Australia portfolio companies: Debt burdens

The numbers aren't encouraging. Australian private equity funds raised $141 million in the first eight months of 2011, according to AVCJ Research, well short of the $2.4 billion they picked up in the entirety of last year. It is far cry from the peak of 2007, although the trough of 2009 should be bettered.

Archer Capital is currently in the market and expected to reach its A$1.2 billion target. CHAMP Ventures is seeking to raise A$450 million for its seventh fund and has so far received commitments of A$275 million. Stuart Wardman-Browne, a director at the firm, told the Australian Private Equity and Venture Capital Association (AVCAL) conference last week that it has been tough going. Concessions have been made on fees and the firm is tapping offshore investors for the first time.

Wardman-Browne made another admission: CHAMP Ventures is giving detailed assessments of portfolio companies to investors, explaining how underperforming assets can be turned around. Other sources confirm this is not confined to one private equity firm.

Lurking doubts

This investor hesitancy is in part fueled by dramatic headlines about portfolio company debt. Several iconic businesses have already gone into administration, others are teetering on the brink, and still more companies are locked in restructuring talks with their creditors. Secondary sales have spiked as GPs look to return some money to investors.

Private equity has a profile problem - and industry participants say it is rooted in the excesses of 2005-2007.

"The PE model is a value creation model: buy well, improve the business, sell well. A small part of that picture is that if you increase the leverage of companies, you basically turbo-charge the equity returns," Andrew Thompson, national head of private equity at KPMG Australia, tells AVCJ. "But what that transpired into was people pitching very high multiples to win auctions. It almost didn't matter what you paid because the market would inflate you out of whatever situation you were in."

Gary Stead, co-founder and managing director at Shearwater Capital, an Australian opportunistic credit investor, traces the problems back to the early 2000s, specifically the Pacific Brands IPO in 2004. The offering raised A$1.26 billion and secured CVC Asia Pacific and Catalyst Investment Management an IRR of 141%.

A feeding frenzy ensued as the likes of KKR, TPG Capital and The Carlyle Group entered the market. Competition was intense and fed by cheap and easy credit. According to market sources, the leverage available on deals went from 3-5x in the early 2000s to 6-7x as the investment boom reached its peak in 2007.

"Then the market imploded with the global financial crisis," Stead says. "These guys got caught with overleveraged businesses, which had been bought on growth assumptions that were no longer true. I think most people would privately admit that nearly A$2 billion has been wiped out."

Debt packages now being offered by banks are back at multiples of 3-5x.

Bad balance sheets

The damage is most spectacularly visible on the books of media conglomerates Nine Entertainment and Seven West Media. CVC Asia Pacific, owner of Nine, is grappling with a debt burden of A$3.5 billion. KKR-backed Seven West, formerly known as Seven Media, was bought out by West Australian Newspapers earlier this year and is now looking to refinance as much as A$2 billion of maturing debt.

However, similar problems have been apparent among portfolio companies for 2-3 years now. Pacific Equity Partners' (PEP) REDGroup Retail is among the more notable failures. The book, entertainment and stationery vendor was on a high in 2009, having added the Borders franchise for Australia and New Zealand to its existing Calendar Club, Supanews and Whitecoulls brands. With revenues reaching A$685 million, management was talking of IPOs and expansion. But REDGroup fell fast and hard. In February, it was handed over to administrator Ferrier Hodgson due to its inability to repay $158 million in debt.

Other companies to enter receivership include: Affinity Equity Partners-backed clothing and footwear retailer Colorado Group; Riviera, Australia's biggest luxury yacht builder and a portfolio company of Gresham Private Equity and Ironbridge Capital; and Unitas Capital-backed Yellow Pages, which was bought at 13x earnings in 2007, slumped to 7x on the public markets and was eventually sold at 5x. The firm was carrying debt estimated at A$1.2 billion.

The Sydney Morning Herald pulled no punches in assessing the situation in April: "A frequent complaint from private equiteers about their stereotype goes: why are we unrelentingly portrayed as rapacious, greedy and arrogant? They may have a point. If only some of their number weren't so rapacious, greedy and arrogant. And not to put too fine a point on it - dunderheaded."

The counter-argument is that problems have largely been restricted to consumer-oriented companies such as retail and media that were hit badly as spending seized up in the wake of the global financial crisis.

As one source notes, the impact was not immediate. Australia, untroubled by recession, became the first G20 nation to raise interest rates in October 2009. Over the next year or so, rates increased from 3.25% to 4.75%. This, combined with the country's comparatively small market size and limited currency pool and positive sentiment concerning China's natural resource demand, meant that risk was perceived as being light. Domestic stock markets firmed up and, in the space of three years, the Australian dollar doubled in value, reaching AUD1.09 to the US dollar in May 2011.

But hidden in the shadows of this promising picture, consumers were growing nervous. Many had refinanced their mortgages in 2008, before the interest rate hike. That came on the back of a 25-year trend of saving less of household income, down to -5% by that same year. Today it's back to 12.5% saved. But 17.5% swing has devastated discretionary spending profiles.

REDGroup's problems were exacerbated by rising competition from the likes of Amazon.com. Customers began shopping for books online in earnest, won over by 40% price savings an exemption from the Goods and Services Tax.

"It wasn't so much a debt-and-equity issue as an ongoing business viability issue," one Australian banker says of REDGroup. "The thing about retail is that it's a high fixed cost business. So if you have high gross margins, say 50%, and you lose 10% of your customers over a 4-5 month period, it will wipe out your profits."

Success stories

Not all private equity firms were dunderheaded. CHAMP Private Equity and Quadrant are singled out as those who didn't get caught up in the overbidding sweepstakes and have since achieved some notable successes, bracing market conditions at home and abroad notwithstanding.

Bain Capital's buyout of Australian accounting software company MYOB for about A$1.3 billion in August is a good example. Archer Capital and HarbourVest Partners the company for around A$450 million in January 2009 and sought to exit for A$1 billion. But a bidding war between Bain, KKR and UK software manufacturer Sage Group resulted in the third-largest private equity exit ever seen in Australia. Bain eventually triumphed, paying about 11.3x EBITDA.

According to a source who worked on Archer and HarbourVest's acquisition as well as Bain's secondary transaction, in both cases gearing was conservative but this has allowed - and should continue to allow - for strong earnings growth.

"Does it have a reasonable debt load as a result of this deal? Yes. But does that in any way amount to high pressure? No. The bank leverage being offered these days can't create this unless there are earnings issues," the source says.

Other upside indicators of recent vintage include CHAMP Private Equity's exit from Study Group, an English-language tutoring service, to Providence Equity Partners for A$660 million (US$ 570 million) in July, and CHAMP's A$250 million sale of private hospital chain Healthe Care to Archer Capital a month earlier.

Many recent exits have been made to secondary or strategic buyers, which is unsurprising given the weakness in the public markets and the lack of IPOs. In the first eight months of the year, PE trade sales in Australia totaled $5.7 billion. This comes after $6.6 billion in 2010, within touching distance of the 2007 peak of $6.8 billion.

Clearly a driver is the imperative to show solid returns on the eve of what may be their most critical fund raising exercise ever. At the same time, it is a function of the challenges that remain in the debt markets. A 4.75% cash interest rate filters through to borrowing by private equity firms while high-yield debt is a relatively immature market.

"We're really dependent on wholesale banking markets to provide funds. But when you put a margin on top of the high basic rate, and then add fees on top of that, the costs end up sizably higher," says Mark McNamara, global head of private equity at Baker & McKenzie in Australia.

Tom Keck, a partner with US-based StepStone, a global gatekeeper with Australian interests, concurs. He notes that global credit markets bounced back in 2010 and there was a lot of restructuring and swaps, enabling struggling businesses some breathing space. Australian firms don't have this luxury because there aren't as many sources of capital.

"You try and restructure with your existing group but if you run out of options there, things have to change hands," Keck tells AVCJ. "You don't have the high yield market to turn to try and raise some rescue finance, for example."

In this context, Keck thinks that consolidation in Australia's private equity industry is inevitable, with 15-30% of PE firms potentially sidelined because they can no longer attract investment. Others AVCJ polled agreed, with some even saying that this was a conservative estimate.

Dealing in distress

Although conditions are difficult, most industry participants think Australia is over the worst. Many of the companies grappling with debt issues are already well along the way to refinancing, aided by more pragmatic lenders. KPMG's Thompson argues that opportunities are rising from the deadlock of the last 2-3 years, but it necessitates a considerable shift in mindset.

"What we're seeing is the rise of many of what you'd loosely call special situations groups within hedge funds, PE umbrella firms and investment banks, who view these situations as very high potential plays," says Thompson.

They are not only targeting private equity portfolios. Thomson sees it as a wider issue in the economy where people are reluctant to put their businesses into administration because it tends to trigger serious value loss. Investors can therefore buy up the debt on the secondary markets and negotiate with company boards to secure what are in effect controlling positions. It is the "loan to own" approach in a nutshell.

For example, Colorado Group recently emerged from administration with a new name - Fusion Retail Brands - and A$70 million for capital expenditure and marketing. Most of the company's A$450 million in debt has reportedly been converted to equity, leaving just A$90 million on its balance sheet. "Hedge funds control the business now," says Shearwater's Stead. "It's become a ‘loan to own.'"

Stead breaks down the situation into two categories. The first is loan to own, with banks selling debt in leveraged PE businesses to hedge funds. The second is new private equity funds scooping up problem assets on the cheap.

"We haven't seen much of this yet, though I think other local buyers, such as Premier Investments, have been able to do it. And I certainly expect to see more going forward."

 

Boxout: Overleveraged media

Nine Entertainment and Seven West Media between them own Australia's two top-rated television networks and its top two magazine publishers. It is a classic case of new media being held back by old: Nine posted EBITDA of A$414.9 million for the fiscal year ending June, up 16.4% year-on-year; but magazine unit ACP, which accounts for 30% of total earnings, saw its income decline by 18.5%.

Business isn't helped by a slowing consumer spending, which has an inevitable knock-on effect on advertising revenues. As a result, both companies are struggling to service their debts.

CVC Asia Pacific first invested in Nine's former company, PBL, in 2006 via a 50-50 joint venture, committing A$1.8 billion ($1.76 billion) in equity. A year later it picked up an additional 25% stake for an estimated $530 million.

The private equity firm is currently assessing how best to deal with Nine's A$3.5 billion in debt - A$2.6 billion of senior loans due in February 2013 and $900 million in mezzanine loans due in April 14. It is estimated that hedge funds hold 20-30% of this debt. CVC's options include issuing more debt to private investors in the US, a debt-for-equity swap, or a combination of the two.

KKR first got involved with Seven West - then known as Seven Media Group - in 2006, subscribing to a A$735 million convertible note that entitled it to half the company. Seven then borrowed A$2.5 billion, reportedly at a gearing ratio of 62.5% gearing, assuming a flow back of some A$3.2 billion.

Earlier this year, 45% shareholder West Australian Newspapers (WAN) took control of the business through a A$4.1 billion buyout, which saw KKR's holding fall to 12.6% from 45%.

Although it was reported this month that Seven West is mulling bank proposals to refinance as much as A$2 billion of maturing debt, sources tell AVCJ that the company is no longer in danger - the merger with lightly-leveraged WAN brought Seven West's debt burden into manageable range.

This saved KKR much embarrassment but its huge equity loss is likely to linger as "a slow death scenario," as one source put it.

 

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• Topics
• Australasia
• Credit/Special Situations
• Australia
• Distressed
• Archer Capital
• AVCAL
• CHAMP Ventures
• KPMG
• Shearwater Capital
• Pacific Equity Partners
• REDGroup
• Colorado Group
• Consumer