Where they've only known good times

Australia may be a modestly sized private equity market, but it's also one that limited partners have often expressed great enthusiasm for – citing its average level of outperformance compared with other developed markets. This track record surely cannot be entirely detached from the fact that the country's economy has remained buoyant for an impressive length of time. Reference is often made to Japan's “lost decade” of economic stagnation – at more or less the opposite end of the spectrum in Asia-Pacific is the 16 consecutive years of economic growth delivered by Australia up to and including 2008. But, with this record now under threat from the global slowdown, the country's private equity firms find themselves facing a whole new operating environment.

Because of the benign context within which they have invested and managed their portfolios for the best part of two decades, the challenge for private equity firms in Australia is arguably starker than elsewhere in the region where various types of economic, political and currency-related crises have been commonplace over the years. To refer back to Japan: distressed turnaround investing is effectively the normal modus operandi. For many Australian private equity firms, it's a whole new ball game.

As the Australian economy deteriorates (as surely it will – only the speed and duration is up for debate), limited partners will be speculating on how their capital will be effectively managed through a downturn by professionals who have only ever known an upturn.

It wasn't meant to be like this. One by-product of a long run of economic success is a hardening belief that the good times will last forever. The optimism at last year's Australian Venture Capital Association gathering on the Gold Coast was striking. It wasn't strident, noholds-barred optimism, admittedly, but the tone appeared notably more upbeat than it seemed to be in Europe at the same time.

Underpinning delegates' confidence in the Australian market's resilience was the belief that demand for commodities in Asia might drop off a little but would remain essentially strong. A professional at an Asia-focused fund of funds manager recently commented to PEI: “There was shock at the speed with which China, in particular, adjusted. There was an assumption among exporters that the good times would continue and that's been shattered.”

There are other reasons why Australian GPs might be feeling a little dazed, aside from the sudden deterioration in Australia's trading prospects with the outside world. Of more immediate relevance to them may be the lack of leverage that has more or less brought an end to the larger deal market – a part of the market that took off during the twoyear bubble.

In addition, concerns are being expressed about over-leverage within portfolios. Plus, the retail and mining sectors seemed to act as magnets to private equity firms in Australia in recent years and these sectors are, let's say, not without their problems. Some portfolio firms are already sending out distress signals. It was to be hoped that the recent collapse of Australian Discount Retail, backed by private equity firms CHAMP and Catalyst Investment Managers, was not a sign of things to come.

In addition, there are difficulties for those already on the fundraising trail or planning to hit it sometime soon. The Australian fundraising market has traditionally been dominated by the large domestic Superannuation funds. Now, these funds are facing some pretty severe liquidity issues. As with institutional investors elsewhere in the world, these issues are being partially eased by secondary sales and also by the benign effect of write-downs on the denominator. Nonetheless, there is still a net effect of less capital for new commitments. And that's even before you take into account the stated ambition of the Super funds to diversify their private equity portfolios internationally – leaving less capital for local funds to scrap over.

Now for the post-script: that famous Aussie optimism is not without foundation, even today. A recent forecast from the country's Reserve Bank suggests that – although the economy may suffer its worst year since the Second World War – it is still set to “perform better than its international counterparts in the difficult period that lies ahead”. And who's to say that private equity practitioners in the country won't also demonstrate that they can outperform in bad times as well as good? Here comes the acid test.