Australia: Feeling the squeeze

There are signs of a faint pulse in the Australian private equity market: figures from the Australian Private Equity and Venture Capital Association Limited (AVCAL) indicate that private equity deals accounted for seven per cent of total M&A and private placement deal values in the 2012 financial year, slightly up on the five-year average of six per cent.

But the sector is still facing some serious challenges, notably a substantial reduction in the availability of leveraged finance. Research by PwC suggests that the number of leveraged lenders has shrunk by around 25 per cent since the 2007/2008 financial crisis.

“The market for senior leveraged loans is restricted to the four major banks plus Sumitomo Mitsui and Mizuho Financial Group, Crédit Agricole and HSBC, plus Macquarie Bank and Investec,” says PwC partner Charles Humphrey. “There are also some opportunities in the US high-yield debt market, although the strong Australian dollar is making swaps more expensive.”

Justin Reizes, head of Kohlberg Kravis Roberts Australia, agrees debt funding is not as easy to access as in other markets. “Australia lacks a liquid subordinated debt market,” he says. “International banks left the market after the financial crisis and for two years it was hard to do deals. Other markets recovered quicker.”

One significant blow to the Australian was the withdrawal of a number of French banks at the end of 2011, including Société Générale and BNP. “They were big lenders to the leveraged finance sector, especially on large deals,” says Reizes. “If you only need two or three banks you can do a deal with the domestic banks. It’s really the large deals where it is harder now than previously.”

Mezzanine finance is also very expensive in Australia. “It’s not a liquid market and it’s very spotty in terms of openness,” he adds. “The lack of a subordinated market is an issue because you can’t get the right level of leverage. Plus interest rates are higher because base rates are higher.” Australia’s cash rate is currently 3.25 per cent.

There is some good news though, says Humphrey. “Money is available for the right opportunity. It’s possible to achieve funding for deals with a leverage multiple of about four times EBITDA, with buyout multiples of eight times EBITDA, resulting in 50 to 60 per cent gearing. So deals with an enterprise value of up to A$1.5 billion are achievable.”

Humphrey says financiers have the capacity to fund deals to the tune of A$500 million to A$600 million – a case in point being Pacific Equity Partners’ acquisition of listed contract cleaners Spotless Group in May this year, which had a total enterprise value of A$720 million. (Spotless chairman Peter Smedley memorably described the private equity due diligence process to reporters as “like having 400 of your in-laws in the living room with you when you’re trying to put the baby to bed.”)

But to get this level of leverage requires strong relationships with banks, and a solid investment portfolio.

 

SUPER-SIZED FUNDING GAP

The $A1.3 trillion Australian superannuation fund sector has long been a big investor in private equity (funds and direct assets). But the dynamics in the sector are changing thanks to new regulations called MySuper, which give Australians more control over how they want their pension invested.

According to Humphreys, there is ongoing speculation within the market that super funds might start pulling back from private equity, based on concerns about their weighting to riskier asset classes. In particular, they’re worried about the higher fees associated with the asset class, since many super funds are measured and ranked by fees. Others are starting to evaluate whether to build their own direct investment capability, he says. Ultimately, this could all reduce allocations to domestic funds.

“Private equity in Australia is still maturing as an industry – it’s only been around since the mid to late 1990s,” says Quentin Jones, who’s a partner with Equity Partners, a firm that specialises in buying smaller businesses valued between A$20 million and A$80 million. “Back then you had a few thought leaders that would advise super funds, which invest five to seven per cent of funds in alternative assets, including private equity funds. But now super funds feel they should be investing globally in private equity assets, so commitments are being channelled offshore.”

What this means for a business like Equity Partners is that overseas funds with Australian super fund clients will invest in their funds – so they now have to build relationships with Asian fund-of-fund businesses interested in gaining exposure to Australia.

Macquarie Investment Management’s head of private markets Michael Lukin has also witnessed this changing dynamic first-hand. His firm is one of the largest investors in the Australian private equity market, managing more than A$7 billion on behalf of Australian super funds.

“Over the last five to ten years, we’ve seen increasing globalisation and control by super funds of their private equity portfolio. So instead of investing in fund of funds, they have appointed advisers that select funds globally,” says Lukin.

Macquarie first invested offshore eight years ago; now, he says, he has twice as many investment staff located offshore. “Lots of super funds were 100 per cent invested in Australian assets but this has now dropped to 25 per cent or less. What this means is that Australian private equity managers are increasingly needing global capital to help support fund raisings.”

One other noticeable change has been a switch to fewer but more meaningful LP/GP relationships. “The number of investors has reduced, but those that are investing are more engaged than in the past,” says Lukin.

All told, the result has been that the core group of private equity managers has reduced to about 10 players. “Other firms are trying to raise capital on a deal by deal basis. There’s also a lack of emerging managers – and it’s hard to see how that will change,” he adds.

One firm that has recently enjoyed success on the fundraising trail is Anacacia Capital, which invests in small management buy-outs with revenues of A$20 million to A$100 million. Its second fund raised A$80 million in mid-2012 within weeks of releasing its fundraising documents, easily beating its A$50 million first close target; it now intends to raise somewhere between A$100 million and A$150 million before the end of this year.

The Anacacia Fund I was named in 2011 by Pensions and Investments as the top fund for investor returns globally from all private equity funds raised between 2006 and 2008 – the vintage that is now returning to raise successor funds. Jeremy Samuel, managing director of Anacacia, says: “Top firms can raise local support and cherry pick from international funds who want access to the very best general partners.”

Other firms that are understood to have raised money recently include CHAMP Ventures, which reportedly held a final close on A$475 million this year; Crescent Capital Partners, which is thought to have closed on A$490 million; and Archer Capital, which apparently raised A$1.5 billion for its main fund and A$300 million for its growth fund this year. But a number of other well-known Australian funds that have not achieved recent exits may struggle to raise capital, sources say.

 

THE PRICE ISN’T RIGHT

As for exits, completion rates have been woeful for 12 months, thanks largely to macroeconomic uncertainty.

Humphrey says there is still a mismatch in pricing expectations. “There is not an active IPO market to act as a reality pricing check for vendors, who are sometimes moving to exclusivity with bidders too soon. Vendors then have difficulty accepting the prices offered because they believe they are not fair market prices. In the absence of a competitive auction process or active IPO market, there is not sufficient evidence to force them to lower their price expectations,” he says.

According to Humphrey, bidders are having difficulty achieving funding support for deals with ‘hockey stick’ projections. When there’s a big difference between current earnings run-rates and potential earnings based on operational improvement (and other) initiatives, there is often not enough evidence of traction against these initiatives to bridge the earnings gap. But this may change once markets pick up and confidence improves, he suggests.

Limited partners are also pressuring general partners to monetise some investments, as hold rates in portfolios have climbed from three to five years, to upwards of five years in some cases. “Investors understand market conditions are not peaking – but their view of the market is that if conditions are going to remain uncertain or relatively flat for an extended timeframe, now could be an appropriate time to exit,” says Humphrey. “And new funds that are raising equity will need to provide a track record of exits.”

The good news is that GPs believe there is still plenty of opportunity on the deal side. Reizes points out the Australian market is characterised by a large number of natural oligopolies; for instance, there are just two major supermarket businesses, Coles and Woolworths. “From that perspective there is a stable market structure, which is an interesting place to operate for private equity because you don’t have the same competitive threats as you do in other markets and as a result there are a number of attractive businesses.”

Reizes says KKR is looking for deals across the board, but suggests it has a particular interest in healthcare, mining services and retail and consumer. Turnaround opportunities seem to be attracting the industry’s attention too, as evidenced by the reported private equity interest in businesses like Pacific Brands, a diversified consumer brand business and Billabong, a surfwear company.

The other attraction for private equity is the lack of world’s best practice businesses in Australia. “People are not always pushing the envelope in terms of performance improvement,” he says. “[That’s] an opportunity for private equity, because we can make these businesses better.” 

 

Box: CGT row avoided

The Australian Taxation Office (ATO) has clarified its position on the treatment of capital gains arising from the disposal of assets with Australian-sourced income held by private equity businesses not domiciled in Australia.

Before it published its determinations on this subject, there were fears private equity disposals by foreign entities would be subject to double taxation in Australia and in their home countries – thus serving as a disincentive for these firms to invest in the country.

However, after undertaking a public consultation process on the issue, the ATO has now indicated funds domiciled in countries with which Australia has a tax treaty, for instance the UK and US, won’t have Australian capital gains tax applied on disposal of assets with Australian sourced income, if the appropriate form of collective investment vehicle is used.

“The ATO is being more proactive and keeping abreast of transactions and encouraging discussions about disposals. There is a more open relationship between the private equity community and the ATO and many concerns have now been resolved,” says PwC’s Humphrey.

Sighs of relief all round.