Rattled, but hopeful

The subprime meltdown is threatening to prevent the LBO model from gaining further ground in Asia. But not everyone involved in Asian private equity has succumbed to pessimism yet, finds Sharon Lim.

It may seem preposterous that defaults on mortgage loans extended to homeowners in the US would slow down private equity firms chasing LBOs across Asia Pacific. But in a global market place driven more by sentiment than fundamentals, the two phenomena are of course closely connected.

With debt investors around the globe paralysed by turmoil in the credit markets, lenders to private equity-funded leveraged transactions have been stopped in their tracks – and equity sponsors around the world are having to deal with the consequences, or at least to brace themselves for things to come.

Asia is no exception. Until just a few weeks ago, albeit to a lesser extent than GPs in Europe and North America, Asian financial sponsors were still being offered highly leveraged loans on highly flexible terms. “Covenant-lite” structures, to be fair, never took off in Asian private equity en masse, but they did make a tentative appearance. Now that large parts of the debt market appear to have closed, a number or agreed private equity deals are struggling to progress as planned.

One such deal is the NZ$2.24 billion ($1.55 billion) acquisition of New Zealand's Yellow Pages by CCMP Capital Asia and Ontario Teachers' Pension Plan. With a debt multiple of 9x EBITDA, the transaction has been spotlighted as an example of an aggressively funded LBO. Banking sources familiar with the deal say the interest payment on the debt alone was equal to the company's EBITDA.

“A $1.5 billion to $2 billion deal might still be feasible, particularly in markets like Australia and Japan.”

In August, Yellow Pages' new owners attempted to sell bonds to refinance part of the acquisition. The bond offer originally sought to raise NZ$300 million but was scrapped in September even after the target was slashed to NZ$100 million, because potential buyers of the securities were in hiding.

The anecdote is representative of a new dynamic in the debt market that many market professionals had long anticipated. “Risk is being priced back to normal levels,” is another banker's laconic take on the situation. Chris Rowlands, head of 3i Asia in Singapore, says he has seen evidence of debt multiples being scaled back by two turns of EBITDA ever since the debt market squeeze.

However, despite the fact that Asian private equity is clearly being affected by the credit crunch, there is also a general consensus that the impact of the crisis is unlikely to be as serious in Asia as it will be in Europe and North America. Why? Because the use of leverage in Asian private equity deals was never as widespread to begin with.

Leverage recapitalisations for example, which according to Rowlands had become a “favourite past-time in Western markets”, have barely arrived yet in Asian private equity. He also observes that secondary buyouts between financial sponsors have not developed to the same extent in Asia: “The phenomenon of private equity buyers paying tomorrow's price today because of the available leverage has not been as prevalent. IPOs have been far more prominent exit routes than secondary sales in Asia.”

Also significant, sources note, is the fact that the systematic build-up of financial sponsors infrastructure at Asia-based investment banks only started in the past two years, and so staffing levels are not as high as they are in Western markets.

Nevertheless, there are questions over the future of late-stage private equity investment in Asia as a result of the current difficulties in the market place. Richard Pyvis, chairman and chief executive officer of CLSA Capital Partners, the private equity arm of Asia-focused securities and research firm CLSA, says the absence of an exit track record of large buyouts in the region will add to concerns over how the LBO model can be supported at a time of low liquidity.

Some believe the support will be there: Eric Mason, head of Carlyle Asia's leverage finance group, believes “a $1.5 billion to $2 billion deal might still be feasible, particularly in markets like Australia and Japan” (see p. 40).

But in order to get such deals funded, the uncertainty in the debt markets could force sponsors into writing larger equity cheques, which in the long-run could trim returns.

Among the potential beneficiaries of the current situation could be the mezzanine houses, specialist lenders such as Intermediate Capital and the mezzanine fund division at CLSA.

CLSA recently led a $60 million transaction which involved a combination of senior secured bonds with detachable warrants and junior secured convertible bonds that were fully taken up. Stephane Delatte, managing director of CLSA Mezzanine Management, describes the reassessment of credit risk as “good news for us”, because traditional lenders have become more conservative.

Much will depend on how mezzanine funds will expect to be compensated for giving private equity a helping hand. Says a general partner of a pan-Asian buyout fund: “If terms aren't favourable, I may drop the mezzanine tranche totally, and simplify the capital structure with more senior debt and more equity.”

Another area where the credit crisis is threatening to take its toll is the Asian stock market. Already Asian bourses have been showing volatility and given up some of the gains they made earlier in the year as a result of investors' recent mood swings. As a consequence, a flurry of private equity-backed IPOs does not seem likely in the coming months.

Whether a public market downturn will create opportunities for private equity funds to privatise businesses going forward remains to be seen. Asset valuations, many say, have been inflated by the recent run-up in public markets; if a sharp correction happens now, disillusioned shareholders might become interested in selling to private equity.

However, public-to-privates are difficult to pull off at the best of times. A string of failed PTPs in Australia earlier this year have made it clear that there is often a considerable spread between shareholders' price expectations and what sponsors perceive to be appropriate. Lyndon Hsu, head of leveraged finance for Australia at Credit Suisse, says: “Sponsors who think they can buy companies on the cheap via public-to-private transactions – I'd say, think again.”

“Sponsors who think they can buy companies on the cheap via public-to-private transactions – I'd say, think again.”

Hsu also says that with Australian interest rates on the rise and the subprime problem far from over, the amount of leverage available to financial sponsors is already down by one half to three-quarters of a turn compared to pre-crisis levels: “While financial sponsors were able to obtain debt at 6 to 7x EBITDA in the recent past, more realistic debt multiples are closer to 5 to 5.5x earnings today.” And some of the covenant-lite structures devised earlier this year to finance the ultimately unsuccessful acquisitions of airline Qantas and retailer Coles are “like a dinosaur: come and gone”.

But again, the drastic change in market sentiment isn't all bad news. Hsu says banks will still continue to underwrite deals that can be easily syndicated – provided the credit pricing margins are reasonable, the acquisition targets have good credit quality and the leverage being piled on is modest.

An altogether different picture prevails in markets where leverage has never been a primary value generator to begin with. China and India are the most obvious examples.

When canvassed for this article, several growth capital specialists operating in the two countries including representatives from Beijing-based CDH Investments, Capital Today in Shanghai and India's ICICI Venture, played down the impact of the US sub-prime collapse on their respective markets.

That's not to say that China and India are economies where incumbent private equity groups will necessarily enjoy an easy ride. The growing focus of international private equity firms like The Blackstone Group on both countries is bound to have an impact. And new funds raised by local groups have been getting larger too, thus putting upward pressure on asset prices.

The credit crunch seems poised to dominate headlines for months to come. Until investor confidence recovers, private equity professionals across Asia will need to tread carefully to find a sensible route through the obstacle course that financial markets have suddenly become.