Australia: Private equity industry fights the headwinds

The last 12 months have not been without challenges for the private equity industry in Australia. In January the Australian dollar plummeted against its US counterpart, causing issues both for corporates and for investors into offshore illiquids who suddenly found themselves overweight as the “denominator effect” came into force.

And after a politically turbulent year – the country saw its first double dissolution of parliament snice 1987 – Australians will be heading to the polls on 2 July for a general election.

Macroeconomic headwinds have been coupled with an increase in negative public sentiment toward private equity on the back of the collapse of electronics retailer Dick Smith in December.

Prior to Dick Smith's initial public offering in 2013 it was owned by Anchorage Capital Partners. Last November its shares fell almost 60 percent as the company revealed its stock was worth $60 million less than expected, with profits forecast to fall short of its $48 million target. Shares in the company ceased trading in early January.

The same month as Dick Smith hit the headlines, former Pacific Equity Partners-backed Spotless issued a shock profit warning, causing shares to plummet 40 percent.

“There's been some reputational challenges in the market, particularly as a result of Dick Smith, Spotless and a few other private equity-backed IPOs that hit the skids,” says Simon Feiglin, a managing partner in The Riverside Company's Melbourne office. “Even when talking to business owners about selling their businesses rather than listing, it reinforces this old-school [image of] private equity as asset strippers.”

Tim Martin, a partner at Crescent Capital Partners, agrees that thanks to a combination of challenges in the broader economy dealflow is “relatively muted”.

“My sense is it's going to be a relatively quiet market from a dealflow perspective, partly because of the general election, partly because we're in this 'ok but not great' economy. I think it will be generally cautious.”

The fund manager community is also in a state of upheaval. While there are new firms entering the market – such as Archer Growth, Archer Capital's lower mid-market affiliate, which has spun out as The Growth Fund – others are falling by the wayside. The latest casualty is mid-market firm CHAMP Ventures, which has scrapped plans for a new fund and decided to wind down in the face of insurmountable roadblocks associated with succession planning.

Following a bumper 2014, when nine Australia-headquartered funds closed having amassed a combined $5.68 billion, domestic fundraising was more understated in 2015, with six funds raising $2.07 billion, according to PEI Research & Analytics.

A significant proportion of this was Pacific Equity Partners V, the latest vehicle from Australia's largest private equity firm, which closed above its A$2.1 billion hard-cap in September.

Meanwhile, the connection between the local fund manager community and domestic LPs is weakening.

In the financial year 2015, which runs from 1 July-30 June, overseas investors overtook domestic investors as the source of new commitments to private equity and venture capital funds. Australian investors accounted for just $856 million, or 28 percent of new commitments, down from  54 percent in 2014.

Thanks to a compulsory defined contributions programme, Australia's pension market is the fifth largest in the world, valued at around $1.5 trillion, according to Willis Towers Watson's Global Pension Assets Study 2016. What is more, between 2005 and 2015 it represented a compound annual growth rate of 9.1 percent.

Superfunds compete with one another for members on the basis of the fees they charge, meaning the entire industry is fixated on fees and costs. Faced also with regulations requiring superfunds to maintain a highly liquid position, private equity becomes a tough sell.

Some local investors have moved out of private equity investing altogether. In May, AustSafe Super, the superannuation fund for rural and regional Australia, told Private Equity International that it no longer has appetite for private equity investment, although it is still interested in real estate and infrastructure funds.

What is more, the sheer size of the superfunds themselves means huge swathes of the private equity landscape – including most domestic funds – are out of reach.

“In some ways you're effectively self-selecting out of a range of opportunities because of [your] minimum investment threshold,” says one industry-specific superfund LP. “You want each investment to have a meaningful impact.”

With such rapid growth, superfunds have to think harder about manager selection if they want to build relationships for the long term, says Ken Licence, managing director at Sydney-based placement agent Principle Advisory Services.

“In some cases people have been investing via funds of funds, but doing it on a bespoke separate account basis,” he says.

Tempting as it may be for fund managers to shoot for a larger fund size to accommodate hefty equity cheques, GPs should be mindful that the bulk of the opportunity set remains in the lower mid-market. AVCAL data show that in the 2015 financial year equity investments of between A$20 million and A$150 million accounted for the majority of capital invested, with the average equity investment at A$36 million.

Australian fund managers, says AVCAL chief executive Yasser El-Ansary, “understand that dynamic very well”, and maintain discipline around fund size, which also helps to keep valuations reasonable.

Crescent closed its latest vehicle on A$675 million in December 2014 after just 10 weeks in market having attracted interest of more than twice that amount.

“We could have raised a bigger fund but we felt that the best opportunities and most consistent dealflow is in the middle market,” Martin says. “But once in a while a larger deal comes along, and one of the reasons we're happy raising a smaller fund is we've got some excellent LPs that are very happy to co-invest alongside us, which means when you need to you can stretch up to a slightly larger deal.”

For an LP community so focused on fees, direct and co-investment may seem like obvious answers. While co-investment is proving popular among local LPs, for the most part they are yet to embrace direct investment on a large scale, El-Ansary says. 

“We haven't seen a groundswell of momentum towards LPs direct investing themselves into the underlying assets,” he says. “Co-investment, by contrast, is more readily apparent.”

One investor taking the bull by the horns is Queensland government-owned investment manager QIC. Forty percent of QIC's private equity allocation goes toward co-investment, co-underwriting and direct investment, with direct investments for the time being confined to Australia.

In May, QIC agreed to acquire an 80 percent interest in the North Australian Pastoral Company, one of Australia's most significant cattle companies managing 5.8 million hectares across Queensland and the Northern Territory and around 178,000 head of cattle.

NAPCO fits neatly into a wider narrative into which QIC and other Australian investors, both GPs and LPs, have been looking to tap.

“For local deals we are looking at sectors where we believe Australia has a competitive advantage,” says Marcus Simpson, global head of private equity at QIC. “These include food production, healthcare services, leisure, and education. All those sectors have huge links up to Asia which drive growth and opportunity.”