Australia distress: Sifting the strain

The story of diagnostic imaging business I-Med Networks is a familiar one in Australia. Acquired by CVC Capital Partners in a A$2.6 billion ($2.3 billion) deal in 2006, it was one of a spate of highly-leveraged buyouts that came to typify the years preceding the global financial crisis. CVC, fresh from almost doubling its money on a buyout of Ramsay Healthcare, had little reason to doubt its potential. Within five years, though, things had soured.

Bought as DCA, the business was later renamed I-Med, following the sale of its aged care arm to Bupa. But it couldn't hide from its debts. In 2011, a group of 30 hedge funds led by Anchorage Capital and Fortress Investment Group took control of the company. Meanwhile, one third of the I-Med's doctors announced they planned to leave.

No single hedge fund had a dominant position and so no one was willing to assume control of the board. It was left to Allegro Funds to come in as a minority investor, facilitate CVC's exit and lead the restructuring effort.

"Our aim was two-fold," explains Chester Moynihan, managing director at Allegro. "First we would provide capital to fix the balance sheet, sometimes in partnership with hedge funds. Secondly, we would to get control of the business with like-minded people and drive the turnaround."

While I-Med is by no means the only entry on Allegro's track record, it is perhaps the most high-profile entry. As the firm seeks to raise A$200 million for its first institutional fund - it previously managed ABN AMRO Capital II Fund, having been brought in as a replacement GP to tend to a distressed portfolio - I-Med will inevitably be name-checked.

The irony is that Allegro doesn't expect to be doing many more of these deals. Most of the low-hanging fruit has gone and Australia's distress investors are now looking elsewhere.

Happy coincidence

"From a distressed investor point of view, it was a happy coincidence of three things going on," says Alistair Dick, managing director and head of debt advisory and restructuring at Rothschild Australia.

"A number of overleveraged deals that were caught in a global slowdown; a group of mainly European banks were exiting the market quickly and looking to sell out; and local banks often did not have the appetite or the remit to stick around through protracted debt-for-equity swaps so they sold as well,"

On the leveraged buyout side, these low-hanging fruits included another CVC casualty, media conglomerate Nine Entertainment. Acquired between 2006 and 2008, the company ran into trouble as advertising spend plummeted following the financial crisis. Another hedge fund consortium, led by Oaktree Capital and Apollo Global Management, completed a debt-for-equity swap worth nearly $3 billion, wiping out CVC's equity in the process.

The most notable transactions to arise from European banks beating a path to the exit - aside from trading out positions in LBOs to hedge funds, which led to the debt-for-equity restructurings - were probably the Lloyd's International's sales of the BOS International portfolio.

The Blackstone Group and Morgan Stanley were among those to take advantage, forming a joint venture to acquire a GBP809 million ($1.25 billion) portfolio of Australian corporate real estate loans in 2012. That same year, KKR's special situations unit teamed up with Allegro to acquire a portfolio of distressed corporate loans. A third sale, said to be worth A$371 million, went to Sankaty Advisors last August.

"The big wave of distressed activity that came post-global financial crisis has largely played itself out," says Jamie Weinstein, co-head of special situations at KKR. "There was a lot of primary lending activity in 2005-2008 - a lot of it came from non-domestic banks and a lot of it went into LBO deals - and most of those positions have been cleansed. We don't expect to see many big portfolio sales on the corporate side."

According to a restructuring expert at one of the Big Four domestic banks, there is plenty of activity at the small end of the market. He is getting 10 files in the A$20 million space for every one file in the A$40 million space and nothing much at A$50 million and above. And these positions aren't necessarily trading.

Australian banks didn't suffer the adverse effects of the global financial crisis nearly as much as their European and North American counterparts and so they haven't been under the same pressure to sell.

"It's hard when we've been through a period of significant deleveraging and the volumes in the secondary market have gone down," says James Marshall, a partner in Ashurst's restructuring and insolvency group. "But it would be wrong to say there has been a drop-off in activity."

He argues that the opportunities have become more situational rather than following a particular trend. One example is surf wear company Billabong which got into difficulty in early 2012 after accumulating debts more than A$300 million. The company had been the subject of early takeover bids from Bain Capital and TPG Capital but after proposal were rejected, lenders started to off-load their debt exposure to the group.

The company then became the subject of competing offers from two US consortiums: one led by Altamont Capital Partners and Blackstone unit GSO Capital Partners; the other by Centerbridge Partners and Oaktree Capital Management. Billabong initially negotiated a $294 million refinancing deal with the Altamont-Blackstone, but later accepted a sweetened offer Centerbridge-Oaktree.

"You do get situations where somewhat unexpectedly retailers and other businesses get into difficulty and something happens to create a market and you see some trading," adds Marshall. "This will continue to be a factor of this market. The deals have got smaller but there are still plenty of them out there."

Indeed, turnaround specialists like Allegro are targeting the smaller positions held by domestic banks, looking to leverage their operational expertise to work out difficult situations that banks don't want to address or no longer have the manpower to address. Moynihan credits the large debt sales with alerting the banks' restructuring divisions to the role private equity can play in resolving non-performing loans.

"It started with the institutional and now it's moving into the corporate," he says. "We are seeing a mixture of family-owned businesses, some public companies, and a smattering of private equity-owned portfolio companies."
The question is where does leave the large-cap players.

The hedge funds do appear to be less active, content to fly in for intermittent opportunistic plays along the lines of Billabong.

As for KKR, Weinstein says the focus is on private credit, which could involve mezzanine lending as part of a financing package or direct lending to a company, and broadly defined special situations plays. He notes that the firm is willing to do deals as small as $50 million.

Asset heavy

These special situations opportunities may well arise from the asset-heavy sectors, with several industry participants highlighting the potential of agriculture, real estate, infrastructure, and especially mining.

Junior miners are the classic distressed case. Hit hard by the downturn in the commodities cycle, they either have too much debt on the books or want to raise capital but cannot because of falling commodities prices.

However, distress is not confined to mining companies. Ancillary service providers and equipment manufacturers have also been impacted and demands on working capital, low margins and large project risks are expected to create further challenges. For example, earlier this month listed engineering company Forge Group went into administration following weeks trading halts and profit deterioration.

"There are a lot of small to mid-cap mining service companies still reliant on one or two clients," says Chalothorn Vashirakovit, investment associate at Clearwater Capital Partners. "This has presented a lot of opportunity in the past when clients have pulled back on their projects or renegotiated their contract terms and companies have faced a tremendous amount of stress- those are opportunities which we think are quite interesting."

As to whether actual mining companies will emerge as investment opportunities, industry participants are less certain.

Bert Koth, managing director at Denham Capital, notes that, while on paper the average listed junior miner may appear to have another six months before it runs out of money, the reality is the company will likely reduce its cash burn rate until it effectively goes into hibernation.

"When you have a cash crisis there is the opportunity to buy assets at a lower valuation but most junior mining companies do not constitute attractive mining companies, so the opportunity set is a little bit exaggerated," says Koth. "Like in every market you have to look
hard."

SIDEBAR: Mean fields - Agriculture in distress

Drought has made the precarious situation of Australia's cattle farmers a whole lot worse. With 70% of rural Queensland parched, land values are falling and banks are calling on cattle station owners to pay down a portion of their debts of face foreclosure. It is a vicious circle. One distressed farm sale in area pushes down valuations of the surrounding properties, collateral disappears and the process starts over.

Farm debt in Australia has risen from A$40.3 billion in 2004 to A$70 billion, of which A$5-10 billion is classified as distressed. There have been calls for the government to step in and clean up the worst positions. PE investment would also be welcome, but is it economically viable?

"The agriculture sector in Australia is ripe for foreign investment and remains overleveraged and quite illiquid," says James Marshall, a partner in Ashurst's restructuring and insolvency group. "Australian banks are struggling with some of their exposure and there is a lot of interest in how foreign investors might assist through roll-up strategies."

There are two types of farming operation in Australia. At one end of the scale are the corporates, with assets of A$500 million to A$1 billion that are able to raise new capital and get their debt down to a sustainable level.

Even then, large players are not immune to difficulty. Having lost approximately A$1.7 billion over the last five years, Elders has been forced to downsize and restructure its debts. Namoi Cotton sold a stake to US agricultural trader Louis Dreyfus Commodities at the start of 2013 amid concerns about its ability to service debts and stay in business. And then there is PrimeAg whose shareholders voted to wind up the business last October.

At the other end of the scale are the mom-and-pop farms. Typical distressed cases started with the acquisition of a neighboring farm, backed by debt. After five bad years in a row the debt has swollen from A$10 million to A$20 million and is now worth more than the collective value of the land and the cattle on it.

"There are lots of people in that A$10-30 million exposure range who are in trouble, rather than one owner with a distressed position of A$300-400 million," according to a restructuring expert with one of the Big Four banks. "There is an opportunity to do a roll-up and someone will eventually do it. Then the drought breaks, cattle prices go up, the Australian dollar depreciates, and it's happy times again."

There are plenty of strategies and purported opportunities, but as yet no significant activity. Politics - and the potential for government intervention in the sector through a state-backed reconstruction bank - may be partly responsible for private sector hesitancy.

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• Topics
• Credit/Special Situations
• Australasia
• Financing
• Distress
• Australia
• Allegro Funds
• KKR
• Clearwater Capital Partners
• Leveraged finance