Perched 19 floors up, surveying the azure waters of Sydney Harbour, the sprawling Botanical Gardens and iconic Opera House from King & Wood Mallesons’ offices, it’s easy to appreciate the attraction of living and working ‘down under’.
Australia has emerged relatively unscathed from the global financial crisis (GFC), although the nation’s media seem aggressively fixated on the national budget deficit.
Australia’s banking sector, led by the Big Four (National Australia Bank, Commonwealth Bank, Westpac and ANZ), is also in relatively fine fettle: last year, three of that quartet topped the leveraged loan issuance charts in Asia, accounting for $1.24 billion of loans between them.
Their health should mean limited opportunity for private debt funds. Not so, according to the six local luminaries assembled by Private Debt Investor to discuss the lending landscape.
Richard Hayes, a partner at King & Wood Mallesons, which kindly hosted the roundtable, points to the exodus by foreign banks following the GFC. While Asian banks have picked up some of the slack, the pool of available capital was significantly reduced even if the domestic lenders remained active.
Matthew Turner, head of Australian senior lending at private debt fund manager ICG, adds that it was the nature of the banks that left – he names the likes of RBS, BNP Paribas, AIB and Natixis – and the quantum of leverage loan activity they underwrote which had a seismic effect on the Australian market. It meant the Big Four were forced to increase the size of their holds to get deals away, from a maximum of A$50-60 million pre-crisis to more than A$100 million in its aftermath – ticket sizes he describes as “unnatural” for those banks.
“But when dealflow picks up,” he adds, “I expect they’ll shrink back to those smaller, more natural holds and that will leave a big opportunity for institutional money to go and round out the market.
Institutional money will in time change some of the structures and alter the way people think about financing event-driven M&A,” he predicts.
He cites the example of a recent deal done without the involvement of the Big Four, using capital provided by institutions (including ICG) and two investment banks. “It replicated the sort of model you’d more commonly see in the US or Europe, although the structure wasn’t typical of those markets,” he says. “There were probably a couple of terms in that deal that weren’t normal for a leveraged deal like that, but they suited the business and the institutional investors were able to get their heads around them, whereas the rest of the market would have struggled to get comfortable with them.”
It’s a point often made by managers: private debt funds offer much more flexibility than banks. Babson Capital managing director Adam Wheeler agrees.
“Banks are driven by regulation. Australia is very much a bank-driven market and deal structures are driven by capital requirements. What private debt funds bring is more flexibility. We’re driven by the risk / return dynamic. We’re happy to take risk if we’re remunerated for it, that’s the big difference. Banks are driven by how a deal should look, then return becomes a function of that, rather than the underlying credit risk and asking if you could maybe do something a little bit different.”
Babson, he says, is looking at new structures, and recently closed a deal “which looks a lot like a European unitranche transaction”.
“We’re looking at more of an institutional offering where we maybe take a little more tenor, something that banks really struggle to do,” he adds.
The development of the market is contingent on the inflow of institutional capital, argues Turner. Once funds are able to write bigger cheques, they’ll be able to wield more influence over structures, and innovate more easily, he argues.
DEVELOPING LP APPETITE
So what’s holding it back?
The limited flow of capital into the asset class domestically crops up frequently as one reason it’s yet to fulfil its potential. Damien Webb, head of income and real assets at Australian superannuation fund First State Super, argues that while the GFC has had a positive impact on private debt in the country in terms of providing it with deal opportunities, investors haven’t done all they could to support it.
“I think before the crisis, super funds and multi-manager investors like us had toyed with high yield debt but had never really embraced it. Post-GFC, credit became attractive and it forced us to think much harder and deeper about it. There was clearly compensation there for the credit and illiquidity risk, this was a huge opportunity.
“We started, like many managers, in the US syndicated loan market and then spread out to Europe, UK real estate mortgages, and we’re at a point now where all things are considered. It’s a natural, strategic compliment to our investment grade, duration-heavy portfolios and will remain so. Our desire is to deepen our knowledge through co-investments. We appreciate being deeper into the capital markets and talking to a wide range of sponsors, arrangers and providers rather than just having it all bank-dominated and syndicated.”
Webb and his team have taken a seemingly progressive view of private debt and where it stands within a credit portfolio. But even First State hasn’t done all it could, he admits.
“Supers have finite illiquid allocations. Credit spreads are coming in, and it’s maybe getting to stall speeds whereby people will start to ask if it’s enough to justify going into illiquid opportunities. In the five years post-GFC, it was really competitive. You’d look at say a three year piece of paper against infrastructure, private equity, and it would look pretty good – it’s contractual, maybe secured, and it sort of sold itself. With spreads coming in, you start to look at going more junior in the structure, but you can only do that so far and you don’t want to chase it. That’s the challenge for private debt.
The capital response from Australian investors in the wake of the GFC should have been greater, Webb believes. He cites several impediments: first, that private debt wasn’t well understood, and was largely uncharted territory for many investors.
“Look at all the funds, it’s all XYZ Fund 1, because it’s the first time people have raised these sorts of funds. So you take it to the investment committee and they say, ‘What’s the track record like?’ and you have to say, ‘There isn’t one, they’re new.’ But you get through it. Then you think, ‘It has a three year investment period, but is this going to be around for a while? In the end, it turned out they’re still around. Those who went in were handsomely rewarded for it. In essence, institutional investors could have allocated greater amounts to credit dislocation opportunity,” he says.
No segment of the asset class has found this problem more acute than real estate, according to Tim Johansen, managing director of Qualitas Real Estate Finance.
“There’s been reasonable institutional support into private debt for corporate activity, but it’s less visible in real estate,” Johansen says. “There’s institutional support into large REIT investment and corporate loans, but outside of that, attracting private investment from large superannuation and pension funds into mid-market real estate transactions where you’re getting an 8-10 percent return – for a stretch or unitranche – is a challenge. But it’s a long road and you need to bring along your lending partners for the journey. We can produce very sustainable returns, but it just seems harder in real estate than in corporate debt to convince institutional lenders that that’s the case.”
Wheeler commiserates, but argues corporate debt remains the most attractive segment of the market.
“We compare [where we’re investing] with liquid markets like the North American syndicated loan market. We look at the risk profile of those indices, if you will, and compare them what we’re doing over here. When you look at the different asset classes – leveraged loans, infrastructure debt, property-related stuff – the relative value has changed over the last few years. We’ve seen a weight of money chasing infrastructure debt. A lot of banks are very keen on that space, as are a lot of institutions, and we’ve seen spreads crunching. It’s the same in the institutional real estate space – a lot of the premium has gone out of that.
“There’s less money in the leveraged loan market at the moment hence the relative value there still looks ok, and it looks good relative to the broadly syndicated market in North America,” he adds.
A HELPING HAND
The financial sponsor community has welcomed the development of private debt, not just for the additional liquidity it brings to the market but for that aforementioned flexibility too.
“Sponsors have been our biggest champions,” says Turner. “It’s in their interest to see extra liquidity come into the market because it’s been a challenge for them to raise debt post-GFC.
“An interesting development since the GFC is that a lot of the large international PE firms feel more established here,” he adds. “They have permanent bases here, which is pretty supportive of the long term viability of the industry. It’s great for our business too because it opens up larger transactions.”
ICG’s head of Australian mezzanine and minority equity investing, Ryan Shelswell, points out that sponsors are very concerned with cost of capital. “They’re extremely supportive of institutional credit but they also negotiate very hard. The way we look at the world [of corporate sub-investment grade debt], it’s split at least into mid-market and large cap and there’s a huge difference in the spreads you get in those two.” Direct corporate lending is also priced very differently to sponsor-backed deals, he adds.
“Sponsors also have very different concerns to corporates. Sponsors are quite happy to think about upfront fees, but often unhappy about sharing upside because they value their equity cost of capital highly. Corporates are very concerned about fees on day one but perhaps don’t value their equity capital quite the same way as a sponsor does,” he adds.
Hayes, who frequently advises both private equity firms and lenders on deals, says sponsors will often look to use as much institutional capital in a deal as possible because it is typically cheaper, with more flexible covenant packages.
“In an ideal world you’ve got the trading banks sitting side by side with the institutional money,” he says. “Institutional investors typically can’t do the bank guarantees or revolver piece. The trading banks need quarterly maintenance covenants, whereas institutional money can be incurrence-based, i.e. covenant-lite. It’s a much friendlier product, longer tenor, and it’s cheaper. So to fill out the capital structure, include as much of that as you can get, and the minimum sized revolver that you need.”
He cites the example of mining company Fortescue, which encountered problems because of its exposure to fluctuations in the iron ore price. To solve the problem it went to the US market and refinanced its debt with several billion dollars-worth of Term Loan B financing, with five to seven year tenors, “super thin margins” and covenant-lite. “That’s happening with private equity also. You see a lot of dividend recaps replacing old quarterly test covenants with covenant-lite, and cheaper too with longer tenors. It’s a no-brainer.”
Interestingly, when Hayes asks the fund managers present if they’d consider issuing covenant-lite debt, the answer is a resounding, unequivocal ‘No’.
“You need to understand the difference between Australia and the US,” Turner responds. “Do you really need to have the type of quarterly covenants that we require in a market where investors are taking $1 million licks and can flip it in an afternoon? This is a buy-and-hold market here. With the lack of liquidity, you need those terms because without them, how on earth do you manage your asset?”
“We’ve done a lot of analysis of this internally and have come to the conclusion that liquidity is probably the key element driving terms. If this becomes a much more liquid market, then that cures some of the issues from investor base,” he adds.
Although much of the activity from sponsors and corporates last year revolved around refinancings, there are signs that could be changing in favour of M&A. Babson, for example, has completed 20 deals in the Asia-Pacific region over the last 12 months, half of them in Australia, and while most of those closed in 2013 were refinancings, this year it’s been largely new money deals.
“I’m a credit guy so I think excitement is a professional fallibility, but it feels like the right environment for deals to tick up,” Turner says. “We’re looking at six or seven things at present, which is getting back towards a healthy pipeline.”
“People are starting to move past the GFC, it’s starting to fade from memory,” adds Shelswell. “They’re getting tired of waiting and are starting to push the button on deals.”
While M&A volumes are rising, so too are debt multiples although they’re still below pre-GFC peaks according to Shelswell. “Back then, senior leverage was getting up to 6-7x for very good, large assets, with a turn or a turn-and-a-half of mezzanine on top of that. That fell sharply post-GFC to lows of about 2x senior, and has slowly built back up so that now we’re seeing prior-ranking debt getting back to about 4-5x for the highest quality assets,” he says.
On the real estate debt side, “Banks are doing 65 percent loan to value and you can lever that up a bit up to 75 percent with some mezzanine finance,” according to Johansen. “We funded a transaction recently on a commercial office property in Sydney where an off-shore bank provided a 65 percent LTV on the building, an established B-grade asset, and we provided a strip of mezzanine behind that up to 75 percent LTV, and that was deployed at about 13 percent, so a good return. The overall blended cost of capital to the client was still quite acceptable when offset by the cap-rate for that property.
“For development deals, the banks are lending up to 70-75 percent of the project costs. It’s certainly moved up since the GFC as banks and private funds have grown more comfortable with where the market is, but I don’t see it screaming any higher than that. Pre-GFC you had the banks doing highly-leveraged real estate deals, very much outside of their skillset and what regulators would want them to do.”
THREATS, RISKS AND CHALLENGES
Asked for the key challenges for private debt in Australia, Wheeler says a major one is that many investors still don’t know how best to categories it within a portfolio. “Most people who are looking at the asset class are already invested in broadly syndicated loan markets and expect stuff down here to look the same. People are attracted to the relative value down here, but it then becomes a question of how do deal with the illiquidity. The key issue is how to raise third party capital. It will have to come from Australian institutions – it’s tough for someone sitting in Europe or the US to make an allocation solely to an Australian loan fund or arrange a separate account for an Australian allocation.”
“In terms of allocations, you’re right,” says Webb. “Most Australian pension funds have really dialled down offshore exposure to sovereign debt, and are weighing up ramping back up – at current levels it’s not great, but not terrible – but what do you do next?
“At First State Super, we’ve elevated credit – which we call ‘income opportunities’ – to one of our three main buckets. We have growth capital, which includes private equity; real assets, which is infrastructure and real estate; and then income opportunities. The key differentiation there is it’ll be income-orientated, primarily floating rate, primarily high yield. So credit is now a strategic part of our portfolio.”
As a related point, Webb points out that superannuation funds globally are struggling as demographics see more members call on retirement incomes. “We need to find yield from somewhere,” he says.
Australian investors are very different in their allocation strategies to their US and European counterparts, Turner says. “We did some research into the structure of pension funds in the US and Europe and over here. The only thing the Australian supers and offshore ones have in common is about a 39 percent allocation to alternatives. If you look through the funds, US funds typically have a 50 percent fixed income and 11 percent equities. It’s the flipside here, i.e. 50 percent equities and 11 percent fixed income, which is an interesting dynamic.”
Johansen agrees raising institutional capital for a new strategy is the biggest challenge. “We’ve nailed down our ability to find, execute and manage transactions but we also need to demonstrate to borrowers that we have a credible source of capital to support that activity. That means getting out there in front of our institutional partners and showing that we can deliver them sustainable returns with a through-cycle strategy. Real estate debt should be an enduring allocation to private debt participants.”
At least one institution appears to be open to new ideas. Webb says First State Super’s approach will be opportunistic. “We have the relationships already. We may look at some of the more junior infrastructure deals, some real estate deals, and the corporate debt space is very much of interest.
“As a group we’re open to complexity, so if there are things that just don’t quite fit, we’re open to those ideas, to working a little bit harder to secure a good position. We are keen to establish more mandated relationships with groups that are able to move around geographical opportunities for example. Co-investments are a priority – we’re hiring a few people who can do direct security analysis. It’s early days but it’ll be a much greater path for us going forward,” he adds.
There’s much to play for private debt funds in Australia then, both in terms of winning commitments and also levering their way into deals as the market picks up, as it promises to do.
Given the location, it’s perhaps fitting to leave the final words to the host. “From a macro perspective, the clients and boards we speak to have generally moved from survival mode to looking at new opportunities for growth, both organically and via acquisitions,” says Hayes.
As the sun beats down on the sheltered bays of Sydney Harbour below, it’s an optimistic note to end on.