Pacific Equity Partners on life after lockdown

Pacific Equity Partners managing director Tony Duthie talks economic recovery and portfolio resilience

This article is sponsored by Pacific Equity Partners

In early June, New Zealand’s government declared the country free of the coronavirus and lifted all remaining restrictions imposed to stem the spread of the disease – except stringent border controls.

As Australia and New Zealand emerge from months of strict economic and social lockdown, both face the uphill task of economic recovery. The long-term economic cost of closing non-essential businesses, services, shops and public spaces, and enforcing social distancing, will be debated for years. In the short term, these measures have ramped up uncertainty and put the brakes on years of buoyant economic health.

Amid the volatility of recent months, Sydney-based Pacific Equity Partners managed to complete fundraising for both its sixth buyout vehicle, which closed on A$2.5 billion ($1.7 billion; €1.5 billion), and its first infrastructure vehicle, the Secure Assets Fund (SAF) which has more than A$650 million in committed funding including co-invest, as well as conduct a take-private of Zenith Energy from the Australian Securities Exchange.

We asked managing director Tony Duthie about the immediate and long-term impacts of the pandemic on the investment environment and the firm’s plans.

What will the post-covid recovery look like?

Tony Duthie, managing director at Pacific Equity Partners

It’s the big question. In Australia and New Zealand, the governments and regulators responded early to the pandemic in a number of ways. The Reserve Bank of Australia for example cut interest rates twice in March to an all-time low of 0.25 percent. Through its JobKeeper initiative the government has provided subsidies to impacted businesses to help them retain staff on the payroll. At the same time, JobSeeker payments are supporting people of working age who are looking for employment or unable to work.

However, the lasting economic impact of the lockdown is unknown, including on consumer sentiment and purchasing power. I don’t think we’ve felt the full force of the economic hit just yet and there is still hardship to come. JobKeeper is due to finish in September and then some of those people won’t have employment. Unemployment in Australia is forecast to peak toward the end of the year at high single digits – among the highest levels ever recorded – up from an average of around 3-5 percent. At the macro level – but also at the micro level, industry by industry and opportunity by opportunity – the path to recovery is very unclear, and that makes investing challenging.

How does the pandemic compare with the global financial crisis?

During the GFC, the Australian and New Zealand markets were largely sheltered from the worst impacts thanks to the strength of the economies and banking sectors, combined with governments’ willingness to take action. It hurt the stock markets and lending, but it didn’t materially hit the real economy. In contrast, the lockdown has had a major impact on the real economy, affecting hospitality, retail, tourism, travel and leisure businesses the most.

Has the viability of your acquisition of Zenith Energy been affected by the economic uncertainty?

Not at all. Zenith is an off-grid energy producer for clients based in remote areas, such as mining townships. It is an essential service and, like our other three investments in the Secure Assets Fund, the company hasn’t missed a beat throughout the covid crisis. State governments in Australia have been very supportive of mining companies and their service providers, helping them continue to operate during the lockdown.

The Zenith deal is a good illustration of what we’re trying to do with our new infrastructure fund, which is to invest in infra businesses in Australia and New Zealand that demonstrate strong underlying contracted cashflows with identified operating upside, that will deliver, whatever the economic cycle. It is similar to a business we acquired in Fund IV called Energy Developments, which also provides remote energy solutions. That was ultimately a very successful deal for us, generating a 2.6x multiple and a 20 percent IRR.

At what stage is the Zenith deal now?

We are waiting for the regulator to review the scheme of arrangement documentation, which we expect to be completed by mid-August. We are investing alongside Zenith’s founder and existing management team and a consortium comprised of Sydney-based Infrastructure Capital Group and Canada’s OPTrust.

When the deal completes, SAF will be about 50 percent allocated into four deals with an additional A$300 million of co-investment under its belt. From that strategy’s perspective, it’s an interesting time. The ripple effect of the pandemic will throw up opportunities, including further co-investment potential.

Does your pipeline look different in light of covid-19?

For both our core buyout strategy and our infra vehicle, it looks pretty much the same. During the lockdown, a number of businesses – many of them listed – sought to solve their liquidity issues by raising additional equity. To date, we have not participated in any of those deals for a variety of reasons, including quality of business and vendor value expectations. However, public-to-private opportunities are one of our focus areas, and we see a number of opportunities in this space. Zenith is one.

Corporate carve outs are a second area we look at. Driven by the economic challenges facing the US and Europe, over the medium term we expect to see more of those come to market as international businesses dispose of assets in non-core geographies to recapitalise their balance sheets. We saw the same dynamic following the financial crisis and took good advantage of it, completing five deals in about two years.

We have a lot of experience in this area. Over the course of more than 20 years of investment, about half our deals have been carve outs, which we’ve been able to support with capital, management talent and strategic focus. Those post-GFC investments eventually generated internal rates of return in the range of 20-87 percent. It was an extremely good investment window for us, and our expectation is that, post-covid, we are going to see a similar velocity of deal opportunity.

And third, I think there will be an uptick in the sale of private equity businesses to other GPs. Historically, secondary transactions have constituted a relatively small component of the market here. However, pre-covid, there were probably half a dozen private equity portfolio companies for sale, and most were being marketed strongly to other private equity firms. That could well increase for two reasons: one, portfolios are maturing across the industry as a whole; and two, managers of funds nearing the end of their fund life may decide not to support companies that need additional equity or input. That will create opportunities.

Will your sector focus shift due to the pandemic?

I don’t think so. Historically we don’t look at businesses with a large cyclical exposure, like mining, construction or retail. If anything, covid has increased our conviction that these aren’t attractive areas for us. We will continue to focus on non-discretionary sectors like industrial and manufacturing, business services, education, healthcare and consumer durables, such as food and beverages.

Overall, how has your existing portfolio performed?

It is proving robust in the face of significant economic headwinds. We buy businesses in a strong market position where we see the opportunity to drive very significant performance improvement and transform earnings. Our portfolio covers a relatively broad spectrum of the domestic economy. However, we have limited exposure to consumer-discretionary segments. There are no travel or tourism businesses, or companies involved in services such as gyms or laser clinics. These have been popular deals for private equity in our geographies but have been negatively impacted by covid and will probably struggle for some time.

That said, in our current fund, Fund V, the six unrealised investments have not been totally immune. Our business LifeHealthcare distributes medical devices, including implants mostly for spinal and orthopaedic uses. In Australia, those surgeries are categorised as elective and were postponed during the lockdown as private hospitals were put on standby to provide additional intensive care capacity should it have been required. The need for extra beds didn’t materialise and those restrictions have now been lifted. That business went from 100 percent revenue, pre-covid, to circa 30 percent during the lockdown, and was back to 70-80 percent as of early June.

Our business iNova Pharmaceutical, which manufactures over-the-counter products that include upper respiratory medications, has traded above expectations. Although those products are not specifically covid-related, they have seen soaring demand. However, that has returned to normal fairly quickly.

What interventions have you had to make at the company level?

Our portfolio companies have been dealing with the issues in a decisive way, such as enrolling employees in JobKeeper, and addressing any liquidity issues. As a firm, we’ve never lost a dollar of debt from any of the lending banks in Australia, and that provides a huge amount of goodwill. We’ve been able to reset covenants where we’ve needed to.

We are in the fortunate position of having a 29-strong investment team heavily weighted towards managing directors and directors with a significant amount of experience and bandwidth. We’ve all lived through various cycles and challenging economic circumstances before.

And we’ve received great support from our LPs, which are a diverse group by geography and type. Given the strength of our portfolio, we are down the list of issues they are grappling with at the moment. Although they are of course interested in what’s happening here, how the portfolio is performing, and how the team is responding.

Will the switch to remote working we have all had to make have a lasting impact on how you function at an operational level?

This is something we’ve been talking about, but it’s early days. Across industries, people have found remote working, including board meetings and due diligence discussions, both efficient and effective. In future, I expect there will be a shift toward more video conferencing and less face-to-face interaction. Travel in normal times is very time-consuming, even within Australia. In future, we might travel less.