Demand for mezzanine finance drying up

Funding ArrangementsWhen capital values race ahead, property tycoons are happy to stomach the hefty premiums on short term funding. But when prices are seen to have peaked the demand for mezzanine finance often evaporates, writes Gretchen Friemann

Property tycoon Bernard McNamara hit the headlines last year when it emerged he was stumping up just €5 million of his own cash to spearhead the €1.5 billion development of the Irish Glass Bottle site in Ringsend.

To many observers this jaw-dropping discrepancy in the figures appeared to confirm a widely held view that property development is a black art.

Yet the mechanics behind such financial wizardry are easily explained. McNamara was using mezzanine finance to plug an equity shortfall and limit his own exposure to the deal in its pre-planning stages, where the risks are greatest.

By employing Davy stockbrokers to raise €52.25 million in loan stock from the broker's private clients, McNamara secured a 41 per cent stake in the project that he could pay down within a seven-year time frame. But the cost of this flexibility is high. If the loan is not repaid within two years interest is charged at 17 per cent.

Mezzanine finance has always been an expensive way to bridge an equity gap on a large-scale transaction.

When capital values are racing ahead, property tycoons are happy to stomach the hefty premiums on short term funding. But when prices are seen to have peaked the demand for mezzanine finance often evaporates.

And this is exactly what seems to have happened in the past year. According to sources within Davy and Goodbody stockbrokers, two of the largest providers of mezzanine finance in Ireland, there has been no requirement for this type of funding in 12 months.

To some in the market it is sure-fire evidence that values have stagnated or are about to soften.

A source within IIB bank pointed out that mezzanine finance can be justified only when there is a "huge uplift in the capital value".

He said in the past developers could "absorb the 17 per cent-plus rates on short term funding because of the massive profits on offer" from large-scale land transactions.

"When you're paying €100 million for a site that's going to end up being valued at €300 million, mezzanine finance makes sense. But it doesn't work in a market that is stagnant, which is pretty much where we are at the moment."

Others in the industry have argued that mezzanine finance might become more widespread as banks' lending margins increase and their loan-to-value rates contract in the wake of the global credit crunch.

But the source within IIB claimed funding for those who had a "proven track record" was "not a problem". He said institutions still need to "lend money to make money" and argued that the "better guys" in the market would be able to access the cheaper and "more stable bank debt" while the "smaller guys" would have to rely on mezzanine finance or some other form of funding to bridge any equity gap on a deal.

If this prediction is correct there may be some tough questions ahead for investors. One of the main criticisms of mezzanine finance is that it offers "equity risk" at a "mezzanine return".

In other words investors often have little downside protection if a deal collapses.

In the case of the Irish Glass Bottle site, a memorandum prepared for Davy's clients and secured by The Irish Times last year, shows that McNamara has given a personal guarantee to repay the principal of €52.25 million but not the interest.

However in a section entitled "risk factors", the document also stated: "Although we understand that Bernard McNamara is currently of significant net worth, there is no guarantee that will be the case should the guarantee ever be called upon."

Market experts said this was a common strategy in mezzanine financing. Vincent Dodd of GlobalReach, a new investment house that specialises in this type of funding, explained that investors are often given a guarantee on the principal and/or the interest.

And he claimed that in some cases mezzanine investors were offered a share in the development's profits under certain circumstances.

But he pointed out that mezzanine finance was "an art not a science" in that its "characteristics" varied with every transaction.

He added that this type of funding was "usually carried out at subterranean level" with few details surfacing into the public domain.

The private nature of mezzanine finance, its frequent lack of downside protection and the widely differing structures mean it is often accused of being equity by another name. And, as a source within a well-known property institution explained, that means "your investment is only as good as the people you go in with".

"Most of these deals, whether they call them mezzanine finance or private equity, depend upon the developer's track record at delivering planning permission." And he pointed out that since many of the large-scale projects are still in the pre-planning stage, it will be some time yet before anyone can "judge the real values of these investments".