Australia mid-market: Squeezed middle

Trent Peterson was looking for deals. Two of the three founders at Catalyst Investment Managers, were stepping back and it was decided that, in the circumstances, it would be imprudent to try and raise another blind pool fund. Peterson's new approach was therefore to target companies in which LPs would commit capital directly, with him serving as deal arranger and asset manager.

About six months ago he identified SkyBus, operator of an express bus service between Melbourne Airport and downtown, as a buyout target. The opportunity was presented to a number of parties, including some domestic superannuation funds, but Peterson's partner hails from overseas. SkyBus is now owned by the newly-formed Catalyst Direct Capital Management (CDCM) and Canada's OPTrust.

Peterson describes Canadian institutional investors as among the most advanced in the world in terms of how they approach direct investment situations, coming to the table with a clear idea of "what they are good at and what they are not, where they need help and where they do not." By contrast, the Australian super funds get short shrift.

"A couple of groups I spoke to about SkyBus said, ‘We've got a direct investment team so we don't see what your role would be in this deal.' The conversation finishes quickly from there," he says. "If you ask them later how the direct investment strategy is going, the answer is it's generally not - or it's really a co-investment strategy. They are not putting much money to work and the deals they see are often the ones every other PE firm has already turned down, so there is a significant risk of adverse selection."

The SkyBus transaction is said to have been valued at A$50-100 million ($39-78 million) - classic lower-middle to middle-market territory in Australia. Super funds are looking to make their PE portfolios more global while at the same time their asset bases are growing ever larger. A few groups are unable to write checks small enough for lower mid-market GPs, and with others expected to follow suit, it is unclear how domestic LPs will continue to access the space.

Direct investment is possible solution and Peterson sees himself as a conduit - perhaps doing deals with super funds while they build up internal capabilities. However, he and others are still to be convinced that this approach is sustainable. Super funds own large chunks of Australia's largest listed companies and they are setting the sights on more national infrastructure, yet their support for growth-oriented private companies could end up dwindling in relative terms.

"The Australian institutional market is not as supportive as it has, could and should be and some of that slack is being taken up by overseas investment," says Neil Stanford, PE investment manager at HOSTPLUS.

A healthy development

It is worth noting that super funds have scaled back their exposure to Australian private equity over the last decade with good reason: their entire allocation to the asset class used to be with domestic managers. "When I first came to Australia, our team would say there is no manager selection here, all the investors are in all the same funds," says Marcus Simpson, head of global private equity at QIC, an investment manager controlled by the Queensland government.

This resulted in a bloated middle market; strong returns allowed first-movers to scale up in fund size while others were drawn to the asset class.

According to AVCJ Research, between 1999 and 2002, over $3.3 billion was committed to Australia-focused funds, with more than half of it going to growth capital managers. The four-year period that came immediately after saw fundraising reach $9.4 billion, and half the capital went to buyout strategies. This does not include captive funds launched by banks.

Tim Martin, a partner at Crescent Capital Partners, estimates there were 10-15 players with fund sizes of A$200-800 million up until the global financial crisis. The number of participants in the space has halved as the banks felt the pinch of regulatory restrictions and underperforming independents couldn't persuade LPs to re-up.

"If everyone was doing 2-3 deals a year then more deals were getting done than there are now, but when you look at the track records, some of those deals were questionable and shouldn't have been done," adds Gareth Banks, managing director at CHAMP Ventures. "The number of small and medium-sized enterprises has not changed and the managers still operating are proven with long track records."

The likes of CHAMP Ventures, Crescent and Quadrant Private Equity all claim the competition has eased while the opportunity set remains robust. They live on a diet of buyouts that usually involve founder succession planning or partnering with management to scale a business with a view to exiting it by trade sale or IPO.

The alpha creation is there - arguably even more so now the GP universe has thinned out - and the investors participating in it are increasingly foreign. Australia's lower-middle to middle market is occupied by managers with funds of A$350 million to just under A$1 billion. Quadrant is at the top end of the range, having raised A$850 million for its seventh fund last year, with half the commitments coming from overseas LPs. This compares to one third in Fund VI and zero in Fund V.

Crescent closed its fifth fund last year at A$675 million. The overseas LP contribution was around two thirds, up from 40% in Fund IV and 25% in Fund III.

Each GP's most recent fund were oversubscribed and calls for an increase in the hard cap were resisted on the grounds that it risked moving away from the middle-market sweet spot. The earlier decisions to open up to overseas LPs were made with a view to diversifying the LP base, not because there was insufficient domestic support.

Big and inflexible

However, one of the reasons why other domestic managers have struggled is that they must compete for allocations against global peers within the super funds' international programs. Rules that required many super funds to maintain a minimum level of exposure to Australian PE have been removed.

One group has 4% of its portfolio in private equity, and no longer encumbered by a 25% domestic target, looks at all opportunities on an even basis. Nevertheless, the super fund may also end up overlooking smaller local GPs not on grounds of quality, but because its asset base has grown too large. Given PE's drawdown structure, investments are assessed in terms of the expected size of the super fund five years from now. This forward forecasting means the minimum check size of A$75 million, based on current assets, is smaller than then actual minimum commitment.

HOSTPLUS, which has a 5% private equity allocation, is in a similar position. Stanford recently brought a proposal for a A$25 million investment in a domestic VC fund before the board of trustees and was immediately asked why the commitment was so small. Although ultimately approved, the investment is an unusual one - and partly justified by the co-investment opportunities the fund is expected to deliver.

"There is a problem of deploying capital in sufficient sizes that it is economic given all the work that needs to be done," Stanford adds. "We are growing at about 17% per annum. We are A$17 billion at the moment and there is talk that we could be close to A$40 billion by 2020 and that is a big challenge. I have to think ahead to five years from now - are the commitments I am making today still going to be substantial?

As it stands, Future Fund and AustralianSuper are said to be the only domestic LPs that struggle to write checks of less than A$150 million. The former has A$109 billion in assets and only two Australian GP relationships; the latter, with A$78 billion under management, is known to have decided against re-upping with certain domestic managers due to the need to deploy a larger chunks of capital.

However, the need to make projections based on future capacity complicates the issue. Not all super funds are growing at similar speeds or are at the same stages of development; it is possible that for every commitment lost due to check size constraints more capital will come from smaller players. Michael Weaver, private markets manager at SunSuper, expects domestic allocations to fall in percentage terms but the dollar allocations will remain the same or increase slightly.

At the same time, the industry is subject to macro trends. First, there is a push for further consolidation within the super fund community, which will likely see the emergence of a smaller number of very large groups. Second, fees - and the relative expense of participating in PE compared to other asset classes - remain an issue and have prompted some groups to wind down their programs completely.

A question of fees

The fee debate also holds sway over one of the routes through which super funds might maintain exposure to Australia's middle-market GPs: fund-of-funds.

The feedback from many Australian LPs is that they can no longer envisage entering vehicles in which they have no discretion over manager selection, although they are very much open to advisory relationships. Separately managed accounts would go some way towards addressing the minimum check size constraint and this approach is under consideration by HOSTPLUS, for example, which has historically been heavily dependent on fund-of-funds.

One way or another, super funds are changing how they access the asset class and they end up at different points on a direct investment scale: pure co-mingled fund LP; active co-investor alongside portfolio GPs; backer of managers on a deal-by-deal basis; independent operator.

Part of the appeal is fee minimization. CDCM charges management fees and carried interest that are lower than industry norms to reflect its different role, but Peterson cautions that some super funds don't look beyond this consideration. "When they say they want to have a direct investment portfolio, if lowering fees is at the core of that strategy rather than increasing net returns, they are making a mistake," he says. "Net, net it probably won't cost them less, when you factor in they have a less experienced team."

Nevertheless, with fewer middle-market GPs, there are more managers willing to work under a for-hire arrangement, although it is difficult to identify many deals that have come out of this approach.

Since its inception in 2004 - and in addition to serving as replacement GP on ABN AMRO Australia vehicle - Allegro Funds has operated on deal-by-deal basis but is now in the process of raising a blind pool. This underlines the fact that every GP would rather manage a fund. And although deal-by-deal means no fees are charged on uncommitted capital, it does not necessarily benefit the LP. Managers may feel pressure to secure deals quickly, while a buyer without an immediate source of capital has less credibility with sellers.

"We have looked at these arrangements and there are a couple of things we struggle with," adds QIC's Simpson. "If you do something on a deal-by-deal basis you are concerned about the longevity of the person you've gone into partnership with and what sort of resources he can build around what he has. The other consideration is that you might be a stepping stone to raising a fund? Co-investments are cleaner for us."

QIC started co-investing in 2007 and these transactions now account for about one third of its portfolio by net asset value. More recently, QIC also started taking direct stakes in Australian middle-market companies, although so far as a minority investor supporting existing management teams. Last year it provided expansion capital for Ostwald Construction Materials, a Queensland-based quarry and concrete solutions business.

In this respect, QIC stands alone among domestic LPs. The question is how many others can do the same. Most super funds AVCJ quizzed on the issue have fewer than five people covering PE and no expectations of adopting the Canadian model. In addition to paying enough to attract executives with relevant experience, they must hire enough of them to do the job properly - an active co-investor doesn't necessarily have the resources in place to be a successful direct investor.

"You must also put in place the systems that enable the executives to succeed. This includes the right investment committee structure, the right philosophy and disciplines around making decisions, and the speed at which decisions need to be made is critical" says CDCM's Peterson. "This is currently at odds with the culture that resides in many of the Australian super funds."

The cost of not creating a balanced approach could be considerable: either due diligence expenses run up during the course of processes in which the super fund does not prevail, or in a worst case scenario, write-offs tied to poor investments that blow up.

In or out?

Several super funds claim to be considering or negotiating for-hire arrangements with managers, either on a deal-by-deal or limited mandate basis. LPs and GPs appear somewhat divided as to where it goes from here.

LPs expect leading lower-middle and middle-market managers to remain a force in Australia - they will simply raise more capital from offshore - but their relationships with the super funds may change. The extent of this change depends on how prominent direct deals become.

Simpson of QIC notes that his firm's first investment of this nature was in a company that had been courted by private equity funds. QIC's ability to make a longer duration commitment outside a traditional fund structure and the notion that its status might make it easier to source debt from local banks on favorable terms appealed to the sellers. Despite this "hometown advantage," the firm still expects to work with GPs as a co-investor most of the time.

The GPs, for their part, do not envisage super funds emerging as serious rivals for deal flow. Direct investment programs haven't worked out particularly well in the past, and then the performance of middle market funds is expected to make the prospect of participating as an LP more enticing.

Marcus Darville, a managing director at Quadrant, recognizes that super funds will always have a substantial public markets exposure in order to match assets and liabilities. However, he doesn't see why domestic infrastructure should be favored over private equity, arguing that although infrastructure is perceived as a safe haven it does not necessarily represent a better risk-return bet than private equity.

"The lower level involvement by domestic LPs is the product of being a little overweight offshore or of having a broad program in the past and seeing the failure of that program as a failure of the asset class rather than a failure in their portfolio construction," Darville says. "If the current returns keep coming through, there will come a time when people want to get back in."

Should this prove out, it is unclear how the minimum check size issue can be resolved. For all but a select few super funds, it may be a case of finding a version of the fund-of-funds model that works for them, such as a separate account, and swallowing any additional costs - because these would almost certainly be smaller than the sums required to set up a fully-fledged direct investment program.

"The middle market is one third of Australia's economy and if you are missing out on that you should find a way to address it," says Crescent Capital's Martin. "Alternative assets and PE in particular should play a role in a superannuation fund portfolio, but it has to be on a returns-driven basis."

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• Topics
• Australasia
• Buyout
• Australia
• Catalyst Investment Managers
• QIC
• Crescent Capital Partners
• CHAMP Ventures
• Quadrant Private Equity
• Future Fund
• LPs
• SME