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http://www.theaustralian.com.au/business/buyers-back-on-the-prowl-in-private-equity/story-e6frg8zx-1225905106543

Buyers back on the prowl in private equity
From: The Australian August 14, 2010 12:00AM

THE proposed $2.7 billion buyout of private hospital owner Healthscope may be a turning point in private equity in Australian capital markets.

After several years of relative dormancy there has been a marked pick up in activity among financial sponsors.The Australian brought together five industry leading lights to discuss and debate the current environment.


Panelists

Robin Bishop global head of industrialsMacquarie Capital
Greg Clarke head of leveraged & acquisition finance Westpac Bank
Peter Cook partner Gilbert + Tobin
Greg Minton managing partner Archer Capital
Simon Moore managing director The Carlyle Group

From The Australian

Brett Clegg
Tracy Lee
Scott Murdoch


THE AUSTRALIAN: Can we start by asking Simon and Greg Minton to cast their minds back to 2007 and highlight some key differences that have occurred since that period in terms of the environment for private equity funds.

MOORE: One key change has been a far greater level of internal focus of effort to ensure businesses are performing as well as possible. The Global Financial Crisis was obviously a time that put lot of strain on a number of businesses and the focus really was rather than spending a lot of time trying to make new investments - it was hard to do them anyway as the banks wouldnt lend you the money and, candidly, you werent sure what you were buying in a lot of instances - the focus was much more what you did own, to survive and come out stronger from the experience. Change number two has been the availability of funds; both funds for ourselves as private equity investors and debt capital to assist in financing our transactions. The investors who support us dialled back their new exposures to private equity pretty significantly; in part because their existing proportional portfolio exposure was dialled up by the value of what else they owned in their portfolios going down in value by a greater amount in proportionate terms. At the same time, capital available in the form of debt shrunk dramatically from what had been the case in the more heady days. So you really had two things holding you back in terms of making new investments.


MINTON: I would agree with those thoughts. The other thing we thought about internally at Archer was that there was too much uncertainty to actually to want to invest. We didnt know how deep this global recession was going to be, so we were reluctant in that environment to put a lot of new capital to work. We consciously concentrated on our portfolio partly, because there was not much debt but also because, we were conscious of the equity risk and we must all remember that it is our Investors capital. If we went out and invested thinking it was going to be only a short dip an ended up being a multi-year disaster I think investors would be right to criticise us for being too head strong. We consciously stepped back and asked how bad is this going to be and concentrated on the money we already have out there invested for our LPs.

THE AUSTRALIAN: Were your own investors especially engaged through that period? Was there more dialogue, demands for information about how underlying assets were performing?

MINTON: There was a lot of concern about what sort of leverage levels people had in their portfolios. We went from being able to give quite high level information to being required to provide a lot more specificity about issues like the level of debt, covenants, and covenant headroom.

THE AUSTRALIAN: Simon mentioned the issues around funding and bank lending. If I could move next to Greg Clarke for his thoughts - obviously there was period when debt capital wasnt readily available for the reasons Simon pointed out. Lenders pulled in their horns; there was a lot of focus and attention on the retreat of many offshore players. How are lenders and your own shop Westpac engaged today?

CLARKE: The years 2008 and 2009 were marked by a lack of stability in the market, both in capital markets and economic conditions. As a result sponsors and banks spent most of their time focusing on their existing portfolios. We definitely saw a reduction in debt liquidity, most of which was through some of the investment banks and foreign lenders reducing the amount of liquidity for local LBOs and focusing on home markets. There also werent that many good assets available in the market, not ones that were, in our opinion, good enough to support a leveraged buyout in any event. There were still some mid-market deals done, but not ones that got much press and bank terms were reset at more sustainable levels. From the last calendar quarter of 2009, existing performing transactions and sponsors were able to obtain funding to do reasonably material acquisitions and find new banks to participate in syndicates. That was the first sign of liquidity coming back into the market. This calendar year we are starting to see new flow again. Transactions have not been of the same size or on as aggressive terms as we witnessed pre GFC but we are definitely seeing new deals getting done. As a general statement they have been harder and taken more time to complete but the market has supported these transactions. Weve seen some offshore banks return and started to see investment banks prepared to use their balance sheets again.

THE AUSTRALIAN: Robin what are your observations on how the terms have changed for lending, specifically the magnitude of up-front fees and the nature of covenants?

BISHOP: Obviously the terms across the board are significantly better than what they were two or three years ago. This is simply a reflection of supply and demand and as many of those offshore banks left town it strengthened the hand of the big four banks to set the terms. So the debt terms are relatively attractive to lenders at the moment. Its hard to be specific on leverage levels as there have not been that many assets traded to provide direct comparisons. The sort of leverage levels that were available in 2006 and 2007 were well north of what was available in prior years. Probably they wont be seen again until this generation of lenders has moved on and another generation has forgotten the financial crisis. The multiples were in the high single digits eight to nine times for businesses with relatively low capex. These leverage levels were very large for any business, low capex or high. And it wasnt just the leverage but also the covenants and arrangements that were very borrower friendly and the margins were very narrow. Its obviously moved quite significantly from these levels. I think on recent deals were moving back to something closer to where we were in 2004 and 2005.

CLARKE: Thats a key point. In a sense, all weve done is re-rate back to conditions prior to those peak years.

COOKE: Banks are showing a greater propensity to move on terms than they have in the most recent past. We aren't back to pre-GFC levels but if you are a sponsor things are heading in the right direction. Some key differences are leverage rations are maxing out at 4 times earnings and up-fronts and margins are higher. Things like equity cures, debt buy backs there remains some resistance but we are seeing some potential life in the sub debt market again. Terms of syndication compared to levels of a few years ago remains hard with Sponsors looking to club deals upfront to avoid interest rate flex risk.

MINTON: In Australia there was only one really covenant-lite deal and that was Qantas. We didnt really experience those kinds of deals. It was all very nice hearing about it.

CLARKE: A fundamental difference in the market here is that its still a very bank driven market. Its the banks that provide most of the debt capital. In offshore markets prices got where they were because the banks werent holding the paper, they were distributing it out to other parties. Covenants have not really changed. Its just the levels at which theyre set and how they are defined that have changed.

MINTON: Today we can borrow at three-and-a-half times EBITDA as senior debt compared to being able to borrow at five times EBITDA prior to the GFC. The cost of that debt hasnt really changed. The base rate has gone down and the margin has gone up. Debt is still much cheaper than equity, so if we pay a bit more, for example, at four or four-and-a-half times and then not put that marginal turn of equity, we will be generating a higher return on our equity invested. The multiples of EBITDA at which you can borrow today are not that different than what they were at the end of 2001, 2002 following the dot-com crash.

THE AUSTRALIAN: Whats the biggest lesson that came through from the GFC?

MINTON: Well, put simply, you need to have a model other than just relying on leverage. You need to improve the operational performance of the business to drive returns. The industry as a whole has come to that realisation. I remember having a conversation with one lender where I asked why I could borrow at five times EBITDA on one asset and the same on another when one had half the capex requirement. I couldnt understand why theyre the same? The capital requirements of a business - and what had to be done to it - wasnt always taken into account in establishing the debt package. Things are much different now.

THE AUSTRALIAN: Simon, Carlyle alongside TPG Capital was part of the proposed takeover of Healthscope. Were you surprised the funding was there to back the purchase?

MOORE: I think one of the interesting things has been the evolution of the market over the last two years. We were probably past the high point when we did the buyout of Coates Hire in partnership with Kerry Stokes Australian Capital Equity but we managed to have a $2bn senior facility there across 27 banks. Then as you evolved through the darkest days of the GFC there was probably an ability to put together maybe $300m to $400m of senior debt for a transaction. We probably bottomed out at about a $300m senior facility in the final quarter of calendar 2008 and first half of calendar 2009. Since then you have seen the market gradually evolve its way back. The Healthscope deal involved a fairly unique set of defensive assets that gave people comfort to lend against - both a very steady business and a very significant portfolio of high quality property. So if there was a chance to test the lending capacity of the bank market today for a leverage loan this transaction was probably it. We have ended up with a funded senior debt piece facility of $1.2bn and Westpac have agreed to provide a securitization facility of about $140m. At that level, we were oversubscribed. If the business had been generating more EBITDA then we possibly could have raised more senior debt. The trade-off is that it would be hard to see a larger more defensive business to acquire so at the moment somewhere between $1.2 to $1.4bn is probably the high watermark for a leveraged loan on the senior side.

CLARKE: Theres probably not going to many businesses with such a strong profile from a lenders perspective. As a result individual banks provided higher than normal commitments levels and Carlyle and TPG were able to secure a very good hit rate with the banks that were approached.

MINTON: Was being significantly asset-backed a factor also? That was a real differential weve seen on a couple of deals. Those that were more heavily asset-backed got more support. In MYOB were there was no assets but good cash flow we could only get $230m or $240m at 3.5 times EBITDA.

BISHOP: Its not so much the asset backing but more the defensive nature of the business. If Healthscope was a different sort of business with exposure to, say, consumer spending, then Im not sure it would have been so well supported. Unfortunately people are going to get sick and visit hospitals regardless of where the economy goes, so from that perspective, it is a good credit.

CLARKE: All the banks have enjoyed good relationships in the healthcare sector. Robin is right. Its a combination of a defensive industry, a defensive cash flow, the support of the property, good underlying growth dynamics and high quality sponsors.

BISHOP: I think the other aspect worth considering is that the senior facility was effectively fully syndicated before the final bid was submitted. Just before. Rather than being underwritten by three, four or five banks and syndicated after the event, there were some 17 banks or so engaged during the bidding process. Its extraordinary really.

THE AUSTRALIAN: But upfront fees have surely been ratcheted up as one example of a tougher lending environment.

MOORE: There will be the lenders amongst us here and the borrowers. Wed say that if you have a five year facility and someone charges you four and a quarter upfront, you may as well divide five by four and a quarter and add it to the spread. You really are looking at five and a half over bank bills for a loan against a very defensive asset - the banks voted with their cheque books so thats reflective of market today.


CLARKE: Theres no doubt that bank funding costs are higher and this is being passed onto corporate Australia. And there is also no doubt internally at most of the banks you have to go through a process of getting capital approved, as well as getting the actual credit risk approved. The price of risk has been re-rated across every sector. It doesnt matter if its investment or non investment grade lending the higher combination of fees and margins reflects market reality today.

THE AUSTRALIAN: Where are activity levels likely to be in the coming six to 12 months given the positives from Healthscope but the negatives that came out of the Myer tax dispute?

COOKE: For the right assets lenders are more prepared to step up but equally the sponsors are needing to put more equity on the table. In terms of leverage the market is a quite away from the 2006 leverage levels. I think deal activity and potential is patchy in the short term. That being said you are seeing a reasonable level of deal interest in particular in the recycling of assets to secondary private equity ownership and we will probably see more of that. The IPO market for private equity at the moment is dead but as we have seen in previous market closures sentiment can turn quickly. We should not forget there are a lot of funds both globally and local who have a lot of money and there is some pressure to use although they will be patient. I would also add that to me even when there is an a good opportunity execution just seems harder and deals are taking more time to get announced. The tax issues arising of the Myer float created a lot of uncertainty initially but I think the industry is getting their heads around it. The government's MIT reforms and the consultative approach the government is taking on the taxing of private equity funds on capital account hopefully will lead to the right outcome for all concerned. Nevertheless this issue coupled with the mining tax did heighten nervousness generally about Australia as an investment destination and concerns still remain.

MOORE: I think there is a pathway to resolution that has been mapped out but there is still uncertainty. The ATO is yet to provide its final determinations as to how it is interpreting some fairly key provisions of the Tax Act. The federal government is in hiatus awaiting the outcome of the election. Until those two circumstances change you continue to have uncertainty. We have always taken a view that the tax uncertainty does not drive a binary view on whether to invest in Australia. Its a risk-return thing. So when we talk about it with our international colleagues and investment committee; it is more a question of, well, what does it mean for your net returns? That is what our investors are interested in. If the answer is you are not really sure what the net return is going to be because of the uncertainty in relation to tax, you have to take a worst-case scenario as to what the tax outcome will be. Our investment committee is facing a global opportunity set and trying to allocate capital on that basis. So they are saying that on a risk-adjusted net return basis here is where Australia is going to plot, whereas in the past it was seen as somewhere better. Its relative attractiveness to other jurisdictions has reduced. But that said, tax globally is a moving feast so Australia is one country that has potentially had some significant changes to tax laws and their interpretation, be it mining tax-related or for private equity tax-related. But as you look around the world, there has been some significant changes happening in the United States, the UK and Europe. You can not really view taxes as static. You would like it to be but to the extent that taxes are not, they are a risk factor. Weve demonstrated that were willing to factor that tax risk into our assessment of opportunities in Australia, and if they still stack up then we are happy to invest.

MINTON: CHAMP has closed its recent fund at something like $1.4bn so international investors have voted with their money. Theyve stayed in, which I believe also reflects the strength of CHAMPS performance. It took them a long time to close the fund, in large part due to the tax uncertainty, but once that was substantially resolved, investors have formed a view that it will be fully resolved in a satisfactory manner.. We havent had any investors wanting to withdraw from our funds because of tax.

COOK: They certainlywanted to hear about an assessment of what the impacts were. And hear the thoughts of the private equity funds. They were modeling the various scenarios.

THE AUSTRALIAN: Another theme that you mentioned earlier Peter was secondary sales such as that of Study Group. Is it simply because of the dire state of the IPO market?

BISHOP: I think it partly reflects the health of the IPO market. Its been a poor year for floats. Recently, the float of Bilfinger Berger Australia was deferred. And that was a very high quality business, sensibly priced, well-appreciated by investors, but at the time of pricing the market was very volatile and reasonably the parent wasnt prepared to sell at the price that was required to clear the book. So, in todays volatile market, people are increasingly recognizing that an IPO is a time-consuming, expensive and uncertain process. But it also reflects the fact that selling a business via a trade sale has not been as uncertain and is also less public. This is not just a reflection of the fact that other private equity firms have wanted to look at assets; theres also been very good trade interest. I think people sometimes take a view that its a bit odd for one private equity firm to sell to one another private equity firm, whereas its quite a natural thing. It is no more unusual than one investor on the stock market selling to another stock market investor. Investors have different views on value, different time horizons and business plans. Notwithstanding a degree of negative sentiment towards secondary sales, they will continue to happen. A meaningful portion of the assets currently held by private equity firms will be sold to another private equity firm that sees value, sees an opportunity to invest in the business and to take it to the next stage of its development.

MINTON: The other factor is management. Theyre a stakeholder, a shareholder. They are trading off going through the grief of being publicly listed with going again with a different Private Equity Investor. Many are asking if they can go and find another private equity buyer that might back my team for the next five years? So the secondary market is also being driven by by many management teams saying they enjoy this environment. It seems much more user-friendly than the public market.

BISHOP: I think the issue of one private equity firm selling to another private equity firm says more about the issues associated with the listed market than it does about the private equity market. The listed market will be thinking of how it can ensure it get quality businesses on our exchange. Listed companies come under tremendous public scrutiny, personalization of management, media reviewing every step they take. Whereas if youre a manager working for a business owned by private equity, the focus can be on the business to a greater extent. How much time would a CEO of a listed company spend talking to investors, dealing with media, etc? Its enormous.

CLARKE: As a lender we like the secondary buy-out story because its a company thats lived with a leveraged finance debt structure and the focus on cash flow that this requires. Management is used to the demands.

THE AUSTRALIAN: Theres talk about re-rating of risk, but have vendors checked their expectations given the weaker conditions?

BISHOP: Vendors, as a broad generalization, have retained high price expectations notwithstanding the financial crisis. And actually those expectations have more often than not been met. When those expectations havent been met, vendors havent been prepared to sell. People have been happy to hold their assets, theyve gone through the difficult period of the financial crisis, the businesses have performed through that tough environment and they are prepared to hold onto them unless they get full value. Vendors have deferred selling below full value. And when they have sold, the businesses have tended to go for compelling prices. Loscam was a good example of that. It sold for a good price. Surprisingly, more often than not, people havent been under pressure to sell. There have been few distressed sales of quality assets. At the start of the financial crisis, many thought thered be bargains coming out of this period. But there have not been many at all. Even in cases where assets have ended up in the hands of banks, the banking syndicates have been methodical about ensuring they achieved full prices. The risk is that corporates are looking for these one-off opportunities to buy assets from of distressed vendors at bargain prices. So theres been a bit of a vendor-buyer mismatch. This has been filled in part by offshore buyers, and in part by private equity funds that have recognized there are few bargains out there.

COOK: The only thing I would add is that there are quite a few private equity firms who have been holding onto assets for a quite awhile now and are probably at the end of their normal 4 to 5 year hold period and looking to turn them over. They won't sell at any price but certainly there has been an increase in the last few months of firms seeing more potential value and beginning processes or preparing for processes.

THE AUSTRALIAN: What about deals that are underwater? How are existing lenders responding where covenants have been breached?

COOK: There is no doubt there are deals that are or have been underwater some for a long time where covenants have been tripped and the equity is in serious question. There has however been very few instances where the keys have been passed back to the lenders and some might say this is what should have been done more although reputation for a PE firm is a key factor. I think one of the features of the Australian market in the last few years is how the sponsors and the banks have co-operated and been pragmatic and kept their issues behind closed doors(by revising the terms consistent with where businesses were actually trading, converting debt to equity and the like) rather than appointing a receiver or the like. You often hear the phrase for Private Equity that it is patient capital but the banks also deserve credit on the patience side. The consequences of the high leveraged lending before the GFC and subsequent consequences of the GFC(particularly on foreign lenders in this market) and economic downturn could if lenders were trigger happy led to an early 1990's style run of receiver led sales with major consequences for the Australian market and confidence in the economy. Some would say lenders had no alternative as there really was no place to sell. That may be right and with more appetite for M&A and businesses turning around with the right revised debt structures we may see more bank led sales as the universe of buyers increases.

THE AUSTRALIAN: What are we seeing in terms of multinationals? Are they reviewing assets, looking at hive off local divisions?

BISHOP: At the margin, yes. But I dont think were going to see a big wave of that. I think the Bilfinger Berger Australia example is a good one. People do want to optimize their portfolio and they need to know they can do it. Private equity is there, strategic buyers are around but the listed market has proved to be somewhat unreliable.

MINTON: If ever a multinational was going to pull its money out of Australia, with an exchange rate of US92 cents, nows the time to do it.

MOORE: There is a confidence now that we are seeing private equity firms buy assets. There was a period of time when people were skeptical whether we were open for business; especially with people coming out of foreign markets where the state of the general economy and resulting activity levels are a lot sicker. European corporates in particular have been quite wary frequently their response has been is this opportunity to sell real? If I start this process, will it go anywhere? I think now we have seen a few transactions, multinationals are willing to contemplate starting asset sale processes. That said, normally you need a catalyst back at headquarters before a sale will be contemplated.

THE AUSTRALIAN: Would you ever approach on an unsolicited basis for a portfolio asset?

MOORE: Im sure Greg and I spend a fair bit of time wandering around trying to talk to people about selling their Australian assets - sometimes with the encouragement of the local management team. That is part of the game. You look at how the parent company is traveling, you look at where their Australian operations are, and you look at the currency. There are points in time when the three line up and there is an opportunity more often than not there is not. Ironically, part of the problem is that the translated earnings of the Australian business have become far more meaningful to the parent company in the last few years than they have been previously. And so while the parent may receive a meaningful amount of capital back, the offsetting challenge is what will the next quarterly earnings number look like? If I sell Australia, I will have a big chunk of change but Ive got a bit of a problem when it comes to reporting.

COOKE: And boards are reluctant once they receive an approach to engage with just one party. Proprietary deals are pretty difficult. They tend to throw it open to a wider field if they think it is a good idea.

THE AUSTRALIAN: Whatare the factors in considering who you partner with in making a consortium investment?

MINTON: For us its historically been that weve worked with the firm before, and that we-like-minded in our approach to managing the investment? We need to agree on the investment thesis. The main reason we team up is is the size of the equity cheque required. There are prudential limits in our Funds that limit the amount of equity that we can write for an investment. So we often need a partner and they are either one of our competitors or a subset of our Limited Partner base, our Investors.Also, its got to be a meaningful cheque for them. Id love to do something with Simon but hes has such a big fund compared to ours, its just not a relevant investment for him.

MOORE: Similarly, its got to be a good fit both in terms of the individuals on the ground here and institutionally. I think it is the same with the Australian guys as well, each firm has its own culture and the industries they like - and the ones they dont. So you will tend to gravitate towards those you know will be interested in like assets or industry spaces. At Carlyle, we have tended not do things like alcohol and casinos so if you are looking to do anything in those spaces it is unlikely you would come talking to Carlyle. Intuitively, we dont leap off the page. However, other industries we have a deep background in we stand out as a logical partner.