Fitch Ratings says since the onset of the credit crisis in the summer of 2007, European mezzanine investors have supported many of the later transactions at considerably better pricing than pre-crisis vintages. However, mezzanine as an asset class remains vulnerable to the broader leveraged credit market's 2006 and 2007 vintages, which suffer from historically high leverage, peak-of-the-cycle projections and the prospect of widespread refinancing risk.

"Mezzanine debt defaults are likely to rise as the financial crisis continues to take its toll on economic growth. This will reveal paltry recoveries, illustrating how poorly mezzanine was structured before the onset of the credit crunch," says Pablo Mazzini, Senior Director in Fitch's European Leveraged Finance group.

In one of two special reports, Fitch expects new mezzanine transactions will continue to be in thin supply as leveraged products suffer most in the midst of the credit crisis. Notwithstanding improved pricing, structures and successful fundraisings by dedicated mezzanine funds prior to the latest deterioration in financial markets, mezzanine and second lien issuance together amounted to EUR2.2bn in the first nine months of 2008, equal to just 10% of the EUR22.4bn borrowed in the same period of 2007 at the peak of the credit cycle. Going forward, market participants will focus on the performance of outstanding credits, notably the 2006 and 2007 vintages, which represent more than 80 % of Fitch's leveraged credit portfolio.

Mezzanine has played a key role in the structuring of most of the recent transactions. However, contracting demand for senior loans and elevated enterprise value levels mean the primary market is likely to remain subdued in the near term, even if the current seizure in broader credit markets proves temporary.

The 2006 and 2007 vintage deals have some headroom in the form of back-ended maturity profiles, and loose covenant restrictions, as well as a financial sponsor community and CLO creditors, who are keen to use all means to agree amendments, de-leverage and avert widespread defaults. However, the deteriorating financial and economic environment will only exacerbate the early signs of underperformance Fitch has observed on the 2006 and 2007 vintage deals.

"The key question, given current covenant headroom and back-ended maturity profiles, is whether leveraged credits can achieve aggressive targeted cash flow growth in order to de-leverage in time for confidence to return to the broader leveraged credit investor base," says Mr. Mazzini. "If not, then new money investors may decide that outstanding leveraged deals can only be refinanced on the basis of distressed debt exchange restructurings, which will lead to a spike in defaults and reveal paltry recoveries for private equity and subordinated creditors."

Fitch notes mezzanine default rates have started to rise, albeit from low levels during the credit boom. The 12-month rolling default rate for Fitch's rated mezzanine portfolio was 0.65% at Q308. This figure is likely to see at least a gradual increase in 2009, and rise more materially in 2010 as vulnerable cyclical credits require new money. Potential candidates for financial distress (i.e. transactions with an Issuer Default Shadow Rating of 'B- (B minus)*'/Negative Outlook or 'CCC*' and below) represented an aggregate EUR2.5bn in mezzanine debt at end-Q308 (up from EUR1.6bn at end-Q108), encompassing 25 deals across 11 different sectors. Were all of these mezzanine loans to default, default rates could rise to the mid-to-high single-digits by 2010. However, this could increase even further if more distressed situations arise amid subdued economic growth and as credits fail to de-leverage, resulting in greater refinancing risk for 2011 and beyond.