PRINT THIS PAGE

Private equity trends and developments

As a relatively young industry, the Australian private equity market has not suffered as greatly in the general global downturn in early-stage investment. The last financial year saw the second highest ever level of private equity investment both in number and value. Kon Mellos and Nick Wormald of Freehills look at the developments to date.

The private equity industry in Australia has attained another year of strong growth, activity and optimism.

Some key indicators are:

• private equity funds under management, according to the Ninth Australian Venture Capital Journal & Investor Weekly Venture Capital Survey, increased by 9 per cent to A$9.25bn;
• the number of private equity firms increased by 10 per cent to 148;*
• the last financial year has seen the second highest ever level of private equity investment both in number and value;
• deal size is increasing, particularly in the buy-out industry; and
• many of the big global players have been ramping up their operations, including ABN Amro, CVC, Deutsche Bank, JPMorgan and Prudential.

There are some clear reasons for this buoyancy:

• the market, being in a relatively early growth phase, has not suffered as greatly in the general global downturn in early stage investment;
• investors are enjoying more realistically priced investment opportunities, with little competition from the bearish public markets;
• there is no longer a shortage of available funds for private equity investment;
• the contraction to core activities by many local and international corporations has boosted buy-out opportunities, helped by low interest rates and a low Australian dollar; and
• the steady increase in number and value of management buy-outs has led to their recognition as mainstream competitors to trade buyers.

Fundraising

Capital gains tax exemption

In 1999, legislative changes were introduced to attract foreign private equity investment into Australia. The changes exempt certain classes of foreign investors from capital gains tax on private equity investments in Australia. The exemption does however suffer from a number of inherent limitations:

• it applies only to foreign pension funds in prescribed countries (including Canada, France, Germany, Japan, UK and the US) which are tax exempt in their own countries;
• it is generally regarded as not applying to indirect investments through private equity funds;
• it does not apply to investments in entities with total assets of more than A$50m at the time of investment; and
• the registration procedure to qualify for exemption is cumbersome and complex.

These factors have impeded the use of the exemption, which is now widely recognized as having failed to achieve its objectives. As a result, complex international structures continue to be used to achieve acceptable tax outcomes for foreign investors.

Limited liability partnerships

In recognition of the lack of success of the capital gains tax exemption, the federal government has been receptive to recent submissions by the Australian Venture Capital Association seeking further reforms to stimulate the inflow of foreign private equity investment. The most recent proposal, announced to take effect on July 1 2002, takes greater account of globally preferred private equity fund structures.

The proposal seeks to reform the tax treatment of limited liability partnerships (LLPs) by:

• ceasing to tax qualifying LLPs as companies, thereby allowing flow-through tax treatment;
• treating realisations of investments by qualifying LLPs as capital receipts for tax purposes; and
• exempting a much broader range of foreign investors from capital gains tax on investments through qualifying LLPs.

The proposal provides the following key qualifying criteria:

• the LLP must be established in Australia;
• the investments of the LPP must be limited largely to securities in or loans to unlisted entities based primarily in Australia at the time of investment; and
• the LLP must not invest in an entity having more than A$250m in assets at the time of investment or which conducts primarily the business of property development, retailing, finance-related activities or any business of a passive nature (such as a business deriving its income from rent or royalties).

Unit trusts

Pending the implementation of the reform proposals for LPPs, the closed-end unit trust remains the preferred private equity fund structure. Fund structures are becoming increasingly uniform, particularly in light of the terms sought by major private equity fund of fund and superannuation fund investors. Typical features include the following:

• investment in the fund is limited to prescribed classes of sophisticated investors and professional investors, thereby avoiding the need to comply with significantly more onerous regulatory requirements for public offerings of securities, including the need for regulated offer documents and stringent registration requirements for the fund and its manager;
• the fund may comprise two parallel unit trusts which co-invest to reduce the risk that the extent of control over an investee prejudices the flow-through tax treatment of the fund. If a unit trust controls a business (which may arise through a majority equity stake or extensive veto powers) the trust may be liable to taxation as a company. Parallel unit trust structures enable a majority equity stake to be spread across the trusts and allow veto powers to vest collectively among them so that neither trust may, on its own, exercise those powers;
• the manager is entitled to a management fee of approximately two per cent a year of committed capital less the cost of realized or written off investments;
• the manager and its executives are collectively entitled to a carried interest of 20 per cent subject to a hurdle or preferred rate of return before tax of approximately eight per cent a year on the amount drawn down from investors. The risk of overpayment of carried interest is addressed by deferring payment until all committed funds are returned to investors or, alternatively, by clawback on termination of the fund;
• the carried interest of executives of the manager may, at least in part, be structured as a direct interest in the fund. This enables executives to access a discount of 50 per cent on capital gains tax when receiving carried interest payments sourced from the realization of investments held for more than 12 months. However, the manager may be liable for fringe benefits tax to the extent that the value of the direct interest at the time of issue exceeds the nominal amount paid by executives for those interests. A low value is usually justified by issuing the carried interest before marketing the fund, thereby discounting its value on account of its contingency on the successful marketing, closing and performance of the fund.

Pre-seed funds

The federal government recently announced an initiative to stimulate investment in technology and innovation through the establishment of pre-seed funds to which it will commit a total of A$78.7m alongside private sector commitments of at least A$20m. The funds, to be managed by specially licensed managers, will:

• target investment of up to A$1m in commercially promising research and development opportunities within universities and government owned research agencies in Australia; and
• as an incentive for private sector investment, entitle the private sector investors to all returns exceeding the total committed capital of the fund.

Innovation investment funds

The innovation investment fund programme administered by the federal government is designed to promote the commercialisation of research and development in Australia through the provision of seed, start up or early expansion capital to small technology companies.

The government has awarded licences to nine private equity managers to establish and manage innovation investment funds to which the government has committed a total of A$221m. The funds may not invest more than A$4m in any one entity. As an incentive for private sector investment in these funds:

• the government has committed up to two-thirds of the total committed funds;
• the government shares, in the proportion of its commitment, in any losses or any gains up to a benchmark rate of return of approximately 6 per cent;
• the government is entitled to 10 per cent only of returns exceeding the benchmark rate; and
• the private sector investors share in the remaining 90 per cent of excess returns but must bear any carried interest payments.

This skewed profit-sharing structure increases to a multiple of up to 270 per cent the returns to private sector investors in excess of the benchmark rate.

Pooled development funds

Investment companies that are structured and registered as pooled development funds under the Pooled Development Funds Act 1992 benefit from significant tax concessions. Income and capital gains on investments by pooled development funds are taxed at the concessional rate of 15 per cent and dividends paid by pooled development funds are tax exempt in the hands of shareholders. Despite the tax concessions, the restrictions on the investment activities of pooled development funds have impaired their widespread use as a preferred vehicle for private equity investment. Most significantly, pooled development funds may not invest:

• in companies with assets of more than A$50m at the time of investment or which conduct primarily the business of property development or retailing; or
• by way of preference shares (unless approved by the regulator) or loans (unless the loan is to an existing investee and all loans by the fund do not exceed 20 per cent of the amount of its shareholder funds).

These investment restrictions have been overcome partially by establishing parallel unit trusts to undertake investments which are otherwise precluded, thereby allowing the combined fund to invest more widely while continuing to afford the tax concessions on investments made by the pooled development fund.

Early-stage investment

The general slowdown over the past year in new investments in information technology has to a degree been counteracted by new investment activity in the growing biotechnology industry.

The investment slowdown in information technology, and the downgraded exit prospects and valuations for many companies in this industry, have raised new funding and governance issues for some companies and private equity investors.

Many information technology companies are currently confronting the need for follow-on funding, in some cases at lower valuations than for earlier private equity rounds. The difficulties experienced by some companies in attracting follow-on funding, or at least at acceptable valuations, has led to a retreat in growth ambitions in an effort to slow the burn rate of available cash and perhaps ride out the present environment of downgraded valuations.

It is quite common in Australia for follow-on funding to require the approval of private equity investors, even if it is in the unusual position of ranking behind the earlier private equity round. Such approval may at times be required from directors appointed by private equity investors rather than private equity investors in their capacity as shareholders. In those cases, directors have an overriding duty to act in the best interests of the company in exercising their right to approve or disapprove any follow-on funding. However, even if the rights vest with private equity investors rather than their appointed directors, any disapproval of follow-on funding in circumstances that are not in the best interests of the company could expose a private equity investor to a claim that it is in fact a shadow director of the company, and therefore has overriding duties to the company.

These risks for private equity investors and their appointed directors may be reduced significantly by adopting the following measures in the governing documentation at the time of initial investment:

• distinguishing properly between, and separating, the functions of private equity investors as shareholders and the functions of directors appointed by them;
• striking a balance between the matters requiring approval by private equity investors and those requiring approval by directors appointed by them;
• in the case of syndicated or co-investments, providing that veto powers may be exercised only with a degree of consensus among the private equity investors; and
• including anti-dilution provisions so that the rules for down-round funding are laid down clearly at the outset.

Anti-dilution provisions, particularly when coupled with a veto power over follow-on funding, would enable a private equity investor or its appointed directors to approve the follow-on funding at a down-round valuation while helping protect the private equity investor against any equity dilution and any potential claim that it has not acted in the best interests of the company.

Anti-dilution protection is more commonly structured as a full ratchet rather than as a weighted ratchet. A full ratchet adjusts the equity stake of the protected investor to the percentage it would have comprised if the protected investor had funded the company at the down-round valuation. A weighted ratchet adjusts the equity stake of the protected investor to the percentage it would have comprised if the follow-on funding was at the same valuation as the earlier funding round. Accordingly, a weighted ratchet will, by taking account of the amount of down-round funding, deliver the protected investor a smaller, but perhaps fairer, adjustment of its equity stake.

Another issue with follow-on funding in the present climate is the inability of many private equity funds to increase their equity stake beyond 50 per cent in any particular company without rendering the fund taxable as a company or potentially liable for insolvent trading of the investee. Liability for insolvent trading would arise if the investor qualifies as a holding company of the investee and is aware, or it is reasonable to expect it to be aware, of the insolvency. These adverse consequences may be overcome by spreading any particular investment across more than one commonly managed private equity fund.

Finally, it is also worth noting that founding shareholders in early stage companies in Australia are commonly entitled only to a proportional share of any remaining surplus on a trade sale or winding up of the company after private equity investors have been returned the amount paid on their investment plus, at times, a compounding annual rate of return. It is less common for founding shareholders to take second preference before sharing in any remaining surplus.

Management buy-outs

General overview

It has been a strong year for management buy-out activity, with several large scale buy-outs including the first public to private buy-out for nearly a decade.

With growing recognition of buy-outs as mainstream competitors to trade buyers, tender sale processes involving multiple private equity bidders, whether or not alongside trade buyers, are becoming increasingly common. In further recognition of a maturing market, vendors have in some instances retained a passive minority interest in the target, thereby benefiting the vendor with the potential upside which the buy-out may deliver on exit and benefiting the private equity investors by reducing the required amount of funding.

Another recent trend in the local buy-out industry is the sign of growth in the availability of mezzanine funding. Although the mezzanine debt market is immature by global standards, mezzanine debt is, where available locally, a relatively cheap source of finance when compared with more developed mezzanine debt markets. In particular, it is not usually accompanied by any form of equity kicker for the lender. Senior lenders do however typically require mezzanine debt to be deeply subordinated behind senior debt on terms which mezzanine lenders in more developed markets may find unacceptable. It is however expected that growth in the local market will lead to the adoption of more sophisticated intercreditor structures for multiple layers of debt funding in the buy-out area.

Public to private

The first public-to-private buy-out since the early 1990s has only recently been completed in Australia — the A$150m buy-out of the clothing retailer, Just Jeans Group, by funds managed by Catalyst Investment Managers and its UK parent, PPM Ventures.

The buy-out of the Just Jeans Group was by way of scheme of arrangement, a court-sanctioned and shareholder-approved arrangement between the target and its shareholders. The distinct advantages of proceeding by way of scheme of arrangement rather than a takeover bid were:

• the required threshold for shareholder approval is 50 per cent in number and 75 per cent in value of persons present and voting for each class of shares, whereas a takeover bid requires acceptance by holders of 90 per cent of the shares to entitle the bidder to compulsorily acquire any remaining minority interests; and
• it allowed greater flexibility with the form of purchase consideration — the target was able to implement a share buy back to return excess funds and dividend franking credits to shareholders on completion of the buy-out.

In an effort to curtail transaction cost risks in the event of the buy-out not proceeding:

• several incremental stages of due diligence were implemented to allow a series of indicative bids concluding with the final offer — this staggered approach to the due diligence and bid process enabled effective management of deal costs to correspond broadly with the degree of completion certainty; and
• it was agreed that the target would pay break fees to the private equity manager, comprising reimbursement of reasonable due diligence costs and compensation for time devoted to the transaction, if the transaction did not complete other than due to rejection of the scheme by the court or failure by the bidder to comply with the implementation agreement which set out the transaction process.

Break fees have been rare in Australia, amid uncertainty as to their legality, but have become increasingly common in the last couple of years. The break fees in the buy-out of the Just Jeans Group were in line with the draft policy statement issued subsequently by the Australian Takeovers Panel. The draft policy indicates the acceptability of break fees for the recovery of reasonable third party outgoings and reasonable internal costs. It considers up to 1 per cent of the bid value as being reasonable, but this will ultimately depend on the bid value. The Panel also indicated that target boards need to be convinced of the benefits to their shareholders before agreeing to any lock out. Such agreements are more likely to be acceptable if the lock out does not apply beyond the period reasonably required by the bidder to assess the target and prepare its offer.

The conflicts of interest facing directors of the target who participated in the buy-out were managed by delegating board decisions of the target to an independent committee comprising directors who were not participating in the buy-out and who were not associated with the major shareholder that instigated the transaction.

In addition, an independent adviser was appointed to report on the fairness of the offer, even though this would have only been required legally if there was an overlap between the boards of the bidder and the target or if the bidder already owned 30 per cent or more of the shares in the target. In practice, it is nonetheless advisable that an independent report be obtained to facilitate board recommendation of an offer and court approval of a scheme.

The buy-out of the Just Jeans Group received considerable media attention. It is hoped that it will foster a greater acceptance of the public-to-private route by boards of smaller listed companies and will in turn lead to increased buy-out activity in the public market.

Additional tax reform

Australia has moved to draw a clearer line between debt and equity interests to prevent the franking of interest payments that appear to be dividends and the tax deductibility of dividends that appear to be interest payments. These new rules have applied from July 1 2001.

The characterisation of an instrument as debt or equity has the following implications:

• whether distributions in respect of the instrument are frankable and the recipient is entitled to an inter-corporate dividend rebate or an imputation credit on receipt of the distribution;
• whether the distributions are tax-deductible to the payer;
• whether the distributions to non-residents are subject to withholding tax (and if so, at what rate); and
• what constitutes debt or equity for the purposes of the thin capitalization rules, which limit the tax-deductibility of interest payments by highly geared foreign-controlled entities and resident entities with foreign investments.

These new rules have the following implications for some commonly used private equity instruments:

• redeemable preference shares with fixed-rate dividends will typically qualify as debt, meaning that dividends cannot be franked but will, subject to specified limitations, be tax-deductible for the company;
• fully participating convertible preference shares will typically qualify as equity, thereby preserving the franking of dividends; and
• convertible loans will typically qualify as debt, meaning that interest will be taxable in the hands of the lenders and tax-deductible for the borrower.

© IFLR 2002

With kind permission of the IFLR. To subscribe to IFLR, or for further information, please contact Simon Oliver, Associate Publisher on 44 (0) 207 779 8496 or fax 44 (0) 207 779 8665 or email soliver@iflr.com

Freehills, MLC Centre Martin Place, Sydney, NSW 2000, Australia, 612 9225 5000
101 Collins Street, Melbourne, Victoria 3000, Australia, www.freehills.com.au