Welcome to mezzanine finance

Christophe Evain and Piers Millar of Intermediate Capital Group discuss mezzanine finance and their company''s approach to this unusual product.

Intermediate Capital Group is a UK listed company and the leading provider of mezzanine capital in Europe. In September 2001 the company established a presence in Asia with the opening of a Hong Kong office. Managing Director Christophe Evain and Investment Director Piers Millar run the office. Intermediate Capital has yet to complete an Asian investment but Evain and Millar believe that mezzanine capital will find a home in Asia.

So why did you decide to open an office in Asia?

Evain: We succeeded in Europe by being the first specialized mezzanine house in the market. We investigated Asia and found that the market here doesn't really use mezzanine finance but is starting to look at majority control deals. Some countries in Asia now resemble the European buyout market in the early 1990s and the US market in the early 1980s. So our thinking is that if the Asian buyout market is to grow, then there could be a big role for mezzanine as the market becomes more sophisticated.

So what exactly is mezzanine finance?

Millar: Mezzanine capital sits between the senior debt and the ordinary share capital in the company's funding structure. So it can be either a debt instrument or an equity instrument: a subordinated loan with equity upside such as warrants or options; a convertible bond; or it can be preference shares. It is a middle risk and middle return instrument where we rank behind the debt but it takes on a lower risk profile than straight equity.

Why has this form of finance not been available before in Asia?

Millar: Structured finance has played a role in some property and infrastructure transactions but it's only now when the private equity market has been looking to move towards buyout/majority control type situations that there has been more of an opportunity in the corporate sector. The private equity community has also been looking at enhancing their equity returns and this can be achieved through a more sophisticated financial structure.

Asia is a high risk, high reward, all or nothing kind of place. Do you think that this more measured approach to investing that you espouse is really appropriate?

Evain: It is now different because people have learnt some lessons. Prior to 1997 people were investing private equity money into deals where they had no control but they have found that a more cautious approach is more appropriate.

By some estimates returns from private equity investing an Asia have been around bank interest rates over the past ten years. Why do you think returns are going to go up?

Millar: As the market gets more sophisticated people will see that there is a greater distinction between senior debt and equity risks and there is a risk layer in the middle. By differentiating the risks properly you will improve the equity returns. In Asia, returns have not been as high as they have been in other markets but these should improve as the market becomes more sophisticated. Moreover, any region which experienced a crisis similar to that in 1997 would have had disappointing returns.

So do you think that now the risks are less but the returns could be greater?

Evain: The returns should be getting back to the level they reached before the crisis. At the same time, the private equity industry has become increasingly sophisticated as it has learnt from past experience about how to cope with the risks.

So the types of deals you are looking at are buyouts and perhaps some expansion capital of existing projects?

Evain: Buyouts will definitely be a core part of our business. We also think that in Hong Kong businesses could have a need for expansion capital to develop into the mainland. So you get the upside of China and the safety of Hong Kong.

That is rather like a mezzanine finance structure in itself. What are the typical sizes of the deals you are looking for?

Evain: We are looking to do deals between $5 million and $50 million. It is typically committed for the long term so there are no scheduled repayments but pays a cash interest and is less dilutive to owners and managers than straight equity.

What funds will you be investing? Your own money, existing third party funds or will you be raising a dedicated Asian fund?

Evain: Initially we will be investing our own balance sheet but we are investigating the possibility of raising a third party fund.

What is the average life of your European investments?

Millar: It has been just under four years but we expect it might be slightly longer in Asia.

What are the main challenges you will face bringing this model to Asia?

Evain: At this stage, we have focused on explaining when to use mezzanine and what structures and types of deals are suitable. Essentially, whenever there is a funding gap people can come to us and it is our role to help them structure a piece of finance for their business which is cheaper than equity.

Is there any competition from the banks here?

Evain: There is a role in the financial structure for equity, mezzanine and senior debt where each layer is taking a different level of risk and therefore requires different skills. We focus entirely on investing into the middle risk mezzanine layer while the banks tend to look at the senior debt and our experience so far has been that people are more likely to succeed doing what they know best.

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