included mezzanine debt.

“But we would look for cash to come in as amortisation, not being paid to a mezzanine provider for them to get their running return,” she says. “We prefer it when all the cash is available for the bank.” Other banks don’t mind having mezzanine debt in a deal at all, but they are being strict about their criteria for its inclusion.

“Most banks would be willing to accept mezzanine financing, but would negotiate the deal and the term sheet in a way that gives the mezzanine player restricted rights, so it can’t upset the deal,” says Kent Gardner, chief executive of Evans Randall. From a bank’s perspective, certain conditions must be met before mezzanine debt can be brought into a deal.

“We like to make sure the borrower has genuine hurt money going into a deal of a reasonable level,” says Nationwide head  of commercial property finance Mark Bampton. “If we are providing a 60-65% LTV senior loan, we won’t expect the borrower in every case to have 35-40% of personal equity going in.

“We will allow some mezzanine debt in there but it will come back to these basic principles: do we clearly have first priority and are we entirely comfortable with trigger points for us to take control if the business plan is not delivering to expectations?” Bampton adds: “We will want to know the full terms of the mezzanine loan, even if it’s a PIK [payment in kind] arrangement, rather than one that pays current interest. We do want to know what the cost of the mezzanine is, so we can factor that in too.”

Inter-creditor agreements are more hotly debated than ever, with both senior and mezzanine providers seeking to protect their positions. The simple reality is that senior banks are controlling the debt position – they want first mortgage charges and clearly defined trigger points for when the junior lenders are switched off if a default occurs. Junior lenders, on the other hand, want those trigger points to be closer to them than they are to the senior debt holders.

Assessing the worst case scenario

They also want the priority of the senior debt capped with regard to interest, fees  and the cost of any hedging liabilities, for example, so they can assess what their worst position could be, based on a set figure. In some existing deals, junior lenders may have been hoping for the opportunity to “loan to own”, but they can only take senior debt and equity out if the senior portion gets fully repaid at par first: as long as there is no breach of the senior loan, they have no choice but to sit tight. On the flip side, they get well paid for taking that position.

Another consideration is the possibility of having mezzanine on top of mezzanine  in a deal. Earlier this year Partners Group teamed up with Duet Private Equity to finance the junior slice of the capital stack on two deals: the refinancing of 17 Columbus Courtyard in Canary Wharf; and the acquisition of the Magasin du Nord department store in Copenhagen.

In the first instance at least, Partners considers itself to be “the ‘senior’ mezzanine provider”, having injected preferred equity at a loan-to-value ratio above 80%. Elkouby says the new inter-creditor standard, which is slanted towards senior lenders, “is that senior lenders don’t want to see mezzanine providers have any enforcement rights and very limited consultation rights, so the only right mezzanine lenders have is to clip the coupon and buy out the senior debt before the senior lenders enforce”.

While the balance has shifted, new deals such as Evans Randall’s £242.5m purchase of Drapers Gardens in the City last November, for which Eurohypo provided around £170m of senior debt and Pramerica £38m of mezzanine debt, show that a compromise between the more stringent requirements of the senior lenders and the mezzanine lenders can be reached.

Evans Randall analyses each transaction to determine its return on equity. “If you can borrow debt at sensible levels that enhance your return on equity, then you  are willing to borrow,” says Gardner. “We’ve seen yields around 10-year averages in terms of the central London market but borrowing costs at their lowest levels. Even if you have a senior loan at a 60-70% LTV, the cost on that compared with traditional borrowing is historically lower, so there is room in the deal to have mezzanine.

“The deal will be more highly priced, but when you blend your rate on mezzanine with your rate on senior, you should still be able to reach an all-in rate of financing that, as an equity player, makes the deal work.” What’s more, mezzanine debt pricing has come down, partly because there is more certainty in the market as a result of a greater volume of deals compared with the bottom of the market in June 2009. There are also an increasing number of mezzanine players entering the market, ranging from pension funds to mezzanine funds to ultra wealthy individuals and family offices.

Mezzanine debt pricing has fallen from the high to mid teens and stands at around 8-10% for 60-75% loan-to-value ratios and 12-18% for LTV ratios up to 80%, inclusive of arrangement and, in some cases, exit fees. With senior debt typically only stretching to LTV ratios of up to 65%, the mezzanine  tranche in a deal can be anywhere between 50% and 75% of the loan’s value, depending on the level of equity and type of collateral.

Low LTV ratios and a scarcity of standard  bank debt have allowed mezzanine lenders to step in and many of these have considerable firepower (see table). However, a number of players that launched distressed funds and mezzanine vehicles in 2008 with 20% returns in mind have struggled to invest the money. Mezzanine providers often focus on prime real estate. William Newsom, Savills’ head of UK valuation, says this presents a dilemma, in that prime yields have fallen such that the figures do not always stack up with the mid to high teen returns being sought. “Mezzanine providers must cut target internal rates of return or venture into secondary territory,” he says. “But yields on secondary assets often are not high enough to produce the returns mezzanine and equity providers seek.”

Another challenge for mezzanine lenders is that “they are willing to look at a broader variety of deals than there is currently senior debt to support”, points out Duet’s managing director, Dale Lattanzio. This is said to be a stumbling block for DFS retail chain owner Advent in attempting a sale and leaseback of some stores.

Mezzanine doesn’t tempt MGPA

Nonetheless, take up of mezzanine finance has not yet become widespread. Even the reduction in pricing hasn’t been enough to tempt the likes of MGPA, which turned down mezzanine debt on two of its deals, including its £134.6m purchase of Harbour Exchange in London Docklands last year. “A lot of people have raised money looking for returns that just aren’t feasible,” says one borrower.

According to Steve Willingham, MGPA’s head of debt: “The increase in leverage and structural risk is significant by adding mezzanine to the deal; therefore if a mezzanine lender requires a 12-15% return on a risk-adjusted basis, you’ve got to be earning an exceptional equity return to make it worthwhile taking the mezzanine.”

While some mezzanine debt deals are known to be in the pipeline, including one for the purchase of a large UK office asset, the borrower quoted above doesn’t believe  it will become a bigger part of the real estate business “until mezzanine lenders understand the market better and where it’s really required, i.e. 55-70% LTV on transactions that require active management.” At that lower level, the financing might command a lower price still.