Where should an Australia-focused fund top out in order to avoid bumping up against the offshore funds in the country’s limited large cap market? Quay Partners’ Jake Burgess talks maximum fund sizes and argues there is more room at the top.
The last decade has seen the Australian private equity industry follow an accelerated maturation curve. It has changed from being a relatively unknown niche sector of finance in the early 2000s to a mature industry and an integral and important part of capital markets today. During this period, given the low base from which it started, the ascent of the local private equity industry through the boom was in many ways even more dramatic than that seen in the Europe and the US.
In the mid 2000s, two of the most prominent developments in the marketplace were the raising of a number of funds of about A$1billion or greater, and the arrival of the offshore private equity funds.
Prior to 2006, the largest fund ever raised in Australia was the $500 million buyout fund raised by CHAMP Private Equity back in 2000 . Then, from 2006 to 2007, both local and international institutions strongly backed the sector and five buyout funds of around $1billion or more were raised .
These were CHAMP’s second fund, which raised $950 million; Ironbridge’s second fund, which raised just over $1 billion; Pacific Equity Partners third fund and fourth funds, which raised $1.2 billion and $4 billion respectively; and Archer Capital’s fourth fund, which raised $1.4 billion. To put this in perspective, as a crude measure an A$1 billion fund relative to GDP is the equivalent of a $17 billion fund in the US.
The presence of these larger funds changed the composition of the Australian private equity deal landscape, ushering in a significant increase in deal size. Although numerically the smaller sized deals (sub $75 million equity cheque) still prevailed, the larger deals were substantially greater in terms of money invested.
PE Deal flow by Equity cheque. Source: Quay Partners deal database
Meanwhile, Australia also appeared to hit the radar of the regional funds due to some highly profitable exits through the 2003 to 2005 period. From about the middle of 2005 to the middle of 2009, offshore private equity funds took significant market share away from Australian GPs. By Quay Partners estimates, offshore managers completed 16 of the top 30 LBOs seen from 2005 to the start of 2010.
During this period competitive pressures increased markedly in the Australian marketplace. The result was sharp increases in the pricing of large deals (complicit in this were the banks), and consequently many LPs came to view Australia as overcapitalised and too competitive.
The consequences of the high prices paid for deals during this period are still working their way through the collective portfolio. It appears likely that there will be a broad range of company and portfolio returns, from the very good to very bad. This may potentially lead to some managers struggling to raise funds in the future, and is not dissimilar from the experience around the world presently.
However, unlike the rest of the world, despite the relative size of the local funds compared to GDP, the levels of dry powder in Australia currently are relatively low, which appears to be reflected in lower pricing. Average EBITDA multiples have dropped back to less 6.5x times locally, their lowest since 2005,according to recent statistics published by the Australian Private Equity and Venture Capital Association. This compares to EBITDA multiples of up to 10x seen in 2007, at the peak of the boom.
These pricing multiples are significantly lower than those being reported out of either the US or Europe, where the capital overhang is more pronounced and pricing apparently remains high. Moreover, deal flow in Australia is starting to normalise, albeit slowly. The local trading banks remain open (if not keen) for business. For local private equity managers this infers that once sentiment improves more generally in capital markets, they should feel reasonably good about the forward prospects for their market. Profitable exits are starting to flow and new deals are getting done in a relatively uncompetitive environment.
Optimal fund sizes
So now that the market here looks to be in the early stages of normalising, it raises questions about where a conceivable “equilibrium point” for large Australian private equity funds might lie. This is the eternal question – how much money is too much? Perhaps counter-intuitively, our view is that there is opportunity for growth in the number of funds in the market from present levels: it could likely sustain at least three or four, possibly more, funds of A$1 billion to A$1.5 billion in size with competitive tension remaining relatively low.
This estimate might appear to clash with the observations about the competitive dynamic in the period 2005 to 2007 – there were five funds of about $1 billion raised at the time, and look what happened to pricing. But it should be noted that many of those newly raised funds were invested in only 18 to 24 months, with several managers doing four or five deals a year, despite having the relative luxury of a five-year investment period.
Throughout the private equity peak in Australia, deal velocity was a significant if not key contributor to pricing pressure. In a more moderate deal flow environment, combined with the previously mentioned greater maturity of the industry and broader recognition of the role private equity can play in the Australian capital markets, things could be different. We might be in a situation where, going forwards, the market can sustain the same amount of funds and still deliver strongly for LPs. Four funds doing two deals a year over the length of their investment period is only eight deals completed in the market per annum.
Setting the limit
However, our cautionary observation is that while we can see that the $1billion to $1.5billion space on the whole is not over capitalised presently, when we look at historical deal statistics we are more sceptical that an individual country-specific fund can be much greater in size. We point to two factors in support of this assertion – the segmentation of competition in the LBO space and the structure of most Australian industries.
Looking at the deal statistics, when you assess the split of deals between onshore and offshore private equity deals, there is not too much overlap between the two groups. In fact, the Australian managers seemed to readily fish down in deal size, with median equity cheques of about $100 million, but a number completed in the $50 million to $100 million bracket, which seems small for a A$1billion plus fund. In fact, the segregation of the deals done suggests that in hindsight the offshore funds were not too contributory to the competitive dynamic for deals targeted by the Australian managers. They may well have been in the fray during the auctions, but their market share (as measured by deals made) declines markedly from equity cheques of $150m downwards.
Large LBO funds deal flow as measured by equity cheque. June 2005 to Jun 2010. Source: Quay Partners database
The obvious explanation for the split in sizes of deals done by local and offshore players is that it is a result of the differences in fund size, with the offshore managers typically investing from larger funds.
This is true, but the chart ‘Deal Volume by Equity Cheque Size’ also demonstrates a low volume and wide dispersion in deals completed with an equity cheque greater than $200 million.
We think spread in the size of very large deals is more likely symptomatic of the patchiness of the deal flow at the very large end of the scale. And this is the reason why we’re sceptical of a country-specific Australia fund of greater than $1.5 billion. On the evidence shown, an Australian fund that is systematically trying to invest, say, $300 million equity cheques, would need to be involved in almost every opportunity that came to market. This is a very difficult task given the highly intermediated nature of the big deals – the investment banks in Australia have got the market well covered, and so generally everyone with capital will get a chance to bid on large opportunities.
There are conceivable counter-arguments to this, primarily the fact that deal flow generally increases to meet the buyers’ market. But when we look at the structure of Australian industry we’re more sceptical that this can continue into the larger deal space.
The Australian Tax Office (ATO) publishes industry statistics based on revenue. These show that in 2008 there were a total of 2063 companies that lodged tax returns with $100 million of revenue or greater.
Australian businesses by revenue. Source: Australian Tax Office, Taxation Statistics 2007-2008, Ch 3
These figures show that numerically (as opposed to by value) Australia is an SME-dominated marketplace. What is less clear from these figures is that structurally, many – if not most – industries in Australia are near oligopolies, dominated by several very large players, with a significant gap to the second tier. So a large proportion of the businesses that are greater than $250 million in revenue are in fact posting revenue in the billions. Good examples of these quasi-oligopolies include the Banking, Steel, Wine and Equipment Hire industries. We take this as a further indication that the opportunity set diminishes rapidly at the large end of the spectrum.
The ATO statistics, industry structures and the historical pattern of deal flow suggest that numerically the opportunities reside in lower end of the market. For large deals (>$200 million equity cheque), the broader jurisdictional overview of the international funds is an advantage – it allows them allows them to be more opportunistic in their approach to investing in Australia, and removes the pressure to complete.
From an LP’s perspective, this potential limitation of country-specific fund sizes is not a bad thing; it’s merely an idiosyncrasy of the Australian market. In fact, we are pretty optimistic for the Australian private equity sector looking forwards – there are a number of managers who appear to be coming through the global financial crisis strongly, the economy here is in good shape, confidence is slowly returning and the market is relatively underpenetrated.
The separation of competition between the offshore and onshore private equity players looks to our eyes to be about right for a market such as ours. While it might constrain the ambitions of local managers seeking to raise mega funds, it also suggests that the local competition might, for the time being, stay relatively low – which is good for returns.
Jake Burgess is a partner and a member of the investment committee at Sydney-based Quay Partners. Quay Partners was established in October 2000 as Australia’s first independently owned private equity fund of funds. Quay currently has assets under management of A$980 million and has advised more than A$4 billion in assets. Today, the firm’s activities include fund of fund management, private equity investment advisory services, and secondaries investment.