Edition: August/October 2018
Expert Opinions

TO DIVERSIFY AND ENHANCE PORTFOLIO RETURNS

There are compelling reasons to consider investing in mezzanine debt funds, believes Ashley Benatar of Ashburton Investments.

Over the past decade, the local stock market has experienced poor returns and a great deal of investor uncertainty. Investing in mezzanine debt can not only provide valid diversification to a portfolio but also enhance yield while reducing volatility.

What is mezzanine debt?

It sits between equity and senior debt in the capital structure. In the event of default, the mezzanine funder ranks behind the lenders of senior debt but ahead of the equity providers.

A mezzanine investment has two parts:

  • A debt component, generally a subordinated loan, which has an interest rate set somewhere in the mid-teens. This instrument has an interest component that provides the investor with regular cashflows in the form of interest payments;
  • An equity component which provides the investor with longerterm capital gains in the form of equity-related upside should the equity in the investee company rise in value.

Mezzanine debt fund managers will generally target gross returns of around a 20% p.a.

Benatar . . . clear advantages

Volatility cushion

Because the core of a mezzanine investment is a loan instrument which generates around 60%-70% of the total return, even if the equity portion does not perform, the mezzanine investor should still achieve a 15% p.a. return (two-thirds of the targeted return) from the contractual interest coupons. Mezzanine investments are therefore less volatile and can outperform equity in a low-growth environment.

Portfolio spread

Diversification for investors’ local equity portfolios can be achieved by adding investments in offshore equities, high yield bonds, investment grade bonds, REITs and commodities.

Previously equities had a low correlation to the other asset classes and hence adding these other assets to a portfolio created diversification. However, because the correlations have increased, investment-grade bonds are currently the only true diversifier to equities.

With SA bond rates close to all-time lows, investors are seeking additional yield. It can be achieved by investing into mezzanine funds which offer cash yields of around 15% and potential total yields (including the return from equity kickers) of 20% and higher.

Additionally, with bond rates expected to rise, bond returns could decrease as capital values fall. Unlike bond investments, mezzanine funds perform relatively well when rates rise.

Weak economy

Although SA gdp growth is forecast at under 2% p.a. over the next three years, equities are projected to return 12% and bonds 9% p.a. A portfolio comprising a 60/40 equity/bond portfolio would show 10,8% over the same period. This leaves little headroom for pension funds to cover their liabilities. Adding an investment into mezzanine debt, which targets 20% returns, will increase the returns of the portfolio and add the comfort of diversification.

Active involvement

Mezzanine investments are generally made in mid-market companies. These investments are originated by the team managing the fund from their proprietary networks. The team is heavily involved in an active analysis and diligence of the company prior to making the investment. The investment is also tailor-made to suit the company and the mezzanine lender’s requirements, with the fund manager actively managing the investment.

Premium for lack of liquidity

Traditional investments into equities and bonds are liquid and can be easily accessed at low fees. An investment into a mezzanine fund by comparison is illiquid, has higher fees and can be hard to access by investors seeking to invest less than R50m. But the lack of liquidity and higher fees are compensated by higher returns. A mezzanine fund is well suited to pension funds, endowments and sovereign wealth funds which have long-term investment horizons.

Conclusion

While investors should keep a portfolio of traditional assets, which are liquid, it is important to add an alternative asset such as a mezzanine fund. It offers investors regular cash flows in the form of interest and longer-term capital gains from equity upside. Because around two-thirds of the return is generated from the interest component, in a low-growth environment mezzanine could outperform equity.

Higher interest rates will reduce the value of bonds but increase the return on a mezzanine investment. This highlights the low correlation between mezzanine and traditional assets.

Ashburton Investments

www.ashburtoninvestments.com