Tim Sims is softly-spoken, answers questions with relevant (but sometimes boring) data and doesn’t like having his photograph taken. A former consultant at Bain & Co, this low-key personal manner is reflected in an almost scientific approach to private equity – which emphasises research, detail and the practical implementation of strategy.
Nonetheless, as co-founder and managing director of Sydney-based buyout firm Pacific Equity Partners, he has done some big and dramatic things.
That includes raising the largest ever Australian buyout fund, an A$4 billion (€3.2 billion; $4.2 billion) vehicle that closed in early 2008. Even though the fundraising climate was buoyant back then, some sources have questioned whether it was simply too much money for a country with a population of 22 million.
Was Fund IV too big, in hindsight? “Categorically not,” he insists. “The majority of deals in Fund IV have been in the same size range as Fund III. There is a commonly held view that smaller deals make more money or have higher proportional returns than bigger deals. There’s nothing intrinsic about a smaller business that makes it easier to get it to perform at higher levels than a bigger business. According to data from our own investments, large deals have delivered 2.5x the money, middle-tier deals 2.3x and smaller deals 2.4x. There is no clear correlation in our experience between [deal size and performance].”
In 2013, PEP hopes to raise another A$3 billion of capital: an A$2 billion core fund with an additional A$1 billion co-investment vehicle that is structured on a discretionary basis.
Sims says that the core fund, which will be a traditional 2-and-20 structure, will not go far beyond this target number. “This is not targeting $2 billion and ending up much larger.”
The co-investment facility will be aimed at certain large LPs who “demonstrate co-investor capacity”, according to Sims. For every dollar an LP invests over a certain (as yet undetermined) amount in the core fund, they get a 50 cent co-investment opportunity. “We see a large number of institutional investors interested in actively making direct discretional co-investments,” he says.
Some LP sources told Private Equity International that the co-investment sidecar will likely appeal to large investors such as US or Canadian pension funds or sovereign wealth funds. Indeed, PEP held a meeting for investors in December, which had “a big turnout with a lot of large LPs”, according to a source who attended.
Appealing to these investors makes sense for PEP, which historically has only had a small percentage of Australian LPs. Sims says Fund I was 10 percent local, 90 percent foreign, and the proportions haven’t shifted much in the 15 years since. Foreign LPs to back PEP have included Harvard Management Company, Stanford Management Company and Yale University, according to PEI’s data division.
Before Fund IV, the record for Australia’s largest fund was held by PEP’s Fund III, which closed on A$1.25 billion in 2006.
That doesn’t seem particularly big today; in fact, country manager Archer Capital closed an A$1.25 billion fund in December 2011, just four months after launch.
But Australian private equity has come a long way in the last decade – and PEP has been instrumental in driving this evolution.
Sims recalls that in 1998, when PEP was founded by former Bain & Company management consultants (Sims is the former chairman and managing director of Bain’s Australasian and African operations), the institutional wisdom was that private equity funds would not exceed $100 million in size and that no management fees would be above 1 percent.
But PEP, which soon became the country’s largest private equity player, brought a grander vision to the domestic private equity market, one domestic source suggests. “They pioneered a range of innovative transactions, particularly in larger size buyout transactions in Australia. PEP has enabled investors to participate in a range of industries and a set of transactions [that] just were unavailable to them before.”
Investors strongly supported PEP: since 1998, each of its new funds has been roughly three times larger than its predecessor.
But it’s a different world today – and although PEP is trying to raise a smaller fund this time around, some industry sources are questioning whether the target is still too big, given the changing competitive dynamics in Australia.
The region’s fundraising climate has certainly cooled. Fundraising totals for Asia were down 30 percent in 2012 to $31 billion, according to PEI’s data division – while Australia fundraising was down almost by half, with only $1.1 billion raised for the country.
Deal value has also dropped. Although Australia is one of the region’s key buyout markets, the country’s total private equity deal value fell about 20 percent to $7.2 billion in 2012, down from $9.1 billion in 2011, according to Mergermarket data.
At the same time, global giants with deep pockets are zeroing in on Australian opportunities.
In December, Kohlberg Kravis Roberts closed a $6 billion Asia fund – the largest ever raised for the region. TPG is also raising a $4 billion vehicle for Asia, while Bain Capital closed a $2.5 billion Asia fund in 2012. Likewise, pan-regional firm Affinity Equity Partners, whose previous Australian deals include the A$900 million buyout of Primo Smallgoods in 2011, is raising a $3.5 billion pan-Asia fund. All of these firms will presumably hope to deploy some of this fresh capital in Australia.
It all means more competition for PEP – against a background of apparently diminishing dealflow.
IN THE SWEET SPOT
But Sims remains undaunted. In fact, as one might expect from a former consultant, he has numbers at his fingertips to counter most of these arguments.
The new fund and co-investment sidecar will target PEP’s traditional investments – businesses with enterprise value in the $250 million to $1 billion range, he says – ideally putting PEP in the sweet spot between local players such as Archer Capital and CHAMP Private Equity, and the global buyout firms.
In this particular segment, he believes the domestic deal market is very healthy indeed. In 2012, PEP reviewed almost 100 deals, bid on 25 and went all the way on five, Sims says. Two of these businesses ended up not being sold; the other three were acquired by PEP for a total equity outlay of more than A$1 billion.
One of those was a A$720 million take-private of cleaning services giant Spotless Group, which PEP sealed in August. Spotless had rejected PEP’s previous offers, as well as past offers from the Blackstone Group and CVC Asia Pacific. So PEP lobbied the major shareholders, who eventually accepted a cash-out at a modest premium, Sims says.
There are various types of deals available in Australia, Sims suggests. One comprises entrepreneurs who had hoped public markets would rebound and give them attractive IPO opportunities. “They haven’t seen that and are older and wiser, often with succession challenges. Quite a few of those have come to market [in 2012]. “
Corporate carve-outs represent another possible opportunity – both divisions that have been written down and are available at a discount, or subsidiaries that are performing strongly in local currency because of the strength of the Australian dollar, which might prompt their owners to sell. “The future remains uncertain and they have cash needs at home.” And then of course there are take-privates.
Foreign competition is another topic he is happy to talk about. Although some global firms have done successful transactions in Australia, the country has not been the easiest market for non-local firms. This was highlighted last year when CVC suffered one of the largest losses in private equity history, writing off an A$1.9 billion investment in struggling Australian media company Nine Entertainment.
According to Sims, A$8 billion has been invested in Australia by overseas players since 2006. His data suggests that A$5 billion of this is now gone or carried at less than 1x valuation; A$1.5 billion is carried at 1x valuation; and A$1.5 billion is valued above 1x.
“Perhaps half of the $1.5 billion above valuation has been realised. The economic record of firms from outside coming into Australia is disappointing in terms of returns.”
These results are not necessarily a reflection of the firms themselves, Sims says, but of other constraints unique to Australia.
For example, some foreign groups simply do not have the local presence, opting instead to do large deals from a distance (CVC is an exception, as it has had a local office for more than a decade). Many have been reluctant to open an office with permanent staff in Australia because they would then be subject to a more stringent tax regime – which is why some choose to invest from Hong Kong. “With such large funds, there is a practical limit to the scale of deals that can be served from a remote location,” Sims suggests.
A MIXED STORY
Aside from the size of the new fund or the potential competition, the main deciding factor for most potential investors in PEP’s new fund will be performance. In Australia, as in other markets in Asia, brand is no longer enough to raise capital.
“LPs want to know the most recent track record and [whether], through tough economic times, the GP has been able to deliver for investors,” Jeremy Samuel, managing director of Anacacia Capital, told PEI recently.
In this regard, PEP has certainly got a mixed story to tell. In 2011, the firm released A$3 billion in enterprise value across five exits (although these deals were from Funds II and III). Among them, Tegel Foods returned nearly 4x (see box, below) – but Independent Liquor made just 1.1x and vacuum cleaner retailer Godfrey’s was sold for less than 1x.
Fund IV is about two-thirds invested, across eight portfolio companies. Five of the eight investments were made in 2010 or later – and as of January 2013, there have been no realisations.
The destiny of the fund has been shaped by the global financial crisis. Indeed, Sims splits investments in the vehicle into two categories: pre and post GFC.
Most of the post-crisis deals (2010 or later) are too immature to be realised. But four positions are coming to the point of exit consideration, Sims says. He expects PEP to realise nearly A$2 billion in the next 18 months and has high hopes for strong returns from cinema exhibition and advertising firm Hoyts Group, share registry Link Market Services, snack food maker Griffin’s Foods and smoke detection and video security firm Extralis.
“These businesses are both growing and generating cash with the result that continuing to hold them yields attractive investment returns at low risk.”
EBITDA in Fund IV grew 25 percent in its first year (2008), he says. But in the next two years, profits went sideways and down, driven by the investments that went sour. One was PEP’s investment in REDGroup Retail, owner of Australian bookstores including Borders Australia, which was acquired in August 2008.
Borders went into bankruptcy in 2011. Sims cites factors related to the financial crisis such as a pull-back in consumer spending and the introduction of Australian industry regulations that created a cost disadvantage (bookstores were prohibited from sourcing books offshore, where they are 37 percent cheaper than in Australia). In addition, e-books were a fast-growing and profitable part of the business – until the exchange rate shifted and e-books in US dollars became radically cheaper for Aussie customers, who started buying them in overseas markets.
“The business went from best of breed in performance to zero cash and profits in four months,” Sims explains.
American Stock Transfer & Trust Company (AST), a share registry firm that was acquired for A$450 million in May 2008 to complement the existing PEP portfolio company Link Market Service, also provided a major challenge after the financial crisis. It was massively impacted by the sustained low interest rates in the US – again, something PEP did not anticipate – and also had to be written down on PEP’s books because of a lower US dollar exchange rate.
Sims describes AST as a solid business hurt by record low interest rates in the US for an unprecedented period and “a new exchange rate norm”.
But it is now on the mend, Sims says. “PEP is on plan to recover value [in AST] within the next couple of years even without an economic recovery in the US. A US recovery would make the business return multiple very attractive very quickly.”
He concludes that REDgroup and AST’s failure to meet expectations was due to significant external factors, i.e. “changes in the environment so dramatic that they overwhelmed the potential of the business … Each of our challenged investments have that common aspect. Our loss ratio has been 7 percent, mostly in retail, through the crisis. Outside the crisis adjustment, the norm for our loss ratio in 15 years has been closer to 1 percent.”
Nonetheless, he admits that PEP has learned a few things from the deals that fizzled. “We probably won’t make major cross-exchange rate plays and [we] probably won’t do traditional retail in future funds. We are also more sensitive to radical external changes. We have made some adjustments to process, to speed up our reactions in those environments.”
The firm’s risk appetite remains unchanged, he insists. “The conclusion is not to change our investment model radically to deal with events that are so extreme. We shouldn’t pull back from positions that fall more than two standard deviations from the norm. We should be taking those risks.”
Sims’ sureness and the confidence of the PEP team has been noted by several LP sources. Some see it as a plus; others see it as believing too much in their own story.
“Investors have been impressed by PEP and in the early funds were well-rewarded by PEP. But there has been, for some time, an emerging concern about the question of overconfidence,” says Les Fallick, chairman of Principle Advisory Services in Sydney.
Sims dismisses this suggestion. The biggest player in a market often has to contend with that perception, he says, particularly if it has broken new ground in private equity – as PEP did in 1998 by introducing the leveraged buyout.
“Some elements of the Australian institutional funding market were unhappy with our business model when we arrived. It was unfortunate, but inevitably that left a sense among some that PEP was a little arrogant and dismissive of the existing framework. In reality, our culture is deeply ingrained with a service-oriented approach, based on 20 years of experience working intimately with clients where there is little room for anything other than attention to service and sensitive engagement.”
“Certainly, we have a confident culture, a clear sense of how we go about doing business. So you get that sense of a confident team on the move; perhaps like a sports team, going out to play.”
As the firm begins to raise Fund V, the industry will be watching how this game plays out with interest.
PEP BY NUMBERS
Capital raised since 2007
Rank on the PEI 300
New fund/co-investment sidecar targets
Fund IV investments
Fund IV exits
Box: Chicken pickings
PEP’s Tegel deal is a good example of how the firm uses both consultants and its own resources to drive operational change
Pacific Equity Partners emerged from a consulting foundation – three of the four founders are former Bain & Co executives – and it places a strong emphasis on transforming portfolio companies. “We have people in the company oriented toward practical outcomes and they tend to be on the entrepreneurial side of the spectrum,” says Tim Sims, managing director.
Oddly, however, it has no in-house operational unit – because according to Sims, that might “obfuscate hard decisions around the quality of CEOs”.
“We experimented with that model early on, but given the accountability model we want to run, it wasn’t helpful. If the operations people working for the CEO are also members of the organisation who own the company, then that creates a strange environment for the CEO to live in.”
Instead, PEP brings in specialists working in particular areas of business change, including consultants from Boston Consulting Group, Bain & Co and others.
An example is the firm’s 2006 buyout of poultry processor Tegel Foods.
At the time of acquisition, the business was faltering, with profits down almost two-thirds in the previous two years. A business transformation plan was developed, which included refocusing the business strategy, re-building and investing in Tegel’s product line and operations, developing platforms for further growth, and improving relationships with key customers.
The firm hired a new CEO and recruited a new management team capable of executing on the plan for a management buy-in, then worked closely with management to support the business transformation. Five PEP executives worked closely with the business during the holding period for a combined average of 20 days per month.
It clearly worked: when the business was sold to Affinity Equity Partners in 2011, the exit yielded an internal rate of return of 100 percent or 3.9x its original investment, according to the firm.