PRINT THIS PAGE

LBOs past and present

While private equity is still a relatively young market in Australia, the leveraged buy-out has been conducted there since the mid-1980s. They have not, argues Andrew Rothery of GS Private Equity, yet reached the levels that were predicted for it in previous years: but the recently-finalised tax reforms brought in by the Australian government at the end of 2002 are likely to increase LBO firms' access to capital from overseas investors. This will encourage a more rapid growth.

The enactment on 19 December 2002 of legislation designed to remove Australian tax hurdles impeding the flow of private equity capital into Australia marked an important inflexion point in the development of the Australian private equity industry.  It also provides a prompt to ask about where the Australian industry has been and where it is likely to head.  In this article I won't attempt to answer that question for the whole of the Australian industry but, rather, focus on the segment I know best, leveraged buyouts (LBOs).

Past

The Australian LBO market can trace its beginnings to the privatisation of the Packer family's listed vehicle, Consolidated Press Holdings, in 1984. Although the deal wasn't labelled LBO or “public to private” the reality is that that's what it was.  The Packers used a significant amount of bank debt to make a takeover offer for their listed holding company, Consolidated Press Holdings (“CPH”), and that debt was serviced from the operating cashflows of CPH.  Observers of the CPH deal applied the transaction blueprint to a small number of other deals in the following years and in 1986 Australia's first dedicated buyout firm, the Byvest Management Buyout Group, was formed.  Within the next two years Byvest had a small number of competitors including DBSM Capital Partners and Citicorp Capital Investors Australia.  At that time it looked as though the Australian LBO industry was about to take off.

Unfortunately, that period proved to be a false dawn as a result of the devastating impact of the recession and record high interest rates in Australia at the start of the 1990s augmented by the particular financial problems suffered by the State of Victoria.  All but one of the LBO firms, Byvest, fell by the wayside as their portfolios were decimated and/or head office decided to withdraw from the country.

It took another five or so years for the local institutional investors to finish licking their wounds and to venture back into LBO funds.  The second half of the 1990s saw several new LBO firms emerge (including the successor to Byvest, GS Private Equity) with the result that there are now some six or so dedicated LBO firms operating in the Australian marketplace.  By my reckoning, the period 1997 to 2001 saw the total capital committed to local LBO firms rise from about A$350m to $3bn.  Added to the warchests of local LBO firms are the capital commitments of offshore LBO firms, which are an increasingly frequent feature of the Australian M&A landscape.  CVC Capital Partners (via their regional affiliate, CVC Asia Pacific), The Carlyle Group, KKR, Hellman & Friedman and several other leading LBO firms have either made investments in Australia or have reviewed Australian investment opportunities.  New York's Castle Harlan has established a joint venture with a local private equity firm, Australian Mezzanine Partners, thus generating the marvellous acronym, CHAMP. And the UK's PPM Ventures owns a local LBO firm, Catalyst Investment Managers.

This significant increase in the supply of capital was matched on the demand side in calendar 2001 with a record year for Australian LBOs.  Over A$2bn of LBOs were done in that year.  The break-up of the listed conglomerate, Pacific Dunlop, provided two high profile deals in 2001: the A$730m buyout of Pacific Brands led by CVC Capital Partners and the A$250m buyout of the automotive parts distributor, Repco, co-led by GS Private Equity and Gresham Private Equity.

Present

While calendar 2002 did not match the prior year for activity, it still saw some A$700m of buyouts completed in Australia, albeit with a much reduced average deal size.  That said, there is no denying that 2002 was a quiet year in Australia for the large LBO practitioners.  And for those players, 2003 has started where 2002 left off: quietly, with no compelling sign of an immediate upturn in dealflow. 

I believe there are several factors keeping dealflow slow.  First, the overwhelmingly negative sentiment of the public equity markets is ossifying corporate M&A activity.  Listed companies see ‘business as usual' combined with keeping a low profile (ie, keeping their noses clean) as the best way of managing their shareholders and equity markets.  Now is not the time for surprises.  Second, unlike the US, the real economy in Australia is still very strong.  This combined with low gearing and low interest rates means that very few corporations are facing financial pressure sufficient to cause them to divest businesses.  Finally, private owners of businesses thinking of selling still have unrealistic price expectations (perhaps as part of the ‘dotcom' hangover).

These factors are cyclical and, as anyone who has been in the LBO business for a reasonable period of time will attest, dealflow always tends to be lumpy.  Further, Australian subsidiaries of groups that have hit the wall in the US and Europe and the continuing break-up of local conglomerates will inevitably see dealflow pick up again.

A number of other positive factors remain in place in the local market.  Banks remain keen to lend.  Senior debt of 3.5 to 4.25 times trailing EBITDA is not uncommon in Australian buyouts with a further 1.0 times EBITDA of mezzanine debt frequently available.  And deal pricing has, by and large, remained at sensible levels.  Recent transactions suggest that 5.0 to 6.0 times trailing EBITDA is still the applicable benchmark for pricing most industrial deals.  As you can see from these numbers, Australian LBO firms have been able to employ gearing levels well in excess of those achieved in North America and Europe in recent years.

So where are the local LBO firms in their life cycles?  Most of the leading local players have set their second funds going and are starting to make inroads into the realisation of the investments in their first funds.  Only a couple of local LBO funds have gone the full distance with the returns from those completed funds being more than satisfactory in the eyes of the investors involved.  The onus on local LBO firms is therefore very much about demonstrating that, not only can they put money out the door, but they can secure profitable exits.  Third funds will not be raised until exit track records have been established.

There is also a strategic dimension in the life cycle of LBO firms.  Here Australian LBO firms have enjoyed the luxury of being able to observe their international counterparts most of whom are located further along their strategic life cycles.  They have seen major LBO players in offshore markets evolve away from simply arbitraging the costs of debt and equity via gearing up investees.  While leverage is still an important component of returns from local deals, Australian LBO firms now emulate leading firms in the US and Europe insofar as they strive to demonstrate:

• expertise flowing from focus (on target industries, transaction sizes, etc);
  
  
• abilities to drive the rationalization of industries; and
  
  
• value adding capabilities in operational areas.

Having said all that, there is no denying that Australian LBO activity has not yet reached the heights expected of it.  Why?  And will this situation change?

There are three main reasons why the industry has not yet met activity level expectations.  First, it was only in the late 1990s that local investors equipped local LBO firms with the capital they needed to complete the deals that were on offer.  Second, it was only then that offshore players started to make their presence felt, albeit sporadically.  Third, we have not seen the feedback loop of ‘success breeding success' in operation.  There simply hasn't been enough in the way of well-publicized successful exits to capture the attention of people who can influence dealflow, in particular, managers of prospective LBO targets.

None of the reasons listed above is a permanent impediment to heightened LBO activity levels, so there is still cause for optimism.  Intelligence suggests that there is a significant number of LBOs done in the last five or so years that have been traveling well and have excellent exit prospects.  Success will breed success sooner rather than later.  In addition, local LBO firms have better access to foreign private equity capital as a result of the new tax laws effected in December last year.

Future

So let me conclude by discussing briefly those new tax laws.  In response to lobbying from local private equity firms the federal government enacted new tax legislation designed to remove a major hurdle to the inflow of foreign private equity capital into Australia.  Until December last year the biggest pool of private equity capital in the world, the tax exempt endowment and pension funds of the US, faced the prospect of paying Australian capital gains tax on investment profits made in Australia.  This meant that Australia was out of step with other developed economies that had effectively recognized the tax exempt status of those funds and certain institutional investors from other countries.  The new legislation creates a new investing vehicle, the Venture Capital Limited Partnership (“VCLP”), and provides an exemption from Australian tax on profits from Eligible Venture Capital Investments made by a VCLP to the partners in that VCLP who are:

• tax exempt residents from Canada, France, Germany, Japan, the UK and the US;
  
  
• venture capital funds of funds established and managed in those same jurisdictions; and
  
  
• taxable residents of Canada, Finland, France, Germany, Italy, Japan, the Netherlands (excluding the Netherlands Antilles), New Zealand, Norway, Sweden, Taiwan, the UK and the US who hold less than 10 per cent of the committed of the VCLP.

The same exemption is provided to those same categories of investors in another new vehicle, the Australian Fund of Funds (“AFOF”), provided the only investments of the AFOF are investments in VCLPs or co-investments alongside those VCLPs. In addition, the AFOF must be formed in Australia and its general partners must be Australian residents.

To qualify as an Eligible Venture Capital Investment (“EVCI”) the investment must satisfy all of the following tests:

• It must be an ‘at risk' investment in shares, or options over shares, in an unlisted Australian resident company or a listed Australian company that delists within a year of the initial investment.
  
  
• The company must have 50 per cent or more of its employees and assets situated in Australia for at least a year following the initial investment.
  
  
• The company's gross assets must not exceed A$250m immediately before the initial investment.
  
  
• The primary activity of the company must not be property development, land ownership, finance, insurance, infrastructure construction or acquisition, or passive investment (ie, investment generating interest, rents, dividends, royalties, lease payments).

For the local LBO firms seeking to attract foreign capital and focusing on larger deals, the A$250m size cap is an annoyance.  It is to be hoped that this cap will either be scrapped or significantly increased before too long.

There has been much ‘hype' associated with this new tax regime.  In the same breath as statements made about “leveling the playing field” some people in and around the industry have made noises about an expected torrent of foreign private equity capital into Australia.  The reality is, I suggest, otherwise.  The new tax laws have certainly removed an impediment to the free flow of private equity capital into Australia, but they will not of themselves cause the floodgates to be opened.  Offshore investors will apply the same tests to, and make the same due diligence enquiries into, investment opportunities in Australian private equity funds and Australian businesses that they apply or make in the case of investment opportunities elsewhere in the world.  If the opportunity is deserving of an injection of foreign capital that capital will flow accordingly, but investors will ensure that the supply of capital does not grossly exceed the demand for that capital (at least in the long run).  Rather than opening the floodgates, the new legislation has unlocked the door.  Nevertheless, local LBO firms now have a better chance than they have ever had of tapping into foreign pools of private equity capital.  This is an important development in the context of an economy whose local pool of such capital is quite limited.

Regardless of the precise impact of the new tax rules, there is likely to be some thinning out of the ranks of local LBO firms.  To date, local investors have placed their bets on local LBO firms quite widely.  The next round of fundraising is likely to see local investors being more discriminating in their decisions regarding recipients of capital commitments.  Foreign investors will no take their cues from the local investors.  The result should be a smaller number of better-capitalized local LBO firms.

But those who survive in the ranks of local LBO firms have every reason to be optimistic.

Copyright © 2003 Andrew Rothery

GS Private Equity is one of Australia's leading private equity investment houses with $295 million in funds under management and the longest track record of any leveraged buyout manager in Australia. For further information please visit www.gsprivateequity.com.au.

Andrew Rothery is a pioneer of the MBO market in Australia, an experienced company director, and a management consultant and lawyer by professional background.