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Keeping the faith

Australian buyouts have delivered strong returns in recent years, and new funds being marketed are in demand as never before. But as the level of capital in play increases, is it time to worry about competitive pressures? Andy Thomson finds few are panicking just yet.

Buyout firms operating in the Australian market know a good deal when they see one. Just ask Ramsay Health Care. In October 2003, the Sydney-based hospital operator bowed out of the auction for rival Affinity Health when a bid of AU$813 million (€509 million; $621 million) was submitted by a private equity consortium led by Ironbridge Capital and CVC Asia. Ramsay, which thought the price excessive, could hardly have confessed to its misjudgement in a more eloquent manner than when subsequently buying the business for AU$1.4 billion from the consortium in April this year – delivering a return of three times capital invested to its erstwhile bid adversaries in the process.

Affinity Health is just one example of a string of lucrative exits that have made Australia one of the world's best-performing private equity markets in recent years. Its momentum has not gone unnoticed by the country's superannuation (pension) funds, which dominate Australian institutional investment in the asset class. The “Supers”, as they are commonly known, have around AU$700 billion of combined capital and some of them allocate as much as seven per cent to private equity. And yet, despite their financial heft, even they are beginning to find themselves muscled out of the larger domestic fund offerings by international investors. Australian private equity, it seems, is very much in vogue around the world.

Take for example the recent AU$950 million fund raised by CHAMP Private Equity, the ([A-z]+)-based investor affiliated to US midmarket buyout firm Castle Harlan. CHAMP, which had raised one previous fund in 2000, achieved its wish of pulling in European investors for the first time when the likes of the Netherlands' AlpInvest Partners and AXA Private Equity of France signed on the dotted line. In also eliciting a commitment by Japan's Mizuho Bank, CHAMP managed to diversify its client base while also breaking down barriers in the process.

“More and more international investors are seeking access to private equity managers in the Australian market,” says Veronik Verkest, consulting director at Principle Advisory Services, a Sydney-headquartered placement agent whose clients include Australian private equity firms Gresham Partners, NBC Capital and Wolseley Partners. “There is clear evidence that in some instances they are displacing domestic investors who previously had a seat at the table.”

The impressive track record of the Australian buyout market – buoyed by strong economic growth and bullish capital markets – is one reason why international investors are keen to grab a slice of the action.

In addition, Australia is seen as a relatively safe way of accessing Asian markets – albeit indirectly. “We back leading Australian management teams who are proven in their industry to take advantage of opportunities in Asia through a “step-out” strategy,” says CHAMP Private Equity director Paul Wilson. “This incremental growth is a sensible way without betting the farm. Investors in our fund like the concept of a stable base in Australia, with governance and stability, combined with exposure to fast-growth Asian economies.”

Julian Knights, managing partner at Sydney's Ironbridge Capital, says Australia is seen as a good prospect by foreigners in terms of its juicy returns, while still allowing them to remain in a comfort zone. “It's a bit less competitive than the US and Europe, while looking and feeling like the sort of market Western investors understand. It's not as easy to get comfortable with Asian markets.”

CASHING IN
But as international investors increasingly wake up to Australia's strong performance, the question now being asked is whether too much is being staked on the future being able to live up to the past. In other words, can the current level of performance be maintained in the years ahead? Some say the amount of capital garnered by funds over the last year or so could ultimately make Australian private equity a victim of its own success. In addition to CHAMP's new pool, three listed private equity vehicles have between them accumulated more than AU$2.5 billion in recent months: two of them climbing to the previously alusive AU$1 billion mark.

Known locally as “cash boxes”, these funds have come to the fore at an opportune time, with reallocation of capital a priority for both institutional and retail investors. “The property boom has given way to a slowdown. Lots of people have cashed in and have been looking for a new home for their money,” says Principle's Verkest.

First to take advantage was Allco Equity Partners (AEP). The firm is a joint venture that brings together Sydney-based financial structuring house Allco Finance Group and the wealthy Melbourne-based Liberman family (both of which invested AU$100 million in the fund). The two parties had for some time been making private equity investments together – which ostensibly combined the financial engineering skills of Allco with the Liberman family's experience of running businesses (as well as their networks in the two cities) – but had not invested from a dedicated fund.

That changed with the appointment to AEP of managing director Peter Yates, the former CEO of Publishing and Broadcasting Limited, a media company controlled by business tycoon Kerry Packer. Yates, a renowned investment banker with Macquarie Group in the 1980s, promoted AEP as a “corporate activist” fund that would seek turnarounds of underperforming companies. It was a message that was well received by investors as AEP accepted AU$550 million of commitments, after having reportedly received expressions of interest that could have hiked the total to around AU$2 billion.

Last month, AEP undertook its first deal when buying a 17 per cent stake in Baycorp, a credit records and debt collection business – at the same time submitting an offer for a further 50 per cent in a deal worth AU$470 million in total. Yates says the firm was encouraged to bid by AMP, the Australian life insurance company, which is a major shareholder in Baycorp as well as the third-largest investor in the AEP fund with a AU$75 million allocation. “It [Baycorp] has been a poor performer,” says a source close to the deal. “Its shares were worth AU$6 three years ago and AU$3 now. But it's a stable business, it's in the financial services sector – which is one of AEP's areas of focus – and it's ungeared.”

AEP's strategy appears compelling: having put into play listed underperformers by taking an initial minority stake, it will either cash in at a profit should a higher subsequent bid emerge, or else proceed with its plan to shake up the company by whatever means necessary. What is more, it is a strategy that places it outside the private equity mainstream – as a result of which one could argue that its existence does not significantly increase the competitive landscape.

Indeed, Paul Wilson of CHAMP says that AEP's activities will have a beneficial effect on the market in general: “It will increase deal flow because it will force conglomerates to focus on maintaining healthy balance sheets, and that will drive divestments of non-core businesses,” he insists.

But what of the other cash boxes belonging to Babcock and Brown Capital and Macquarie Capital Alliance Group, which both raised AU$1 billion in February and March respectively? The Macquarie fund, which raised a large proportion of its funding offshore, is expected to target mainly overseas investment opportunities. This was demonstrated when the group swiftly completed two deals in Europe: first leading a consortium that acquired pan-European directories group Yellow Brick Road from 3i and Veronis Suhler Stevenson for €1.8 billion in May and then purchasing BBC Broadcast, the digital media services arm of the British Broadcasting Corporation (BBC), for £166 million in June.

Meanwhile, Babcock & Brown is expected to complete just a small handful of large, potentially industry-transforming deals. Suffice to say, the more traditional medium-to- large-sized Australian buyout firms are not expecting to be seated at the same negotiating table as the cash boxes on a regular basis.

ASIAN INVASION
But while the level of competition among domestic funds may not yet be of sufficient intensity to cause widespread alarm, there is a view that large pan-Asian funds will make their presence felt in the years to come.

Two recent developments have been noted in particular. Firstly, the successful close of CVC Asia's latest fund on a target-busting US$1.975 billion. Australia is expected to be the recipient of a sizeable chunk of this capital, given that Australian deals were among the big success stories in the firm's previous fund: notably the sale of Affinity Health and IPO of Pacific Brands.

And secondly, the announcement that JP Morgan Partners Asia – shortly to close a new US$1 billion-plus fund – is poised to open a new office in Melbourne. When it does, it will join the likes of Carlyle Group and Newbridge Capital of the US and Hong Kong-based Affinity Equity Partners, all of which have an on-the-ground presence in the country.

One might have thought such developments would be a cause for concern at a firm like CHAMP which, having almost doubled the size of its previous fund, has arguably departed the upper midmarket for the bona fide LBO space. But Wilson argues that, with 12 investment professionals, CHAMP has a better chance of obtaining quality deal flow than pan-Asian competitors with just one or two local professionals. He also expresses the hope that pan-Asian GPs will increasingly provide exit options for Australia-focused investors in the form of secondary buyouts – a type of deal more in its infancy than in the US or Europe.

But despite Wilson's optimism, questions are being asked about the sustainability of returns at the upper end of the market – though it is worth highlighting that how the “upper end” is defined is something of a moot point. Firms such as Ironbridge Capital (whose team closed a AU$450 million debut fund last September having spun out from Gresham Private Equity), Archer Capital, Catalyst Investment Managers and Pacific Equity Partners would all be seen as midmarket by the standards of leading European markets, but are nonetheless among the largest GP groups in Australia.

Among local practitioners, the mid-market tends to be most frequently defined as those firms targeting opportunities to invest in a large swathe of private companies, many of which are said to be facing generational issues and/or requiring expansion capital. This part of the market is dominated by funds taking minority stakes rather than control positions, such as ([A-z]+)-based trio ANZ Private Equity, Crescent Capital Partners and Quadrant Capital. Although there is a view that such firms find it tough to identify exit routes for portfolio companies, that perspective was challenged recently when Quadrant delivered a 144 per cent internal rate of return when floating Penrice, a soda ash business, on the Australian Stock Exchange in July in an AU$80.5 million IPO. The listing ran contrary to one commonly expressed view, which is that the stock market is not a willing recipient of small-cap stocks.

Many more success stories such as this and Australian institutional investors may begin to re-think their traditional weightings in favour of larger buyouts. One organisation that has always invested across the spectrum is Quay Partners, which became Australia's first independently owned private equity fund of funds manager when it was launched in 2000. Since then, the firm has set about building a balanced portfolio, incorporating mid-market, venture and secondaries offerings (a small but growing niche in Australia), in addition to large buyouts.

Stephen White, a managing partner at Quay, says there is great diversity to be found in the mid-market: a point emphasised when his firm backed the NZ$75 million (€52 million) AMP Pencarrow Private Equity Fund, a new fund launched by way of a joint venture between AMP Capital and Wellington, New Zealand-based Pencarrow Private Equity in June. The firm will invest in small management buyouts and expansion capital transactions in New Zealand. White says Quay's investment was the first by an Australian institution in a New Zealand-based mid-market buyout fund.

Perhaps Quay Partners' willingness to diversify points the way ahead for Australian institutional investors as they eventually seek to reduce their reliance on the Australian market in general and on the larger buyout space in particular. However, that may be some way off. Given the returns that Australian buyout firms have delivered in recent years, faith in their ability to deliver further performance will take some shaking. And while competition is on the up, the general view is that it will be another five to ten years before sale processes in Australia become as claustrophobic as they are currently in the US and UK. Buyout firms down under are still trusted to know a good deal when they see one.