MEZZANINE FINANCE/ PRIVATE EQUITY

Indigo Capital

Indigo's team looking after investments in the German region. From left: Nicola Duderstadt, Adrian Lurie, Martin Stringfellow and Nicole Waibel

Mezzanine finance or junior debt is an important element in buyout transactions and in financing growth. In this specialised niche, Indigo Capital serves small and mid-sized European companies with a capital requirement of between €10 to €30 million.

The company's four founding partners, Richard Collins, Christopher Howe, Kevin Murphy and Martin Stringfellow, have been working together since the beginning of the 1990s when they ran Kleinwort Benson Mezzanine Capital. Since then, when they launched their first fund totalling €130 million, they have concluded 61 deals and invested over some €800 million equally across France, Germany , the UK and the rest of Europe. At present the firm is investing Indigo Capital IV. This fund was launched in January 2003 and has total committed capital of €475 million.

Says Martin Stringfellow: "If you look at the intricacies of our business, and the fact that each investment decision is based on an outcome five to six years down the line, it is important not to get carried away. As investors we always look at the fundamentals such as a sustainable business model and a path to profit growth. Of course, irrespective of the sector they are in, no two businesses are exactly alike. Therefore when we assess an investment opportunity, we discuss it in the team and we get the views of all the people around the table. We have some very experienced people and we have somewhat less experienced but extremely smart people. And I think with this combination we try to make prudent decisions and avoid mistakes. The overriding objective is always to create and maintain a true collaborative relationship, both with our investors and investee companies."

This is not all. With the firm operating across Europe , its investment specialists have an international outlook in everything they do. At a minimum they are all bilingual, with half the team-members speaking three languages-namely English, French and German. The advantages of this are clear. Interaction with clients is enhanced and the scope for misinterpretation is reduced.

Stringfellow illustrates: "Approximately ten years ago, I attended two meeting with the management of a German company. In the morning they spoke in English and in the afternoon in German. The morning presentation did not reflect well on the company. In the afternoon, when the managers spoke in German, they came across as entirely different people and addressed the relevant issues in a very professional manner. The contrast was like day and night. But only those of us who understood German could make this distinction."

All client interaction is co-ordinated from Indigo Capital's offices at 25 Watling Street , a stone's throw from St Paul 's Cathedral in London and an office in Paris . To get an idea of what the basic requirements for attracting mezzanine funding are, and what Indigo Capital looks for when assessing financing opportunities, we asked Martin Stringfellow to give us his thoughts. This is what he had to say:

"From the perspective of European small and mid-sized companies, there is a growing interest in mezzanine not only because of the various forms it can take, but also due to the fact that in recent years, banks have become more cautious in their lending behaviour. This funding gap can be bridged by mezzanine more effectively than with equity alone. The prerequisite for attracting mezzanine investment however is that the business is profitable and is generating sufficient cash flow. Therefore businesses having difficulty servicing their present debt, or those that are barely profitable above the financing are not really suitable for mezzanine. The important thing to keep in mind is that mezzanine should not be seen as a refinancing tool to service a company's current debt obligations, but as a layer to fill the gap between bank debt and equity. For instance, because of the underlying risks associated with a management buyout or the acquisition of another business, full debt financing of such transactions is not attractive to banks. Other applications include financing the development of new products, markets or facilities. In privately held companies, mezzanine can be used to buy a shareholder out, enable shareholders to improve the liquidity of their investments, reorganise shareholding structures or strengthen the balance sheet. Mezzanine can also be used as bridge financing in advance of a planned IPO."

He further adds, "One of the keys to a sound investment decision is the ability to assess the management of the investee company. Our experience has taught us that this is the most difficult part of the process. Therefore we put a lot of emphasis on the ability of managers to articulate their business model and financial goals; to understand how they see the way they make money; the way they compete and defend themselves against competitors; and the way they understand the financial impact on their business. Although one could over-emphasise these points, some managers tend to lack a thorough understanding of the factors that really enable them to make money. In other words, they are not fully aware of what their competitive advantages are and how to maximise their profits. In some cases companies do not have a clear idea as to which of their products are the most profitable, or are unable to let go of loss-makers. We often hear the justification that they need to keep selling products or services that are less profitable or even loss-makers to generate growth for those that are more profitable. This is typical of an entrepreneur-driven mind set. As entrepreneurs, such managers are usually good salesmen, often with excellent products. Their emphasis is more towards generating revenue and less towards cost optimisation. For us, on the other hand, when we evaluate an investment opportunity, financial discipline is a key factor, as it can make or break a business.

All such assessment of the prospective company's strategy and management takes place before we commit. By the time we make the investment, we will already have agreed to a business plan and the monitoring process, which would include regular visits from us, usually for board meetings. What does that actually mean in practice? Does it mean that we exercise certain rights that we have and demand people do things in a specific way? No. Does it mean that we vote against things on the board? Probably not. At most of the board meetings we go to there is very little that is actually voted upon. We are there to observe, guide, discuss and deliberate on the company's market development and strategy and look at ways in which we could add value. This 'partnership' role is crucial for us, because our aim, like that of the management of the company we invest in, is to see the business grow."

A typical example of this partnership approach was the recapitalisation of Scandinavian Mobility, a Danish manufacturer of mobility aids and beds for the disabled and the elderly. The founder of the business, who owned half the shares, wanted to buy back the other half held by a bank. Indigo Capital financed the entire transaction and the owner regained full control. Subsequently the company went public and provided Indigo Capital with an exit opportunity.

"The deal was ideally suited for mezzanine," says Stringfellow: "The owner instilled confidence as he voted by staying. In such transactions, you don't have the trauma of a change of control because continuity is assured by the owner-management led top team which is good for business."

To understand how some of Indigo Capital's deals are constructed, we have taken one of the firm's earlier deals, MediMedia's buyout transaction, as an illustration. MediMedia is a niche publisher of medical journals and promotional materials distributed in 25 countries. The company was part of IMS International, which had been acquired by Dun & Bradstreet (D&B).

Dun & Bradstreet was only interested in IMS International's market research business, and was therefore looking at ways to divest MediMedia. The senior managers at MediMedia saw an opportunity for reducing costs and generating additional growth through a management buyout. As such, they bid for the company. The leveraged buyout was funded with 84% debt. This included senior debt of $32 million, a mezzanine component of $15 million, and a vendor note from Dun & Bradstreet of $11 million, which was junior to both the mezzanine and senior debt. The mezzanine component was in the form of a subordinated loan with an equity 'kicker' and a put option. The put option could be exercised after seven years of the financing. Its purpose was to enable Indigo Capital to exit the investment in case the management decided to stay private.