Restructuring looms large

Some of the headlines emerging from the Australian private equity industry in the past month have been heartening.

With the stock market picking up, several private equity firms are seizing the opportunity to list portfolio companies. TPG-backed Myer Group, Archer Capital-backed Ascendia Retail, and Goldman Sachs JBWere Private Equity and Quadrant Private Equity-backed Kathmandu are all due to list on the Australian Securities Exchange in the next few months. There has even been a notable trade sale: that of CHAMP Private Equity-owned United Malt Holdings to Australian bulk grain holder GrainCorp for A$757 million.

But despite the attention lavished on these pending realisations, there is another story playing out right now in the Australian private equity industry behind the headlines: one of overleveraged portfolio companies and struggling GPs.

According to one Sydney-based corporate restructuring adviser, a third to a half of all private equity portfolio companies in the country “have been restructured in some way shape or form over the last 18 months to two years”. The majority of these cases are, he said, “just sponsors and banks acknowledging they had made a mistake in their gearing levels”, although a handful are more serious.

The problem was in part caused by the banks themselves, which were happy to lend ever-increasing amounts of debt to private equity sponsors before the crisis. At the peak of the market, debt was being provided on some deals at up to 6x earnings. As one GP with an Australian focus put it: “Australia’s really borne the brunt of very optimistic and free lending practices, like the US and Europe.”

As an example of the frenzied deal doing that happened at the top of the market, one Sydney-based GP spoke of a company his firm had bid for. His firm, he said, had offered to pay A$180 million and lost. The winning GP had secured A$190 million in senior debt alone, with a further A$20 million in mezzanine, in a total transaction value of A$280 million.

Some of the pre-crisis leveraged loans are now finding their way onto the market in the form of damaged goods. In fact, according to Michel Lowy, co-founder and CEO of boutique investment bank SC Lowy, which opened business recently in Hong Kong to focus on distressed and illiquid investment opportunities, most of the LBO-originated debt opportunity in Asia is concentrated in Australia at the moment.

There are, he says, currently about 10 LBO deals in Australia that are “not necessarily distressed, but certainly stressed and trading”. According to Lowy, the reason deal flow is concentrated in Australia and not in other Asian LBO markets like Japan, is because the lenders in Japan were typically local.

“In LBO deals in Australia, you had a lot of foreign banks. It’s the foreign banks that have started selling assets,” he said.

Keeping businesses going is key

Thus far, the number of private equity-backed portfolio companies that have actually gone into receivership can still be counted on the fingers of one hand. They include CHAMP- and Catalyst Investment Managers-owned Australian Discount Retail, which went under in January after talks with banks over repayment of the company’s A$96 million in debt failed. Also seen sinking earlier in the year was Riviera Group, a boat builder sponsored by Gresham Private Equity and Ironbridge, which entered voluntary receivership in May.

Speaking at the recent 2009 Australian Private Equity & Venture Capital Association (AVCAL) conference, Peter Shear, Sydney-based head of acquisition finance at Bank of Scotland International (BOSI), said: “The few receiverships we have seen involved too many stakeholders and too many points of view. We haven’t seen many because banks have been coming to the table. There’s a lot of goodwill in the system – to date that has got us through.”

Speaking on the same panel, Peter Anderson, a Melbourne-based senior partner at McGrathNicol, which specialises in corporate advisory, transaction services and corporate recovery, added: “It makes sense to keep businesses going – returns are driven around going concern businesses.”

Shear went on to say it was likely a sizeable number of portfolio companies that have already been restructured once would need to be restructured again in the next 12 months. “We’re not going to see all of the operational outcomes [that the initial restructurings were based on].”And, as he put it: “It’s easy to restructure once – it’s not so easy the second or third time round.”

Sources also say that the situation is being made even more difficult by the conservatism of the banking sector in Australia, which has been reluctant to use certain restructuring tools such as debt-for-equity swaps. One notable Australian transaction where a debt for-equity-swap was used involved a global private equity firm and a foreign bank. It came in August, when CVC Capital Partners’ restructured travel and hospitality company Stella Group. To make the deal happen, according to media reports, UBS wrote off more than A$500 million in debt in return for 40 percent of the company’s equity.

Australian banks are less keen to go down this route. Speaking to PEI Asia a couple of months ago, Julian Knights, a managing partner at Ironbridge, said: “One of the things that is different about the downturn in Australia, compared to say Europe, is the attitude of the banks. Australian banks are extremely solidly capitalised – which is positive. The negative is they are reluctant to entertain the option of restructuring companies – certainly not anything that implies a write-off of their position.”

According to Shear and Anderson, banks are taking a wait-and-see attitude on these measures. If the “handful” of debt-for-equity-swaps that have been put in place generate good returns over the next 12 to 18 months, it could be that the market sees more of them.

In the meantime, portfolio management will likely remain the primary activity for some of Australia’s GPs at a time when they would rather be starting to deploy some of their dry powder. Data shown at the AVCAL conference showed that as of June 2008, Australian GPs had $6.5 billion in committed but uncalled funds. This figure most likely still stands, it was said, due to the fact that fresh fundraising since then – by firms like CHAMP Private Equity for example – would have offset any decrease in dry powder due to new or follow on investments.

“It stands to reason that the more problems you have in your portfolio, the less time you have to focus on your pipeline,” said BOSI’s Shear. “We will see some preoccupied with portfolios and others able to get out there and make new acquisitions. Equity is going to those perceived to be doing better and bank funds also.”

Insiders predict it will take a good 12 months for the dust to settle on the industry. However,  it should become apparent quite quickly which firms have portfolios that are in better shape: they will be the ones securing debt from the banks for new investments.