Hard to please

On paper, the Australian private equity market has a lot going for it: a developed economy that has weathered the financial crisis relatively well, some big companies, a strong domestic investor base, and easy access to the fast-growing markets of Asia. But times are tough for the country’s private equity managers – particularly those on the fundraising trail. Dubious tax changes, a difficult exit environment and the strength of the Australian dollar have spooked investors, forcing GPs to work ever harder for their money. Some are unlikely to live to tell the tale.

FRUSTRATED FUNDRAISERS

Fundraising was the hot topic at this year’s Australian Private Equity & Venture Capital Association conference on the Gold Coast in September, where the tone was distinctly sombre. Michael Lukin, managing director of Macquarie Funds, suggested that only the top quartile of funds will raise the capital they need, as once trusting investors react to the negative returns they’ve experienced in recent years. “It will be binary,” said Lukin. “People who have come through the cycle well will have successful fund raises. Others will just not get funded at all.”

Even the best-known local managers are finding it difficult. Stuart Wardman-Browne, director of CHAMP Ventures, said his company has had to cut fees and (for the first time) tap offshore investors for its seventh fund, which has so far raised $275 million of its targeted $450 million. “We thought it would be easier,”  Wardman-Browne admitted. “We have had to concede on fees.”

Scott Voss, managing director of Harbourvest Partners, believes that lower fees are here to stay, at least until equity markets and asset prices stage a sustained recovery. “The market would have to have a pretty significant run,”  Voss says. “It’s much easier to lower fees than to raise them.” Other terms are changing, too, he says; for instance, some limited partners in funds are insisting on being able to withdraw money faster. “That is having a material impact on (internal rates of return),” he warned.  

Due diligence has also become much more detailed, according to Wardman-Browne; investors are delving deeper to ensure the numbers behind business cases stack up, keen to establish how private equity ventures will add value. “We have ended up talking through each individual company in significant detail with each potential investor,” he said. “People have really wanted to understand those issues. They wanted to know if we had learned from mistakes.”

“(The market) is not great, from a non-Aussie perspective,” admits Joncarlo Mark, founder of private equity advisory firm Upwelling Capital Group. Mark, who was formerly senior portfolio manager of the alternative investment management program at the California Public Employees’ Retirement System, was making his first trip to Australia to scout out possibilities for tapping the country’s growing pools of capital – and he believes the outlook is tough, particularly for local managers.

“The local institutions are saying: ‘we need to diversify out of Australia-only private equity funds,’” he told Private Equity International. “There will be a little bit of transition period that will occur and there will be a reluctance to fund every single fund in this market.”

Stewart Kohl, co-chief executive officer of Riverside, strikes a similar chord. “The capital markets are doing a shakeout right now,” Kohl told PEI at the conference. “The marginal private equity funds aren’t getting funded anymore. That’s the way Darwin predicted it. If you can’t get your next round of funding, it doesn’t matter how big you used to be.”

GREAT BARRIERS TO GROWTH

One thing that certainly hasn’t helped was a decision by the Australian Tax Office last December to start taxing gains from private equity asset sales as income, not as capital gains. The decision stemmed from a $628 million tax bill levied on TPG in November 2009 on the $1.4 billion profit it made from selling Myer department store.

The move was slammed by AVCAL chairman Andrew Rothery, who argues that it will just spook overseas investors. “It’s incredibly frustrating,” Rothery said at the conference, where he was talking about how private equity can turn around failing companies and add value. “We need to be seen as the good guys. It’s stupid for a country that has always been a net importer of capital. It’s crazy to spook overseas capital.”

Not everyone is convinced that the ATO’s move will have a material effect on investment decisions. “The tax decision is a bit of sideshow,” says Michael Tierney, a managing director and head of Asia-Pacific leveraged finance at Credit Suisse. Economic fundamentals and individual business cases are far more likely to drive decisions about whether to invest in a private equity fund, he believes. And he cited the example of Bain Capital’s estimated $A1.3 billion acquisition of MYOB, Australia’s largest independent software vendor, in September, as an illustration that the buyout model still works. “Good funds will have no trouble raising capital and executing deals,” he insists.

However, it’s certainly true that managers are battling with volatile public markets. Although Australia’s economy has fared relatively well in recent years, its equity market has struggled along with all other global bourses. After topping the 5,000-point mark in April, the Sydney All Ordinaries Index had lost about 20% of its value by the end of September, falling below 4,000 points. This has made it harder for firms to realise investments via an initial public offering.

With no sign of this volatility subsiding, managers in the region are more likely to seek trade sales, sell businesses to each other, or even to hold onto assets. Secondary buyouts have tended to account for about 60% of total dealflow in the past – but that proportion will increase this year, says Joshua McKean, a partner at Australian GP Ironbridge. “We will struggle to see much of an IPO market this year,” McKean reckons.

BUCKING THE TREND

So is there any cause for optimism? One snippet of good news to emerge from the AVCAL conference was that private equity funds are having better luck than expected refinancing all the debt that helped fuel their pre-2008 buying spree – like the package behind Unitas and Canada-based Teachers Private Capital’s NZ$2.2 billion acquisition of New Zealand’s Yellow Pages, which was equivalent to 13 times the business’s EBITDA (earnings before interest, tax, depreciation and amortization).

Credit Suisse’s Tierney said some $24 billion of debt needs to be refinanced over the next five years – much less than the $100 billion feared in 2009. And while much of that debt will mature by about 2013, firms are managing to roll over loans in order to buy time to find new owners for their portfolio companies. Last year, Tierney said US banks sold a record US$312 billion of high yielding debt to refinance private equity acquisitions.

“We’re now in a more stable environment,” Tierney said. “That debt wall was sort of like a jumbo jet coming down the runway toward you. Now it looks more like a Cessna.” (Although as Brookvine chief executive Steve Hall, who was sitting on the same conference panel, pointed out: “It’s still got a propeller”).

Equally, some firms will survive the shakeout – and be in a better position for it. The question is: which ones?
Riverside’s Kohl told PEI that it will be those that can not only access capital, but also specialised talent who can add skills to management. US-based Riverside, which has about US$3 billion in assets under management, recently took a majority stake in Retail Zoo, owner of fresh fruit drink business Boost Juice. The chain is a common sight in shopping malls throughout Australia but needed more scale, Kohl. Riverside now plans to add more brands to the stable, including a Mexican food business – followed, possibly, by expansion overseas and a potential float in a few years’ time.

Riverside, for one, has not been put off investing in Australia. “The quality of companies in a relatively well-performing economy makes Australia one of the most exciting places to do business.” The firm rarely exits its investments via the public markets: just one of the 64 companies it has sold in the last 23 years was a full IPO. But Kohl points out that slumping equity markets are not necessarily bad news for private equity: “When a market is going up it always helps when you go to sell, but it hurts when you want to buy.”

All private equity firms can do is focus on the fundamentals, he suggests. “If we do our work well and make the company bigger and better over five years, whether the stock market went up the in last 45 minutes or down, we will find a buyer that covets that company,” says Kohl. “Our destiny is in our own hands.” Managers who heed this advice will find fundraising a lot easier next time around.