Australia Expert Commentary: Gilbert and Tobin

The 2015 financial year was a strong one for the Australian private equity market on the investment and fundraising front, although exits slowed down from their hot streak in 2013 and 2014.

Uncertainties, however, remain over the impact of new rules governing overseas investors at a time when foreign investment is soaring.

Investment activity was up 54 percent year-on-year at A$3.3 billion ($2.4 billion; €2.1 billion) in the year ended 30 June 2015, according to the Australian Private Equity and Venture Capital Association. The average equity cheque written by funds in Australia rose to A$36 million per investment, from A$26 million in FY2014.

Fundraising activity also showed notable growth, with nine funds successfully recording interim or final closes in FY2015. Much of the money was raised by larger funds with strong track records and reputations, most notably Pacific Equity Partners raising $2 billion and Crescent Capital Partners raising $675 million for their respective fifth funds. Mercury Capital and Next Capital both secured in the region of $300 million and Allegro $250 million.

At the lower end, growth/expansion funds accounted for approximately $160 million which is a significant increase from FY2014 in a space where fundraising has been difficult in recent years. The combined amount of capital raised for turnaround and mezzanine funds was also the largest for a decade.

One notable trend was the rise in the proportion of foreign investors, especially those from Asia. Foreign investors accounted for 70 percent of the capital raised, with new commitments from Asian investors increasing by 261 percent from the previous year and accounting for 30 percent of all new PE commitments.

North American LPs also increased their relative share from 16 percent in FY14 to 23 percent of funds raised in FY15.

The big question is just how this will be affected by Australia's new foreign investment rules (see below).

Low exit levels  

Including VC sponsors, the total number of companies exited by sponsors fell to 51, compared with 70 in FY2014 and 68 in FY2013.

In FY2015, PE trade sale exits fell to their lowest levels since FY2009, with only 20 portfolio companies sold to trade buyers through the year. These deals had an aggregate deal value of only A$897 million, but there were some strong exits towards the end of calendar 2015.

For example, the emerging theme of Chinese interest in Australian medical/health assets was underlined in December 2015 by Archer Capital's sale of health services provider Healthe Care to Luye Medical Group for A$938 million.

Private equity IPOs included Adairs, Pepper Group, Baby Bunting Group and the Link Group. The Link Group IPO, the biggest in 2015, was backed by Private Equity Partners and co-owners ICG and Macquarie.

The solid return demonstrated that equity capital markets remain an available avenue for an exit, although we didn't see the record numbers posted in the previous year.

One area of capital markets that saw a lot of activity was in funds exiting their residual stakes in former investee companies that had listed in prior years. Following the release of their stakes from escrow, Pacific Equity Partners sold down their shareholdings in both Spotless and Veda, and Crescent Capital Partners exited Cover-More. There were also large trades by UBS and CVC (in Mantra) and TPG and the Carlyle Group in Healthscope.

Strategic stakes  

An interesting trend emerged in 2015 where private equity funds either made a pre-bid or took strategic stakes in listed companies without immediately making a takeover offer. Funds in Australia have generally been reluctant to make an unconditional investment into a listed company unless they are certain that they will gain eventual control. In October 2015, Crescent Capital Partners acquired an outright stake of around 19 percent in listed engineering services business Cardno. It wasn't until later that Crescent made a successful proportional takeover offer for the company. Even that subsequent proportional bid was a transaction structure designed to maintain the listing of the target entity as opposed to the more usual take-private approach.

October 2015 also saw KKR take a 10 percent stake in listed miner OZ Minerals. KKR never did make a formal takeover proposal, ultimately exiting this stake for a profit in March 2016.

These transactions were especially interesting in the context of Pacific Equity Partners' divestment of its interest in ASX-listed company EDL by way of a scheme of arrangement under which DUET acquired all the shares in EDL (including Pacific Equity Partners' shareholding of approximately 70 percent) for A$1.4 billion. This deal was a hugely successful exit for Pacific Equity Partners, despite it never having actually taken EDL private after acquisition.

Innovative consortiums

The last year has also seen some innovative consortiums form to bid for large Australian assets.

In March 2016, Brookfield Infrastructure (with its consortium partners GIC Private Limited, British Columbia Investment Management Corporation and the Qatar Investment Authority) and Qube Holdings Limited announced a binding agreement to acquire Asciano Limited for around $9 billion, in would be one of the largest deals in the last five years. Brookfield and Qube had initially led their own individual consortiums in a series of competing bids for Asciano.

In February 2016, a consortium formed between a group of Western Australian farmers (AGC), ASX100 listed agribusiness GrainCorp and fund manager HRL Morrison & Co announced a proposal to corporatise Australia's largest co-operative in what would be the largest transaction in Australian agriculture for some time if implemented.

Foreign investment changes  

Significant changes to Australia's foreign investment regime came into force on 1 December 2015.

Under the changes, approval from the Foreign Investment Review Board (FIRB) is required for foreign investors that acquire at least 20 percent of any Australian business that has total assets valued at least A$252 million, up from 15 percent previously.

There is a higher threshold of A$1.094 billion for acquisitions (outside sensitive industries) by US, NZ, South Korean, Japanese, Chilean and Chinese non-governmental investors. But these higher thresholds are often unavailable to PE funds from these jurisdictions if there is an “interposed” entity operating outside these jurisdictions.

Other changes include:

– new (and substantial) fees on all foreign investment applications;

– $25,000 for business and corporation acquisitions including agribusiness acquisitions (less than $1 billion); and

– $100,000 for business and corporation acquisitions including agribusiness acquisitions ($1 billion or more);

– new penalties aimed at ensuring compliance with foreign investment rules (including criminal offences); and

– a new definition of “agribusiness” and a $55 million threshold for investments in agribusinesses.

On 22 February 2016, the Australian Treasury announced that FIRB approvals would be subject to additional conditions aimed at tax compliance. The new conditions include undertakings to comply with tax laws, provide full disclosure about tax planning, pay tax debts, and for high risk transactions, requires compulsory tax clearances from the tax authority.

There were also changes to what constitutes a “foreign government investor” which could have unfortunate consequences for Australian GPs. An entity that is deemed to be a foreign government investor must notify FIRB before it acquires any direct interest (a term that has a broad meaning) in an Australian entity or business.

This is a real problem for Australian fund managers who can easily fall into this classification because of an (entirely passive) LP investment from state pension funds that come under the government investor definition. By way of example, if two US pension funds comprise more than 20% of the funds invested in an Australian fund then the fund is treated for all purposes as a foreign government investor, regardless of it having an Australian based investment committee and executive team. This has the absurd consequence that even an acquisition of a bolt-on business for $1 would require approval from the FIRB and the payment of a $25,000 fee.

This is manifestly not related to the legislative intent of the foreign government investor regime which was designed to scrutinise strategic foreign government investments in Australia. It is also a barrier to successful local PE investment in Australia, not to mention exits by Australian business owners. The changes are currently undergoing consultation. The government is considering potential solutions so it is hoped that this situation will be remedied soon.

This article is sponsored by Gilbert + Tobin. It appeared in PEI's Australia supplement published in June 2016.