Fund focus: Into the white space

When George Penklis stepped back from Quadrant Private Equity in December 2014, he didn’t envisage returning to the industry with a new firm two years later. Penklis spent two decades at Quadrant, co-founding the business with Chris Hadley in 1994 under Westpac and taking it fully independent in 2005. Six funds were raised between 1996 and 2010, with corpuses increasing in size from A$50 million ($38 million) to A$750 million.

The firm is one of several in Australia whose success has propelled it into a higher tier of the domestic market: Quadrant’s eighth fund closed last year at A$980 million and seeks to deploy A$70-150 million per investment, well beyond the lower middle market space in which the GP made its name.

Penklis is now looking to fill the gap that these transitions have left, teaming up with Gareth Banks, Jonathan Kelly and Paul Readdy, all of whom were previously directors at CHAMP Ventures, a local GP that will not be raising a new fund. The new firm, Odyssey Private Equity, has secured commitments of A$275 million to invest in Australia and New Zealand. It will write equity checks of A$15-40 million for companies with enterprise valuations of up to A$100 million, taking minority or majority positions.

Investors see the lower middle market as a very positive area for investment in Australia, there is strong deal flow – George Penklis

“Investors see the lower middle market as a very positive area for investment in Australia, there is strong deal flow,” says Penklis, who spent the latter part of his two-year sabbatical assisting fund-of-funds ROC Partners on various initiatives. “But it’s also where the gap is – those who perform go up and move out of the space while non-performers fall away.”

Dwindling numbers

Fifteen years ago there are said to have been 15-20 private equity firms with institutional backing in Australia and New Zealand’s lower middle market, many of them captive units of banks. That number has since fallen to half a dozen. Stephen White, managing partner at Stafford Private Equity, a domestic fund-of-funds, actively follows about six managers, which he says is “pretty typical” of the market.

According to AVCJ Research, between 2005 and 2010 there were 34 final closes for Australia and New Zealand-focused buyout and growth funds with corpuses of $25-249 million. For the six years following that, the total falls to nine. The same trend is apparent in the $250-499 million space: nine final closes in 2005-2010, and four in 2011-2016.

“With the entry of the mega international buyout funds and larger local funds, there are very few funds with deep relationships among Australian family businesses so we are seeing more opportunities that fit within our mandate and are exclusive,” says Jeremy Samuel, founder and managing director of Anacacia Capital. The GP closed its debut fund at A$50 million in 2008, one of nine in the $25-249 million range from that vintage. When Anacacia raised A$150 million for Fund II in 2013, it was one of just four final closes that year in the entire growth and buyout fund market.

“If you look at the economy, nothing has changed,” he adds. “We are a very stable, international, small business economy with 25 million people, over one million small businesses, and 50,000 companies with 20-200 employees, which is Anacacia’s sweet spot. Management talent in Australia is strong so there is ample opportunity in this small-medium end of the market.”

The Australian Bureau of Statistics put the number of companies with fewer than 20 staff at just over two million in September 2016, while 782,000 of these are considered active employers. They account for 97% of all companies nationwide and – excluding financial services and the public sector – nearly 44.8% of total employment and 35.6% of economic output.

Companies at the top of this tier and in the one above it are classic targets for lower middle market private equity: founders and management teams that are at an inflexion point, whether they need a succession planning solution or capital and expertise scale up. While there is growing appreciation of the role that a financial investor can play in these processes, deal-sourcing remains contingent on deep networks and careful cultivation of opportunities.

However, it is an opportunity set to which Australian superannuation funds have less exposure than before. As these funds have seen their asset bases grow – in some cases driven by industry consolidation –their minimum check size has increased, making it harder to back smaller GPs. “Last time we raised a fund, several LPs wanted A$50 million allocations, we told them we could give them A$30 million and they got board approval,” one manager notes. “Now they will want to write checks for A$80-100 million.”

This attitude is rooted in cost: Super fund trustee boards, wary of the relatively high fees in private equity, would prefer their alternatives teams to write A$100 million checks to five managers – with guarantees of co-investment – than A$20 million checks to 25. “For the super funds it all comes down to the MER [management expense ratio],” Stafford’s White adds. “I think they would like the returns but MER is such a commercial reality for them, and whether they like it or not, they need to manage to it.”

Fundraising challenge

As a result, the traditional source of capital for Australian managers has become a less meaningful allocator to the asset class, which is one of the reasons why the lower middle market space remains underpenetrated.

In the absence of super fund support, a new manager can turn to the likes of ROC, Stafford, Vantage Asset Management and Continuity Capital Partners for institutional support or tap these fund-of-funds’ counterparts in Hong Kong and Singapore. Offshore capital has generally become more prevalent in Australian private equity in recent years. Family offices and high net worth individuals are another option, but there is a general unwillingness to back blind pool funds – hence the increase in managers working on a deal-by-deal basis.

Against this backdrop, Odyssey’s fundraise took an unusually quick two months, not including a recess during the Christmas period. But then the situation is in itself unusual: the combination of executives from two well-established Australian private equity firms with relevant track records. The LP base is institutional, primarily domestic and – according to sources within the LP community – includes a fair number of existing investors in CHAMP Ventures funds.

“We have about 70 years of investment experience between us,” Penklis says of the four founders. “Investors are comfortable with the team and have known about our track records for a while.”

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• Topics
• Australasia
• Fundraising
• Buyout
• GPs
• LPs
• Australia
• New Zealand
• Odyssey Private Capital
• Anacacia Capital