Opportunity knocks, but cautiously so

How you see the opera depends on where you sit, as the old saying goes. And while there are differences in the details, the common denominator among Australian GPs is their belief that a corner has been turned, that market conditions have firmed up and better times are on their way.

Surrounding this optimism are the realities of the market, including a lackluster IPO window, question marks around the taxation issue for foreign investors, and even the Australian superannuation funds are second-guessing the asset class, subverting what has been a long-held position as the number one supporters of domestic funds. Along with the transparency, solid management teams and well-regulated capital markets, Australian GPs have some long yards ahead of them.

LP support, but barriers to the market

Despite CHAMP having closed on the best part of A$1.5 billion, followed by Quadrant with $750 million, there are funds like Ironbridge and Crescent rumored to be coming to market this year, and it is unclear just how much capital is flowing into Australia. Because there have been fewer buyouts, deal numbers have been smaller, which in turn makes LPs question how much capital can be put to work.

Many GPs dismiss out of hand any notion that there's a growing skepticism among LPs on private equity prospects in Australia. That said, many of the larger buyout groups were fortuitous enough to have closed their funds in better times.

The changing attitudes and growing uncertainty about private equity among Australian superannuation funds is something that many foreign LPs are paying close attention to. "When they think about curbing their investment activities - that there are only a few domestic funds worthy of support," says David Pierce, CEO of Squadron, it is a concern for many in the industry.

Jonathon Freeman, Investment Partner with Coller Capital seconds that view, expecting that the upcoming fundraising cycle will be "interesting. How will these funds be received? It's a tricky fundraising market worldwide, and with extra skepticism in Australia [among the supers]," the fate of those in the capital raising cycle in Australia remains to be seen.

Another fund-of-funds source believes that the re-financing risk faced by "some of these funds is very real. Unless foreign capital from other fund-of-funds, SWFs or institutional pensions comes in," the responsibility will fall upon Australian institutions, which have openly said that they view private equity as an expensive asset class, and are becoming more sensitive to the 2 and 20 model.

Peter Wiggs, managing partner with Archer Capital, believes that Australia-based pension players' current views of private equity echo those elsewhere. "They're all in the same spot. Being guardians of pension or endowment money they are obligated to do their best to both grow and protect it, so when they see massive volatility in the asset class, it concerns them."

The taxation issue (which sees more in-depth coverage on page 14) is also causing LPs to squirm. Secondaries major Coller Capital sees it as a very real barrier to entry in the purchase of stakes in Australian funds. "We've come close a few times," explains Freeman, "but there is still a tax issue for foreign investors which is a pain; it makes it just that little bit more difficult. With secondaries in Australia, you are essentially into programs that are not necessarily set up for international investors."

That said, prospects could be good for secondaries players. "We see a lot of deals transacting - pensions selling because people are paying close to NAV... There is huge potential in Australia for [the secondaries market], particularly from fund-of-funds looking to sell off assets, banks as sellers because of regulation and the costs of holding a captive in-house portfolio. When we see all of that play out, there will be opportunities to get involved," Freeman concludes.

Conversely, family office fund-of-funds Squadron includes Australian exposure in its programs and so has managed to navigate any regulatory or tax issues. Tax, however, "is an important consideration," says Anand Ramachandran Prasanna, an Investment Director with Squadron Capital. For a group which focuses primarily on domestic Australian managers looking at middle-market opportunities, Squadron finds that "these funds generally have a structure which works," and the strategy remains appealing because it is less levered and less crowded.

Squadron MD Wen Tan notes, "There are a lot of players at the larger end and fewer opportunities, which is where valuations get pushed up. Likewise, the highest-profile failures have been at the top end." This brings to mind New Zealand Yellow Pages, and more recently REDGroup.

But, the fundamentals of Australia remain compelling. "Compared to the region's emerging markets, the speed of investment is more measured in Australia. For example, in China you have very different deal sizes and fund strategies, often [decisions] made rapidly in pre-IPO situations," says Pierce. Overall, he notes that the group has been "very satisfied with the performance of our Australian investments."

Freeman explains, "We would love to get into Australia," but the market is almost too stable for the type of investment investing Coller practices. "Australia does not have forced sellers; they want the right price, which is not a natural fit for our deal flow." Coller sees itself as more reactive in terms of deal flow and opportunities globally rather than proactively selective about portfolio construction.

This is, for most investors, an ideal combination of dynamics, however.

Exits: Showing what you're made of

After a slow 2009, 2010 was the year of the exit and of proving to LPs that indeed the fund is worth its weight in capital commitments. AVCJ data (see page 20) highlights the fact that trade sales are dominating the exit landscape, while IPOs remain on the back burner. Prospects either way are of course dependent on the asset itself. "If you have a strategic asset with synergies for either an international or local trade player, I think you're in a good place," Simon Pillar, MD with buyout major Pacific Equity Partners notes.

That is a function in large part of the pent-up demand he believes is implicit in the Australian M&A market. Talk among investment bankers is that activity in this segment will be vigorous this year. "The issue for MNCs these days is obviously the strength of the Aussie dollar," he explains. "But by the same token, MNCs in North America and Europe are keen to find some growth somewhere, and the Australian economy is well positioned. GDP growth and the underlying demand growth into which companies down here are supplying is one to one-and-a-half points above OECD averages."

Wiggs explains there is an element of practicality involved as well. "Of course trade sales are always the preferred exit route for private equity in that IPOs are a complete pain, plus you've got added after-market reputational risk which you can do without, especially since you can't control it. Trade sales, by comparison, are perfect: money down, deal done, and no one can track what happens to it afterwards."

The only exceptions to the no-IPO rule are in the resources and resource services sectors. But in the consumer and industrial spaces, but in general bright lights are not on the IPO horizon.

Propel Investments' MD Peter Dowding also foresees an increase in exit activity in the mid-market space as managers focus on seeking liquidity for investors within their market tier. In addition to trade sales, he also expects an increase in secondary activity as managers who raised funds in 2007-2008 come under pressure to put capital to work prior to the end of their investment periods.

"We're of the view that there is interest in the market for quality businesses with a proven earnings track records, hence Propel's current focus on liquidity."

Crescent Capital MD Tim Martin is a little more skeptical, though he shares this sentiment. "I think the reality is that not all private equity deals done in the past will find an easy exit. A long queue has formed, to the extent that it doesn't seem likely they'll all get away quickly even as the market does re-open."

Deal flow still healthy

According to AVCJ data on the market, total private equity investment bounced back in 2010, totaling $11.8 billion in Australia and New Zealand (ANZ), up over 50% compared to the lackluster $7.5 billion and $8.1 billion seen in 2009 and 2008 respectively. "Obviously ‘09 was a very slow year," says Pillar. "There were significant capital raisings that year and activity in 2010 remained modest overall... but coming into 2011 we're pleased with our pipeline."

Adds Archer's Wiggs, "What's really skewed the volumes is the disappearance of the mega-deals. But if you look at deals with an enterprise value of A$100-750 million, they're more or less running at 15-20 transactions [per annum] at the moment. [So while] things may have come off a third or so, activity certainly hasn't collapsed."

Speaking from a sub A$1 billion fund perspective, Cresent's Martin sees plenty of opportunity in the lower middle market range. "The [sub-A$ 300 million enterprise value range] seems less cyclical than the larger buyout segment, which is affected far more by leverage levels and availability of debt."

Auction processes are returning, if still thin, and private vendors seem more amenable to being directly approached. "Crescent has the strongest pipeline we've seen in some time," he says.

Coming into 2011, a fund manager's networks in sourcing deals are more important than ever, notes Propel Investments MD Peter Dowding. Other trends include the fact that "deal sizes, multiples ranges and enterprise values are materially lower" today than they were at the height of the market in 2006-2007, and that where banks are concerned, not every domestic fund is created equal.

Leverage and relationships

For the right target and the right partner, banks are being selectively more accommodating with loans, says Pillar. "But for the right asset, it's not unreasonable to be looking at 4-4.5x senior, and then another turn to a turn-and-a-half of sub[ordinated debt]." The turning point seems to have been the HealthScope deal, which "basically set a new standard and that was in excess of 5.5x if you take into account the public note that was issued."

Dowding agrees and notes that while the Australian debt market is open, and there are players seeking new exposures, the limiter is the focus on quality companies with strong historic financial performance operating in stable and defensive industries. Additionally, relationships between sponsors and lenders are key, as is the sponsor's track record with the bank itself. And these factors have noticeably hardened over the past 24 months.

In Wiggs' view, this is "probably putting a handbrake on deal activity, definitely in terms of size of deals," he told AVCJ. "You can push it to 4X. But beyond that it's tough." And, he believes that it is hard to go beyond $250 million in a single loan tranche, simply because of the limited number of players who have any real appetite for leverage.

"If you look at who a club of debt providers might be for a buyout at the moment, there are potentially six who would come in for $30-70 million each, leading to a number in the $200-300 million range. Thus where we play, particularly if you're comfortable with having capital structures in the 50/50, debt/equity range, you can still do deals from about $200-500 million."

Crescent's Martin articulates their approach to debt differently. "While leverage obviously plays a role in the ability to get deals done and drive returns, it's not the main driver. We typically look to leave debt capacity in our platform deals to enable investment over time into the businesses in the form of add-on acquisitions or capex/working capital funding."

Although firms are having varying levels of success with the banks, the overall feel is that this is a market that is coming back slowly but surely, and is perhaps acting as barrier to the LBO style deals (a la New Zealand Yellow Pages) that got the world into so much trouble to begin with.

There is no question that Australia is a far cry from perfect, but for fund managers entrenched in sound investment practice, enjoying positive relationships with banks, and leveraging their networks to source deals, regulatory hurdles and taxation issues can be overcome.

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• Topics
• Australasia
• GPs
• LPs
• Exits
• Jonathon Freeman
• Coller Capital
• Squadron Capital Advisors
• Archer Capital
• Peter Wiggs
• Peter Dowding