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Udo Neuhäußer

Corporate Mezzanine Financing

Portugal, 16th/17th May 2012

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“Mezzanine or subordinated loan debt is a long term, privately negotiated debt security that fills `the gap´ between senior secured debt and equity on a company's balance sheet. It is generally used when the borrower's debt requirement exceeds the availability of senior secured bank debt.”

Sam Ticknor, Corporate Fuel Advisors

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Companies appreciate mezzanine capital, because the mezzanine investor provides subordinated financing without expecting to have rights a shareholder has.

Mezzanine capital is patient capital.

Mezzanine capital is predictable capital.

Like equity, mezzanine debt is long term capital.

Especially in critical situations the alignment of interests between mezzanine investors and companies can be crucial.

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Banks appreciate mezzanine financing, as it is subordinated to their bank loans and does not give the mezzanine investors any rights to participate, when in case of default the collaterals are sold and the recovery revenues are distributed.

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Is mezzanine capital as attractive for investors as it is for companies and banks?

The mezzanine market definitely has some major limitations and it is far from being appropriate for all situations.

…

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Mezzanine investors prefer companies with predictable cash flow, being able to cover the debt service for principal and interest payments.

Mezzanine investors seek profitable businesses with growth potential. Besides growth stories typical uses for mezzanine debt include corporate acquisitions and recapitalizations, when supplemental financing is required.

The main professional qualification of mezzanine investors is to evaluate the capacity of a company to repay.

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Mezzanine investors definitely do not like small volume financing.

10 million € and more per company is an attractive size from the view of a commercial mezzanine investor.

3 million € is the limit for a commercial mezzanine investor, beneath which normally the fixed costs to evaluate a company and to provide mezzanine financing are regarded not to be proportionate to the advantages mezzanine financing can contribute for the companies.

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If the transaction size is smaller, commercial transactions are only feasible, if the investor already knows the company very well and therefore the due diligence costs are quite limited.

Normally, only banks know their corporate customers so well, that they are able to come quickly to a valid assessment. But the bankers business is not to provide equity or hybrid financing, as bankers are normally not experienced enough to assess the prospects of a company properly. Their core qualification is to estimate the market value of collaterals.

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Lessons to be learnt from the securitized corporate mezzanine boom

The technique of automated rating tools in combination with a big appetite of the capital markets for securitized assets seemed to be very promising. The promise was, that it was possible to calculate the default risk of a company simply by knowing its figures.

In Germany, mezzanine investors invested app. 5 billion € into medium-sized companies by securitized vehicles in the years between 2004 and 2007.

Cheap money: The companies paid on average between 7 and 8 % p.a.

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Experiences I“securitized corporate mezzanine boom”

The default rates were far beyond expectation and fraudulent behaviour from the side of the companies was not an exception.

The market learned from this experience and returned to its former tried and tested structures, demanding a thorough due diligence before investing.

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Experiences II“securitized corporate mezzanine boom”

Experienced mezzanine investors were glad, that the “modern times” with automated decision processes ended and no longer spoiled the price structures of the market.

Those traditional investors had left the market during the boom of securitized mezzanine financing, as they regarded 7 or 8 % p.a. for a subinvestmentgrade-company as irrational – and they were right.

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What is an attractive price from the perspective of a traditional mezzanine investor?

This figures differ very much, when you look all over Europe. Return expectation of commercial mezzanine investors in Germany after deduction of costs for management and expected losses:At least 8 - 9 % p.a.

Including all price elements like a fixed interest rate plus profit-related price elements this translates to costs to an investment grade company between 11 and 13 % p.a.

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Expectation of an anglo-saxon mezzanine investor starts with 13 % and extends up to 19 % p.a.

As capital markets are not fundamentally irrational this difference can be explained: The quality of the companies, the stability of expectations in an economy and the availability of corresponding bank loans make the difference.

In a country like Germany, where you get a corporate loan starting with 3 % for very solid companies, companies do not pay voluntarily double-digit prices.

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Quite objective, cost-based prices are those, which a public bank calculates and which are agreed upon by the state aid administration of the European Commission as subsidy free.

The prices differ for subordinated loans between 3 % for a very solid company and 9 % for an BB-rated-company with limited collaterals.

Conclusion: The fair price range is very broad depending on the rating of a company, the economic environment and the way the deal is structured.

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Two main limitations for the growth of the mezzanine market:

Restriction I “Due diligence costs”:Even a very limited due diligence costs at least 30.000 €.

Often we are talking about 100.000 € and more.

An investment of less than 1 million € is normally not in line with such an expenditure.

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Restriction II “Ability of a company to generate cash flow and its profitability”:

If mezzanine debt has a high coupon or interest rate and additionally the investor requests the right to purchase a limited amount of shares to enhance the investment return, if the company is successful, that is no clever deal for a company with a total capital productivity significantly below these costs.

Conclusion: We often have the situation, that companies able to attract mezzanine capital, do not need it, and companies being short of equity can not afford it.

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Beyond the private, commercial mezzanine market:Public programs, which fit even in cases, where commercial solutions do not work

Biggest public mezzanine program in Germany: “ERP-Innovation Program” (Disbursements > 1 Billion € p.a.; mezzanine disbursments app. 400 Mio. € p.a.)

Main features ERP-Innovation-Program:… provides a mixture of debt financing and mezzanine financing

… the public money is passed through by commercial banks.

… 50 % mezzanine capital (public liability) plus 50 % bank loan (private liability)

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“ERP-Innovation Program” II

The obligation to provide 1 € of bank loan alongside 1 € of public mezzanine capital is a very successful principle: The 10-year-default-rate of the portfolio is significantly below 10 % and less than 1 % per year.

The losses in case of defaults are in total compensated for by the risk premiums paid by the companies.

Unsubsidized (after deduction of an interest rate subsidy) total costs to the companies ranging between 2 and 8 % p.a.

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“ERP-Innovation Program” IIIBanks as intermediaries: No need for any additional intermediaries like mezzanine funds – eventually not being in place.

Combination of a debt tranch provided by a commercial bank and a mezzanine tranch provided by a support bank splits the risks between these two.

The support bank benefits from the knowledge of the commercial bank about their company customers – taking into account the crucial success factor “Know enough about the company before investing”

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Example“Mittelständische Beteiligungsgesellschaften - MBGs” - (“SME-oriented equity funds”):

Mutual funds with the majority of their shareholders being private or semi-public (Chambers of Commerce and Crafts, private and public banks, insurances)

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MBGs IICommon interest of MBGs and their shareholders: Support of companies with mezzanine capital

Banks are interested to participate, as only companies with sufficient equity are of interest as customers for loans.

Chambers are shareholders in the interest of their corporate members.

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MBGs III:Germany is covered with app. 20 regional MBGs, existing for up to 40 years and investing in a range between 50.000 € and 2,5 Mio. € into companies with a turnover of close to zero (start-ups) and app. 75 Mio. € p.a.

All 20 MBGs benefit from public counter-guarantees - without having to pay any fees - covering app. 50 % of the risk!

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MBGs IV

Counter-guarantees enable the MBGs to offer mezzanine capital with an fixed interest rate of about 8 % p.a. plus a limited profit based participation.

Average default rate:Around 4 % p.a. or between 25 and 30 % for the average participation duration

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New Approach:ESF/ERP-Micro-Mezzanine-Fund, addressing companies with a capital need below 50.000 €

… Builds upon an established infrastructure of micro-credit-institutions

… Full liability rests with the public sponsors

… Easy-to-handle product with an one-fits-all-price of 8,5 % p.a., subsidised under the de-minimis-regulation

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ESF/ERP-Micro-Mezzanine-Fund II

The main intention of this experiment is …

(1) Finding out, whether it is possible to qualify micro-credit-institutions to provide mezzanine capital as well and still show a reasonable loss rate and …

(2) Sponsoring experienced MBGs in order to convince or persuade them to extend their supply to micro-companies

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New ApproachEIF/ERP-Mezzanine-Fund-of-Funds

Commercially priced Mezzanine-Fund-of-Fund, investing into private mezzanine funds targeted on medium sized companies in Germany.

Preliminary experience: Will only work out, if the mezzanine funds re-financed cooperate with banks, benefiting from their profound knowledge they have about the individual investee companies.

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Conclusions I

Only if you are able to distinguish the good companies from the bad ones and only, if you are to attach the correct price tag on both of them, you will be successful.

Compared to bank business mezzanine business is very challenging.

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Conclusions II

Bankers normally rely on collaterals easily to be sold in a market in case of default.

As a mezzanine investor you have to make sure, that you are investing into a solid company, which has its worth as a company and not only the collaterals in it.

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Udo Neuhäußer

German Federal Ministry of Economics and TechnologyHead of Division “Equity and Mezzanine Financing, European Recovery Program Budget” Villemombler Str. 76D-53123 BonnTelephone: +49.228 99 615-4640Fax: +49. 228 99 615-4524E-mail: udo.neuhaeusser@BMWi.BUND.DE