Australia webinar: Consistency matters

The participants: Peter Wiggs, managing partner at Archer Capital; Anthony Kerwick, managing director of Pacific Equity Partners; and Andrew Major, general manager for investments at superannuation fund HESTA. Katherine Woodthorpe, CEO of the Australian Private Equity & Venture Capital Association (AVCAL) acted as moderator.

On the health of Australia's private equity market

WIGGS: I think the scene here in Australia has been remarkably stable for the last couple of years. Investment activity by value has been around the A$5-6 billion ($5-6 billion) mark for four years. That equates to A$2.5-3 billion in fund equity being invested each year. With the occasional larger deals being done by pan-Asian funds, the underlying activity has been pretty stable. On the other metrics like fundraising, it depends on who is coming to the market and how much they are looking to raise. There hasn't been much change in LP sentiment in the last 2-3 years and I don't expect too much change going forward. LPs are largely supportive of the managers they want to invest in and not supportive of the ones they don't want to invest in.

Macros are not getting in the way of them making those decisions. On the financing side, it is tough to make any generalization on the markets here given how tightly they are controlled by a small number of players. It is a deal-by-deal market. We haven't seen the sea change that has taken place in North America with massive liquidity and high-yield debt. That doesn't happen here.

MAJOR: In 2011, there was a lot of liquidity in our investments. In 2012, there wasn't quite so much in terms of investments made and investments coming out. It was a consolidation year and 2013 will continue that trend.

When I talk to other LPs in the market, there are those who continue to commit to the sector because they see overall value in the institutional portfolio. A second group has stopped investing and still hasn't come back to the market. Then there is a third group of LPs that are unsure and questioning their commitment to the asset class. One thing that we may see going forward is a little more activity on that front where LPs come to a decision of continuing to commit or withdrawing. In discussions with GPs I also see three broad groups.

There are those that carry momentum into their fundraising and are able to raise capital in a relatively short period of time - I still see some managers raise in excess of their hard caps. Others have lowered their fund sizes to get back to their core business and away from the exuberance of the last 6-7 years. And then a third group of GPs is saying they will continue with their current strategies even though they could raise more. I think that is a positive perspective. When I put it all together, I am cautiously optimistic about private equity as an investment class in the next year or more.

KERWICK: I'm more optimistic than cautious. The current environment is quite favorable, especially in terms of investment. You have a stable operating environment and a stable macro environment that means you can take the beat of future performance.

The leveraged finance markets are still open for the right types of business, with loans available to support a growth investment thesis. There is competition for assets, as always, but you have a corporate sector that struggling to generate organic earnings to meet investor expectations and are not willing to put their balance sheets at risk for transformative acquisitions. As a result, competition for asset is on the low side and we see that reflected in the average multiples that have been paid in 2012.

As we look forward to 2013, I don't see any seismic shift in these settings. It is probably the most favorable investment environment in the last 4-5 years. On the flip side, exits are not as easy. The ability to generate returns falls on value creation and the strategic repositioning investors can achieve with a business, and so we are likely going to see a differentiation in returns going forward. Given the nature of the asset class, it will be a while before this becomes apparent although it will more apparent with the current vintage of funds than before.

On what LPs want to see before making a fund commitment

WIGGS: The whole risk-return focus of LPs has moved. The over optimistic exuberance that led people to chase unrealistic returns based on unsustainable leverage is no longer attractive to LPs. Track records from 2005-2007 where there were a few deals where you hit it out of the park and a few deals where you lost all your capital are not so attractive. These days LPs want to see a tighter range of outcomes.

There is an understanding that chasing spectacular success means taking on more risk and LPs prefer consistency - 1.5-3x rather than 0-6x. At the end of the day, LPs are looking performance through the cycles, which is why they invest in unlisted equities. The other thing LPs are really keen to get right this time is alignment. There is zero tolerance of anything that makes it seem as though GPs are putting their own interests in front of those of the LPs. This was not the case in the 2005-2007 era when pretty much all the LPs turned a blind eye to that stuff.

MAJOR: If I am looking at a new GP that I haven't invested before, first of all I have to understand their strategy and then I have to understand it relative to others who deploy a similar strategy, and with whom I may have or may not have a relationship. You are looking for consistency in strategy, fund size, terms and alignment between the manager and investor. The GP must also have the capacity to execute an investment strategy based on the amount of capital that has been raised and consistency with their track record.

On LP expectations in terms of returns

MAJOR: As a long-term institutional investor in private equity, our long-term return expectation shouldn't change in any way. We have to assess the class against listed equities and it should get a premium over listed equities over a 10-year period. You also need to look at private equity from an absolute returns perspective and then you focus on cost, which should be a discussion about net returns. You commit to GPs that give you returns at least in the high teens. Instead of just asking, "Should I invest in private equity or not?" it should be a decision based on which firms, strategies or regions are going to give you that target return. When I look at the discussions on MySuper and Strong Super, it started with cost but the language has since turned to be more about net returns, which I see as positive.

On private equity helping Australian companies expand overseas

WIGGS: That is more the role of my CEOs than me. Offshore expansion and growth could be a big part of the investment thesis and you have to make sure you get the right management in place and provide them with the capital. It is somewhat different to our pan-Asian competitors, who try to execute on the model that says look we have offices in seven Asian countries, we are networked with everyone, and we can grease the rails for you. Time will tell if they are successful.

KERWICK: One of the things private equity can bring as shareholders of predominantly medium-size companies is supporting calculated risk-taking where the payoff is likely in the medium term and in the short term there is likely to be added cost. One example of this is an international growth strategy. That whole mindset of agreeing with the management team what the strategic plan is over a multi-year horizon, being supportive of that strategy provided that the fundamentals suggest it was the right thing to do, and not shying away even when the going gets tough is fundamental to the value add of private equity. Of the deals we've done here in Australia, over half had some form of international expansion as a driver of the business.

Sometimes you are surprised when it is better and easier than expected, but most o the time it is tougher and issues come out that need to be sorted. Other forms of ownership may not be as tolerant of these strategies.

On the activity in the Australian lower mid-market

WIGGS: There will always be more deal flow at that end of the market because there are more companies. The problem is there are some very poor managers in that space. It is endemic because that is where most of the new entrants start and some survive and some don't. But this part of the market will always be there. One of the advantages they have is banking support. In the mid-market we have to deal with institutional banks that are somewhat concentrated; the lower mid-market guys deal with business banks that have a branch in every suburb, so they will always have more debt options.

MAJOR: As people go through the fundraising cycles, they need one or two funds to prove themselves or otherwise. We are a lot more selective about who we back in the market and make sure that we don't cross strategies by putting two pools of competing capital against each other. We recognize this is an important part of the market but we want to make sure we are only backing managers who can help us achieve our overall objectives. There will be a process of Darwinian natural selection, if it hasn't started already. It is ultimately healthy for the investment market.

On exit options in the absence of IPOs

KERWICK: The consensus is that the market is currently receptive to IPOs but because it hasn't been too popular in the past two years, fewer people are thinking of that option. IPOs are an important means of delivering liquidity and returns to investors - not the only way but one of the more controllable exit routes. The other important route is sales to trade buyers.

The trend that has emerged in the last three years is that - at least with the scale of company we get involved in - trade buyers find Australian businesses very attractive because they provide a platform for growth into Asia and emerging markets they don't currently have. The businesses are also attractive enough to fit into their own strategy in Australia. As a broad generalization, Australia is a country that multinationals want to be in and feel they need to be in. They don't want to spend time fixing a business that isn't performing as it should be, so the ability to deliver a meaningful-sized company on a safe trajectory is quite attractive to a lot of buyers.

WIGGS: Having a quiet IPO market is, net-net, a benefit for buyouts because IPOs are no longer an option for the vendor so they see you as better than a trade buyer. Sales from trade buyer to trade buyer can be tricky sometimes

On the emergence of secondary exits in Australia

KERWICK: It has been underpenetrated historically, but the market is evolving and now we see a steady flow of those. One theme that has emerged is local players selling to global or regional private equity firms that can take a business pretty much like a trade player and use it as a platform for attacking other markets. We have at least one exit that has fallen under that category and the strategy has proven out for the buyer. However, they need to think about how they will manage what is an Australian business already operating at close to or full potential. That can be difficult without resources on the ground here.

WIGGS: We have been on both sides as a seller and as a buyer. The reason it has become more focused is due to the amount of companies private equity has brought in the last few years. It has provided a big inventory of businesses.

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• Australia
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