AVCJ at 25: Tim Sims of Pacific Equity Partners

The massive leveraged buyouts of 2005 to 2007 saw a string of high-profile Australian and New Zealand brands fall into private equity hands - Coles Myer, Yellow Pages, PBL Media, Independent Liquor and Seven Network, to name but a few. Had shareholders not vetoed the proposal, Qantas, Australia's national carrier, would have gone the same way.

In the space of less than a decade leveraged deals went from zero to stratospheric and then, after the global financial crisis took hold, returned to a more subdued level just as quickly. Some prospered while others stumbled, but there is little doubt this period saw a market characterized by venture and growth-oriented transactions uprooted and emphatically transplanted into the world of global buyouts.

Its origins, though, were comparatively humble: the A$50 million acquisition of Frucor Beverages from the New Zealand Apple & Pear Marketing Board by a Pacific Equity Partners (PEP) and Bain Capital-led group in 1998. "If you are looking for when the big bang happened, it was probably Bain Capital and PEP with Frucor," says Tim Sims, a founder and managing director of PEP. "It was the first classic LBO done by international investors in this market place and a lot of the structures and documentation were imported from the US. It produced a 10x money return."

This was PEP's first deal but it took the Australian firm another five years to fully invest its A$150 million debut fund. As to why it took so long for the market to get moving and why it quickly became Asia's leading buyout market - Australia and New Zealand accounted for 44% of regional sponsor-backed M&A volume between 2006 and 2010 - when it finally did, one must explore the evolution of private equity and the nature of corporate Australia.

A frontier market

Initial domestic participation in the asset class was led by Australia Mezzanine Partners and a few captive funds. Their reach was limited by conservative institutional investors that were intent on small funds of less than A$100 million and limited fee scales. From a foreign perspective, meanwhile, the market was largely impenetrable.

"They faced two major challenges," Sims says. "First, it was unclear how you could participate from a tax point of view . Second, there wasn't experience on the ground that allowed foreign investors to replicate the behaviors that were successful in legacy markets such as the US and UK, but in an entirely new market."

There weren't enough law firms and accountants capable of dealing with leveraged buyouts, but the most interesting conundrum lay with the banks.

Australia's banking industry was deregulated in the 1980s and this gave rise to an explosion in lending to a new generation of entrepreneurs - Robert Holmes à Court, for example - who engaged in corporate raiding, staging hostile takeovers of companies fueled by piles of debt. Inexperience counted against the banks and all had their fingers burnt, resulting in a wariness of leveraged deals. They also had little confidence in private equity as a serious contender for assets based on the small domestic funds present at the time.

The frustration for foreign private equity firms, in search of new buyout markets as competition intensified in the US, was that Australia offered rich potential. Though economically strong and boasting a legal system familiar to Western investors, the country was isolated and lacked buyout structures and support mechanisms.

Regulatory nuances also played a role: Australia's domestic tax policy didn't encourage outbound investment for local corporates because measures designed to eliminate double taxing of corporate dividends only applied to domestic profits while losses generated by overseas operations couldn't be consolidated in Australia for tax purposes.

"That resulted in a tendency to over-invest in seeking growth in the domestic economy, which created very large systems of loosely agglomerated corporations," says Sims. "In a contested capital market these entities probably wouldn't have existed." He cites Goodman Fielder as an example: a fully integrated food company producing everything from muesli bars to fats and oils to bread that had no meaningful operations outside of Australia, New Zealand and the Pacific Islands.

This combination of limited international exposure and large, unchallenged conglomerates represented an attractive target for private equity. Indeed, the realignment of ownership is still being felt: Australia is the world's 12th largest economy and its third-largest leveraged buyout market. Noting that it took the US about 50 years to work through its own disassembly of large, inefficient conglomerates, Sims believes that M&A in Australia will remain disproportionally active for at least the next 20 years.

But back in the late 1990s, these developments seemed a long way off. "It was an extraordinary situation on the demand side - a strong economy with some unusual characteristics due to regulatory limitations that made it ripe for contested ownership," Sims says. "We were mature in terms of capital markets and underlying infrastructure but lacked an asset class that had been active in the US for 20 years. I have described it as Tutankhamen's Tomb."

Opening the tomb

PEP is partly responsible for the tomb being broken open. The founders were previously the regional leadership group for Bain & Company and, like many of their counterparts at the consulting firm, they wanted to enter private equity. Rather than follow the well trodden path from Bain & Company to Bain Capital, the group set up PEP, relying on Bain Capital as a joint venture partner for the first fund. This meant money came in from the US private equity firm's stable of global investors, allowing PEP to target deals that were at the time outside the comfort zone of Australian institutions.

The alliance also fostered the development of local service providers. Bain Capital has a strong relationship with PricewaterhouseCoopers in Boston and the accounting firm transferred a team to Sydney to work with PEP. Efforts were also made to familiarize local banks and law firms with inter-creditor agreements and other structures that underpinned private equity in the US.

Gradually, the world started to take notice. CVC Capital Partners was an early arrival but reconnaissance teams from the big buyout firms really started arriving in 2005. They brought with them strong international banking relationships, high leverage and covenant-light arrangements. Given the PE firms' broad goal of writing equity checks of $500 million, target companies needed to have an enterprise valuation in excess of $1 billion - around A$1.5 billion based on exchange rates and leverage available at the time. This was beyond the focus of local GPs like PEP.

Australia's unchallenged conglomerates were a natural target, but relatively few companies fell in the valuation range above A$1.5 billion. "These tend to be unusual businesses - banks, airlines, newspapers and television stations," Sims says. "They are very large asset systems often with significant operating leverage resulting from the returns to scale that helped to establish them in the first place. For example, a television station has attractive margins if you get good advertising support but if it contracts by a small amount the margins disappear."

This was the work of sophisticated deal-makers following investment models that had proved successful in the US and Europe. However, high levels of financial leverage in businesses that carry substantial operating leverage were vulnerable in the event of an unforeseen downturn. And the global financial crisis caused unprecedented and unpredicted havoc.

The irony is that Australia wasn't badly hit - its economy was strong and the fundamental drivers were unchanged. What undermined the country's position were the spillover effects of problems elsewhere.

Firstly, one third of publicly traded stocks were held by overseas investors and many promptly repatriated the capital in response to their home markets collapsing. As a result, the Australian equities index fell by 50% in 15 months. Secondly, domestic banks rely heavily on the overseas wholesale money markets and, although the government quickly moved in with funding guarantees, homeowners were worried about mortgage rates and so cut back on spending. Domestic savings shifted from from 2% of household income to 12% in two years. This compares with 4% to 6% in the US over the same period.

"For reasons that weren't endemic to Australia you had this whiplash effect," Sims says. "Some of the large legacy businesses suffered terribly. Media spend was cut dramatically by advertising companies that were no longer being fueled by consumer spend because consumers were worried about mortgages that were in some way connected to the global financial crisis."

Return to normal

Buyouts have since returned but leverage levels are more modest and covenant-light structures have gone. PEP's fourth fund - a A$4 billion vehicle, including A$1.3 billion for co-investments, raised in 2008 - was designed to target companies with enterprise valuations of up to A$1 billion. It is consistent with a middle-market focus that has been part of the private equity firm's strategy since it raised its second fund in 2004.

Sims expects the larger deal space - investments worth $500 million or more - to remain active at the level of one to two transactions a year. This is partly because many of the investments made in this space in 2005-2007 simply haven't performed as the global buyout firms anticipated.

Of the $8 billion in equity that was invested in larger deals by international players during the period, he says that $5 billion is severely compromised and is carried at less than 1x of the original investment value. A further A$1.5 billion remains at book value and the remaining A$1.5 billion is above 1x but very few deals have been realized.

What may change is the fly in-fly out approach traditionally employed by international private equity firms in Australia. "If you look at the track record, it's hard to apportion blame between the extraordinary economic circumstances and the disadvantages you face as an overseas itinerant investing in a remote market like Australia," Sims says. "Establishing remote offices in this country brings with it a whole new suite of challenges."

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• Topics
• Australasia
• Buyouts
• People
• Australia
• Pacific Equity Partners
• buyout
• Timothy Sims