Good days, for now

Returns are strong, financing options are growing and the first mega-deals are in the bag. But as the sun continues to shine on Australia's private equity market, some practitioners are betraying twinges of doubt about the future. Andy Thomson reports.

Large Australian buyouts, it seems, have arrived. It was back in 1998 that the first such deal first broke the billion A$ mark when Amatek, a building products company, was acquired by CVC Capital Partners in a A$1.6 billion (€950 million; $1.2 billion) transaction. Until the turn of the year, not a single GP had delivered another deal of similar heft in the country. But in the first half of 2006 alone, three deals altered both the record books and perceptions of what is possible in one of Asia Pacific's most developed private equity markets.

The largest of the three was KKR's purchase of the Australian operations of Brambles, a waste management group, for A$1.8 billion in June. This ensured that the previous record deal mark set by TPG-Newbridge, the Asian arm of Texas Pacific Group, lasted just three months. In March, the firm had acquired the Myer department store chain for A$1.4 billion.

Brambles also dwarfed CCMP Capital's A$1.2 billion purchase of South Africa-based building services firm Waco International in January. Not strictly an Australian company, Waco attained honorary status as a domestic deal, because a majority of the company's activities are located in the country.

The trio displayed a common thread, having been the first deals completed in Australia by KKR and TPG-Newbridge respectively, and the first by CCMP Capital since its spin out from JP Morgan Partners last year. There are two competing narratives regarding the significance of this. One interpretation is that the increasing interest of large, international funds in Australia has been vindicated by their apparent ability to find sizeable, quality targets. A second view – a little more cynical in nature – indicates that for any newcomer, simply making a mark can be an end in itself.

The latter argument is hinted at by a leading professional at a domestic Australian GP, who says: “There's been pressure on the local representatives of the international or pan-regional funds to cut a big deal – they've all wanted to establish themselves with signature transactions. My view is that there will be more deals of this size, but that the market is not necessarily the oasis that overseas players might think it is.”

Should that be the case, there will be many disappointed parties. But it doesn't seem to be the majority view in a market where debt financiers in particular are pinning their hopes on a significant ramping up of activity. “The banks have been more aggressive and we've seen domestic Australian players take a step up in terms of the quantity of finance they're prepared to commit and the conditions attached to that finance,” says Paul Wilson, a director at Sydney-based buyout firm CHAMP Private Equity.

Among those in the vanguard of this trend is National Australia Bank (NAB), which acted as joint lead debt arranger alongside Credit Suisse and Goldman Sachs on the TPG-Newbridge/Myer transaction. Greg Lapham, head of leveraged finance at NAB, says his team has grown from four people to 15 over just the last year and a half. “February to March 2005 was when we first started seeing significantly increased deal flow and, with just four of us, we were busting a gut day and night,” he reflects. He adds that, from just a handful of deals in 2004, NAB completed 20 in 2005, and is set to complete as least as many again this year.

Lapham says that, during the last 18 months of frenetic activity, NAB has seen a number of high-profile international banks follow the lead of overseas sponsors by attempting to claim Australian market share. As examples he cites Citigroup, Deutsche Bank, Goldman Sachs and Mizuho Bank. Other observers add to that list Bank of Scotland, Royal Bank of Scotland and Calyon.

There's been pressure on the local representatives of the international or pan-regional funds to cut a big deal – they've all wanted to establish themselves with signature transactions

But it's not just senior debt lenders contributing to the Australian private equity market's swelling pool of liquidity. Mezzanine financing has been a rarely used component in Australian deals to date, but several independent funds have been launched recently. Among these is Arya Capital Partners, a Sydney-based fund launched by Vinod Muthanna, a former head of leveraged finance at Westpac Financial Sponsors Group. The vehicle closed in July this year with A$100 million of commitments, and will be looking to take around eight to 12 positions in deals with an enterprise value of between A$30 million to A$200 million.

Muthanna says the fundraising was a hard sell: “It was a long process, and we ended up having to raise all the money overseas [primarily from US-based institutions]. Australian investors are used to public equity, private equity or hedge funds. Many found our proposition hard to understand.” However, Muthanna is bullish about prospects: “We've only been up and running for a month and we have a big pipeline that we're farming. I'm going out to get more people – probably a team of three – and we'll spend about two years deploying the capital. We'll try and get Australian investors in the next fund, but first we need to get the money working and validate the strategy.”

Australia is also on the cusp of seeing of other types of participant enter subordinated debt structures. A number of local banks are understood to have had internal discussions regarding the feasibility of launching collateralised debt funds, while hedge funds are also assumed to be preparing moves. “We've not really seen hedge funds in private equity deals in Australia yet but, as structures get stretched further, it's inevitable that we'll see more of them,” says Lapham.

As deals get larger and liquidity grows in tandem, it's a natural question to ponder why the Australian market is generating such a buzz. There's an obvious answer, and it lies in the generally impressive returns that the market has shown itself capable of delivering. According to AVCAL statistics, buyout funds formed between 1987 and 2005 have delivered a pooled IRR of 24.6 percent, with upper quartile funds posting 42.3 percent over the same period.

“The past several years have been exceptional in terms of the performance of the industry,” says Wilson. “Overall, you would eventually expect returns to come back to the pack because you can't outperform over a long period of time, but I think there are several good years ahead yet.”

A major part of the explanation for Australia's strong performance lies in an IPO market hungry for new issues. Explains Wilson: “Nine percent of employees' salaries have to go into pensions, and much of that contribution finds its way into the public equity market. You've got to feed the beast, which cries out for new equity issuance.” Private equity firms exiting on the Australian Stock Exchange also benefit from the ability sell their entire holding as soon as a portfolio company hits the market.

Other exit routes are also open and receptive. In certain sectors “you don't have to consider any options other than trade sale” according to one observer. Anecdotal reports suggest companies operating in the booming natural resources industry will have few problems identifying potential suitors, while media and advertising businesses have also proved popular with trade bidders in the recent past. The secondary buyout, a nascent phenomenon in Australia, is also starting to surface – as indicated, for example, by DB Capital Partners' sale of nursing services firm Pacific Nursing Solutions to CHAMP Private Equity in December 2005.

The significant thing is that the first generation had to make money, the second generation wanted to make more money, but the third generation has been born into money. They get BMWs for their 21st birthdays and have little interest in going and running a grimy factory in the suburbs

Andrew Rothery

There is also optimism regarding future deal flow. Not only will secondary buyouts increase options, but public-to-privates are also now appearing on the radar. Such deals have been few and far between to date. Sydney-based buyout firm Pacific Equity Partners (PEP) unsuccessfully attempted to take food manufacturer Goodman Fielder private as far back as 2000. (PEP teamed with Bain Capital to make its third bid for Goodman Fielder towards the end of last year in what would have been easily Australia's largest buyout at A$3.5 billion. The target – which had previously been bought out by New Zealand entrepreneur Graham Hart – elected to go back onto the public market through an IPO instead.)

Of prospects for future PTP deals, PEP managing director Simon Pillar says: “You need to be very selective because the stock market is at a high level in value terms, but you can still find businesses that are not well understood and are out of favour.” One firm presumably endorsing that view is Affinity Equity Partners, the Hong Kong-based GP which in August submitted a A$430 million hostile bid for listed retailer Colorado Group, which bypassed the firm's board with a direct approach to shareholders.

It was not the first investor to ruffle feathers in this way: last year, listed cashbox Allco Equity Partners unsuccessfully attempted a hostile takeover of the whole of Baycorp Advantage, a credit bureau. Allco, which retains a 17 percent stake in Baycorp, in May this year teamed with DB Capital Partners to acquire the firm's debt collection subsidiary, Baycorp Collection Services, in a A$97 million deal.

While opportunities do appear to be increasing at the larger end of the market, an interesting recent development suggests that at least one GP thinks a migration of capital to LBO situations may be creating a gap in the smaller deal arena. Dawes Point-based Archer Capital is one of Australia's largest domestic buyout players with a A$450 million fund. However, the firm has just added a new strategy by closing its first growth capital fund, on A$200 million, in August.

Says Archer partner and chairman Andrew Rothery: “The established players have grown bigger as more capital has been supplied and, not surprisingly, they've accepted it. As a result, we have seen a depopulation of the smaller buyout space as ourselves and others have moved up the curve.” Rothery says Archer's new fund will seek to capitalise on what it sees as an advancing wave of realisations from family-owned businesses.

Rothery elaborates: “Many post- Second World War migrants into Australia built businesses, which are now approaching third-generation ownership. You had the people that came in and established those firms, the sons and daughters that grew them further, and now it comes down to what the grandchildren want to do. The significant thing is that the first generation had to make money, the second generation wanted to make more money, but the third generation has been born into money. They get BMWs for their 21st birthdays and have little interest in going and running a grimy factory in the suburbs.” Archer envisages stepping in where parents are encouraged to cash in their stakes rather than hand the business down.

With confidence in an increasing level of opportunity across the deal size spectrum, it's tempting to think that there is not a single cloud blotting the Australian private equity market's horizon – tempting but not entirely accurate. Australian businesses and consumers, already faced with the burden of rising oil prices, were dealt a further blow when the Reserve Bank of Australia announced a 0.25 percent increase in interest rates in August – meaning a rate of six percent was reached for the first time in five years. At around the same time, National Australia Bank unveiled a survey showing business confidence in the country falling in July, amid strong signs that it would decline further in the months ahead.

Meantime the IPO market, source of Australia's most lucrative private equity exits in recent times, took a surprise turn for the worse in July when Emeco was forced to cut the price of its offering. Emeco, a mining industry equipment provider backed by Archer Capital and Pacific Equity Partners, ended up floating at A$1.90 per share compared with a preliminary price range of between A$2.10 and A$2.50. Says Archer's Rothery: “Emeco is a terrific business and we didn't get the price we'd hoped for, which was a function of market skittishness. Until six weeks prior, the IPO market had been great to sell into, but it just got a little more jumpy.” Rival GPs will be hoping the market calms its nerves sooner rather than later.

Such developments threaten to cast just a little doubt into the minds of investors used to operating in an extremely benign economic environment. But noone's over-dramatising. In the words of CHAMP's Wilson: “There's no imminent blow-up on the cards, and it will be a while yet before private equity-backed companies trip and stumble.” Australian confidence won't be easily dented.