Investors pile up capital on mezzanine level of the stack

Capital raising has been brisk for low-risk/high-return junior debt funds, reports  Jane Roberts

Investing in mezzanine debt has been one of the success stories in the European property market over the past 18 months.

Precise returns to investors are hard to pin down – managers who raised capital for this strategy in 2010/2011 jealously guard  their first-mover advantage – but assuming the investments they have made perform, investors can expect to get mid-teens returns for what they view as relatively low risk.

Amy Klein Aznar, head of special situations and structured investments at LaSalle Investment Management, says the firm’s £100m Special Situations Fund, which has made most of its investments in what she calls “value-added mezzanine”, targets “low to mid teen” returns. With “a significant percentage” of the fund invested, she says “we’re very happy” in relation to meeting that target.

John Barakat, head of real estate finance at M&G Investment, which has a junior debt fund, says: “Our target for our first fund was 12-15% and we thought we would be deploying capital in the 65-80% part of the stack. But if all the investments perform, we will have deployed at higher returns and at lower loan to values – it’s a bit higher than 15% on average and lower risk, which is the really important thing.”

More junior debt mandates ahead

One sign that investors have been happy is that managers specialising in junior debt  expect to have mandates for fresh capital later this year, partly because their existing  investors are interested in committing more cash and partly because the number of investors convinced by the debt investing story is growing.

While much of the rest of the market for raising capital has been very quiet this year it is at an all-time low, placement agent Christophe de Taurines, CEO of Capital & Marketing Group told the London Business School conference earlier this month – mezzanine is a bright spot in the market.

By last summer, some £1.8bn had been raised by five managers (see table opposite) and more capital is being deployed by other investment managers and hedge funds electing to invest capital in junior debt.

They range from boutique, value-added focused manager Wainbridge Capital, which has invested £40m in high-yielding debt, to Och-Ziff, which has just agreed to fund £80m of mezzanine in a single deal for private equity firm Round Hill Capital, to buy student housing company Nido from Blackstone.

Swiss-based private equity firm Partners Group has also made a number of significant investments, often alongside other real estate mezzanine investors; it joined M&G in a refinancing of Ewart Group’s Hammer-smith and Fulham Broadway shopping centres (see December issue, p19), and made several investments with Duet, including refinancing Columbus Courtyard at Canary Wharf and Blackstone’s UK Mint hotels acquisition.

Aznar says there are plenty of opportuni-ties to invest in and the flow of deals has picked up over the past six to nine months: “The majority of deals were completed in the past two quarters. I’m sure other mezzanine investors have experienced the same thing: conversion rates have increased because senior lenders are pulling back and sponsors are increasingly comfortable with how mezzanine and senior debt work together.”

M&G’s junior debt fund is 75% commit-ted. “My expectation is that it will be 95% committed by the end of June,” Barakat says. “We are speaking to investors about our second fund and Prudential is likely to make an investment in it.”

Prudential’s investment in the first fund was £100m of the total £343m raised in several closings over 2010 and 2011. Its 12 US and European institutional investors included the Church Commissioners and clients of Townsend Group.

Dale Lattanzio, managing partner of DRC Capital, which manages the Duet European Real Estate Debt Fund with hedge fund Duet Group, is also likely to be fund raising again soon.

The fund’s investment period runs to the end of June 2012, but can be extended. The vehicle was 53% invested with 11 deals in the pipeline totalling £250m, according to the April results of its listed feeder fund, Duet Real Estate Finance.

A range of returns on offer

As the market develops, experienced managers are fine-tuning strategies to try  as far as possible to meet different return objectives for different clients. Mezzanine’s place in an investment’s capital structure is subordinated to senior debt and ranks ahead of equity, but mezzanine can be sliced up to range from stretched-senior up to preferred equity.

Returns can be earned through steady, lower-risk current paying interest, riskier accrued interest (payment in kind) or contingent coupons linked to performance.

Managers and investors believe that opportunities to invest in mezzanine debt will continue well into the medium term and variations on mezzanine investing strategies are already emerging.

capital 1

Partners Group is a broadly based private equity group with years of experience investing in debt across many sectors and in this cycle has targeted preferred equity in European real estate. Longbow is also now part of a broader-based debt investing group, after quoted company Intermediate Capital Group acquired 51%. It targets middle-sized debt deals worth around £25m each, secured on good secondary UK assets.

Edouard Fernandez, a founding principal of Wainbridge, says: “Our sweet spot is to invest £10m-£20m, where we can be competitive, below the big funds’ radar.”

Wainbridge’s approach is “to look at the risk-reward for high-teen return opportunities rather than differentiating between mezzanine or other types of debt”, he adds. “We are finding some opportunities in senior as well as mezzanine debt.”

Wainbridge can be this flexible in its approach because its capital comes from separate accounts rather than a fund with a prescribed strategy.

“For example, we are about to close on  a senior loan to refinance a residential building that the owner is trying to sell,” Fernandez says. “The existing senior/junior lenders don’t want to extend, so ours is a 15-month bridging loan. If the borrower doesn’t pay, we get the building.”

The biggest capital haul last year was by Pramerica Real Estate Investors’ high-yield-ing debt group, which is working on two successor strategies to its current mezzanine fund. When that fund is fully invested, Pramerica plans to offer investors a choice of risk-adjusted returns, with one strategy focusing on stretched senior and the other lending where a higher return is appropriate.

LaSalle hunts across the spectrum to hit £400m debt investment target

LaSalle Investment Management “has £400m total investible capital for debt, with £300m from a number of separate accounts and our £100m Special Situations Fund” says Amy Klein Aznar, head of debt investing.

“This enables LaSalle to look across the whole risk spectrum, from whole loans, to core mezzanine to value-add mezzanine, to preferred equity. Our UK Special Situations Fund has an element focused on value-added mezzanine/preferred equity-style investing,” she adds.

The team, which also includes Michael Zerda, who previously worked with Aznar at Merrill Lynch before 2008, has committed “more than £200m” in 18 months, the vast majority in mezzanine and preferred equity. Most investments are in the UK, although the team hopes to invest in Germany soon.

One of her business’s biggest deals funded this year was providing the mezzanine for Blackstone’s acquisition of two logistics portfolios (see panel opposite).

“We can invest in very large mezzanine pieces, north of £50m,” she says. “Our deals cover a wide range of different asset types, including logistics, hotels and residential. We are active in retail, which we like as a house. We are close to doing a central London office deal.”

One of the changes she sees is a rise in enquiries for what she terms “constrained” senior investing, or senior debt for assets requiring active management and for which bank finance is particularly scarce.

“We are doing some constrained senior investing – it’s outside the box of what traditional senior lenders will tend to do, for example lending situations where there’s an active management requirement or a sponsor with an asset management plan, and we’ll continue to do that. We are getting more and more enquiries for non-vanilla senior loans.”

LaSalle is believed to have already structured a follow-on fund to Special Situations, which will look to make an increased number of investments in France and Germany, as well as the UK.

Aznar says another fund “would be likely, given our track record and how we’ve established a book of deals, firmly positioning ourselves in the mezzanine debt space. Also, there is a good deal of investor interest in this space and the returns are interesting for the risk profile.”

Notable mezzanine deals in 2012 to date

La Roca Village

  • Transaction size: €120m
  • Sponsor: Value Retail
  • Senior lender: Deutsche Pfandbriefbank
  • Mezzanine lender: Pramerica REI Value Retail refinanced this Spanish outlet village, replacing a €91m loan securitised in Epic Value Retail. The German bank lent €80m at a loan-to-value ratio of “between 50% and 60%” and Pramerica’s debt fund invested €40m of mezzanine debt.

‘Teal’ logistics portfolio

  • Transaction size: £215m
  • Sponsor: Blackstone
  • Senior lenders: Deutsche Pfandbriefbank and BAWAG
  • Mezzanine lender: LaSalle Investment Management

The combined funding for Blackstone’s acquisition from Prologis of 13 UK warehouses was £160m, representing a loan-to-value ratio of 75%.

‘Project Triangle’ distribution portfolio

  • Transaction size: £265m
  • Sponsor: Blackstone
  • Senior lenders: Deutsche Pfandbriefbank
  • HSBC and Wells Fargo
  • Mezzanine lender: LaSalle IM

Blackstone’s second big sheds buy was from London & Stamford. The combined debt was £204m and overall LTV ratio 68%. LaSalle’s  combined mezzanine loans in the two Blackstone deals are thought to be £75m.

Nido student accommodation portfolio

  • Transaction size: c£415m
  • Sponsor: Round Hill Capital
  • Senior lender: M&G Investments
  • Mezzanine lender: Och-Ziff

Perhaps the biggest single senior and single mezzanine loans in the UK this year and at relatively high leverage. M&G lent all £266m of the senior debt while Och-Ziff made an £80m mezzanine loan, taking the LTV ratio to more than 80%.