Business buccaneers

Who could have missed it?

Australia is looming large in the sights of the world’s private equity investors. In the view of big international firms with very deep pockets, it is the lucky country.

Some of our greatest corporate icons – retailer Coles Group and national carrier Qantas to name just two – are targets for private-equity-style makeovers. On 14 December, as INTHEBLACK went to press, Qantas chair Margaret Jackson announced that following detailed negotiations, the board had received a revised proposal from Airline Partners Australia to acquire the company.

Other big names have already succumbed to advances. Publishing, television and gambling empire magnate James Packer is now sharing ownership of PBL’s media assets with the purportedly sharper minds and nimbler business acumen of the team at CVC Asia Pacific.

TV tycoon Kerry Stokes and his new cohorts from US private equity firm Kohlberg, Kravis and Roberts & Co (KKR) embraced a joint venture, the Seven Media Group (valued at $4bn), to pursue media opportunities.

After facing up to the challenges of being a publicly listed travel business, Flight Centre’s founder and Chief Executive Officer (CEO) Graham 'Skroo' Turner and partners determined that five years away from the public gaze presented a better scenario for a high-flying future. They subsequently inked a $1.6bn deal with Pacific Equity Partners.

These headline deals, fuelled by abundant credit, conservative balance sheets and the ready availability of capital, particularly from super funds, are just the tip of the iceberg. This year has also seen private equity players make successful moves on retailer Myer, Brambles’ Cleanaway business and the Colorado Group.

According to the Reserve Bank’s November monetary statement, top-end leveraged buyout activity by private equity firms has leapt to $13bn in 2006, compared to an average $1.5bn in the previous five years.

Along the way, the perpetrators, private equity firms here and abroad, have been portrayed as avaricious predators. 'Locusts or barbarians', claimed recent reports. Investment maestro Warren Buffett calls them 'deal flippers'. In a back-handed compliment, company director Linda Nicholls likens private equity players to pirates. Once viewed as fringe elements, the ocean-going pirates eventually became an organised force that threatened to 'sink' the big shipping businesses, Nicholls says, before explaining that investors ultimately would benefit from private equity deals because they provide a 'phenomenal shot in the arm' to lazy, complacent and inefficient publicly listed companies.

Clearly, there’s confusion over what exactly private equity is and does. Is it good, bad or just plain business common sense? If nothing else, the recent activity has increased awareness, opened the minds of potential targets and piqued investors’ appetites for far-better-than-average rates of return – sometimes upward of 30 per cent.

It’s also raised many questions. Should managers shudder at the approach, either formally (or the increasingly common informal tilt) of private equity firms whose efforts are becoming more innovative and determined? What’s the etiquette of the mating dance between private equity and business? After Coles Myer directors failed to inform shareholders they had received an offer before it was rebuffed, ASIC formed a business consultative panel to consider correct procedure.

By its nature, private equity is unregulated. Murmurs, though, have come from European central bankers concerned about irresponsible investing, mooting the possibility of imposing rules. The US Justice Department has also been asking questions about collusion. Comparatively clandestine, private equity players (like investment bankers) operate in a highly competitive market, where today’s partner may be tomorrow’s competitor. Although private equity firms report to investors and creditors, their modus operandi can seem covert.

Yet despite the current focus, private equity deals are not new. Australia is simply trailing three to five years behind Europe and the US. About 18 per cent of Australian merger and acquisition activity involves private equity, compared with Europe’s 37 per cent.

In 1999 Australia’s first public-to-private transaction occurred, combining the well-known retailer Just Jeans with Portmans and successful street brands Mooks and Stussy, and providing an elegant exit from a family business. By then, some 300 such deals had already occurred in Europe. 'One of the key factors that stimulated private equity in Europe in the late 80s were the headlines that showed significant returns to management teams,' observes Peter Dunne, a private equity specialist at law firm Freehills, which has been involved in a substantial number of Australia’s private equity deals. 'All of a sudden management saw private equity as a viable option. This will be an important factor for Australia going forward.'

Leveraged buyouts have been around predominantly since the mid-80s. Yet some pioneers of the local industry, such as CHAMP Private Equity’s chairman Bill Ferris, were putting together deals even a decade earlier. A sign the Australian market was truly running hot was the fundraising for the CHAMP II fund in August, 2005, which closed just short of a billion dollars but was oversubscribed by eager investors from Europe and Asia to the tune of $2.5bn.

Under the traditional model, private equity firms raise funds from third parties – institutional investors, superannuation funds and wealthy individuals – and seek out established, often quite mature companies whose operations can be substantially improved. Then, using a combination of capital and debt, they aim to build greater efficiencies and higher profits into the business.

In order to do this without needing to bother about the demands of stock exchange compliance and short-term reporting, public companies are often privatised. While public company investors push for immediate results and dividend yield, private equity investors focus on longer-term growth. Ultimately, it’s argued, they are making businesses (and the economy) healthier.

Turner admitted a primary motivation for Flight Centre’s buyout was the short-termism of the sharemarket and the damage this was doing to his business. While he wants to plan and manage for the next five years, analysts and fund managers were focused on quarterly, half-yearly and annual performance.

The timeframe for a return from private equity is typically about five years, although it may be shorter or longer, and always built into the process is a finite time to exit. It may be by a trade sale or IPO or, increasingly common in the new, more sophisticated climate, a secondary buyout by another private equity player who can take the business on to another stage.

A crucial part of this process is keeping key managers involved by ensuring they have a financial stake in the business. 'It doesn’t suit private equity firms to have the knowledge going out of the business,' says the head of KPMG’s private equity division, Ian Knight CPA. 'They don’t want to run these businesses. They want to direct them.' Ferris concurs. 'There’s no greater fertiliser,' he says, 'than the footprint of the proprietor.'

Arrangements with management are embedded in shareholder agreements, which set out the day-to-day ground rules for how a company is managed, as well as the reporting requirements. By necessity, says Freehills partner Mark Rigotti, 'It is collegiate, with both parties, management and the investor working towards a common goal: improving the value for all investors. And some of those investors happen to be managers.'

When the private equity investors reap their returns on exit, the managers also realise their investment. Ultimately, the private equity firm controls the disposal realisation process, and part of this may involve using 'drag along' clauses in contracts to keep the managers in tow. Recalcitrant or poorly performing managers may be replaced along the way. Now rapidly emerging in Australia is a new management class of high-performing individuals capable of meeting the demands of a business turnaround.

A benefit of having private equity partners making the strategic decisions in a business, Andrew Cummins, chairman of CVC Asia Pacific’s advisory board, said in a recent speech, is their ability to act 'without emotion'. In 2004, Paul Moore, CEO of Pacific Brands, candidly described the company’s private equity transformation from being part of a cash-strapped conglomerate (Pacific Dunlop) as a 'rude awakening'. He was given the freedom to perform a corporate makeover unifying a decentralised management and streamlining operations to take advantage of Pacific Brands’ scale.

There were eight months of scrutiny by external accountants and consultants sent in by CVC Asia Pacific and Catalyst Investment Managers during the pre-sale due-diligence process. But in the early days of private equity ownership, Moore reported urgent calls from investors 'going bananas'. All worth the angst, it seems. In April, 2004, the company’s oversubscribed IPO raised $1.252bn and made history as Australia’s largest private equity to public IPO.

Australia has seen some spectacular results. LookSmart, the search engine bought for $2m, turned into $200m in the hands of private equity players. The cable TV company Austar is a standout, remaining publicly listed while CHAMP helped it to clean up its act over three years, and in the process turned an $82m investment into a $557m stake in the company. Between its purchase and sale, the annual rate of return exceeded 100 per cent over three years.

Arguably, what the international megadeals have done is highlight the Australian private equity industry effectively coming of age. It’s now a first option for intermediaries – the brokers and investment banks – when advising their clients about assets. Up until 2000, when venture capital focused on early-stage investments and had some spectacular dot.com stories to tell, private equity was a tangential third, behind IPOs and trade sales. Following the tech meltdown, investors began shifting their sights.

What’s changed is the size and sophistication of the deals, and that seemingly no target is seen as untouchable. International consortia are zooming in on Australia’s strong economy, the outstanding returns reaped by some local players, and a solid working infrastructure of accountants, lawyers, bankers and intermediaries who can support their bids and operations.

Australian corporate governance structures also work with a degree of familiarity for European and US players. 'A further significant change is the ability of private equity to play in the publicly listed arena,' insists KPMG’s Knight. But the market needs to be put into perspective, he says. Although the excitement has been around multi-billion dollar deals, what lies beneath are many smaller transactions that don’t involve public companies. 'Private equity is playing an excellent role in acquiring many of the private companies looking for new owners as the baby boomer business owners move on,' Knight says. 'And we might ask: Who else is going to buy them?'.

It’s the level of debt built into the deals that is causing consternation, and predictions of tears and nasty shocks from the chief executives of two banks, NAB and Westpac. 'Going back two or three years, a debt level of three to three and a half times EBITDA was considered robust and sensible,' notes Ferris. 'Today, people consider twice that to be robust and achievable.'

The PBL Media deal was priced at close to 12 times cash-flow, while the KKR Seven Media price was just short of 13 times cash-flow, 'There’s a willingness by the debt providers to provide a very attractive gearing, and a willingness to actually back a hostile takeover – and that’s where there’s a drastic change,' says KPMG’s Knight. Citing an example, he points to Affinity Equity Partners’ successful hostile $450m takeover of the troubled clothing and footwear retailer Colorado Group after three months of talking failed to deliver a deal last year.

It’s not only the levels of debt that have changed, but also the way debt is structured. Once it was a senior debt package, but now it will have a subordinated layer and a retail note attached.

Ferris disagrees with warnings that the collapse of a big private equity fund could rock the whole economy. Yet in view of the banks’ current willingness to lend, he says the onus is on private equity firms to self-regulate and use their judgement not to go too far. He quotes his long-term partner, Joe Skrynski, who advises younger private equity managers – who have not experienced long-term economic cycles – that they must now 'act as their own credit committees'.

Concern also surrounds the ownership of companies moving from public to private hands. But Knight points out that after closer inspection, predominantly they have the same owners. Many private equity investors are superannuation funds. About 5 per cent of institutional investors funds are going into the 'alternative asset class', of which private equity is the principal recipient. So it’s either ownership through mums and dads directly as listed company shareholders, or through their super funds.

Recent research conducted for CPA Australia on why superannuation funds had not taken greater advantage of private equity’s high returns, showed concerns over the level of competition between private equity funds for quality deals in the market. Researchers Sacha Vidler and Nick Coates say there was often a concern that private equity could be a victim of its own success. There is too much money chasing too few deals.

Other deterrents were found to be the low level of liquidity and the long maturity of private equity investments, with superannuation funds being put off by having to leave money in private equity for the long term. Ramped-up corporate governance requirements for public companies may play a role in encouraging institutional investors towards private equity. 'There are a lot of overheads in compliance, which automatically gives the private equity firms a competitive advantage,' says Freehills’ Dunne.

So what’s the prognosis? Definitely, an upward trajectory for the level of activity in the private equity market despite an anticipated tightening by the credit providers. The availability of credit is already inflating the price of target enterprises. While Ferris has been listening for years to investors asking about 'too much money and too few targets', this is not the case, he believes. He suggests the fallout is more likely to be an adjustment: an acceptance by some investors of lower returns. When he reads about private equity players as 'the barbarians at the gate', Ferris admits to serious frustration. He says: 'Most private equity deals are non-hostile business building exercises over many years, and if the pricing and calculations get out of whack, the marketplace will let us know loud and clear.'

Private equity deals of note

PBL and CVC Asia Pacific: Following a change in Australia’s media ownership laws, James Packer showed his willingness to move away from his father’s blueprint for success. He created PBL Media with CVC Asia Pacific to own the Nine Network and ACP Magazines. The deal also provides a war chest for expansion of his global media network, and more importantly, his rapidly expanding gaming empire.

Seven and Kohlberg, Kravis and Roberts & Co (KKR): Not long after PBL Media was created, Seven Network owner Kerry Stokes arranged a deal of his own, selling 50 per cent of his television, magazine and online business to KKR for $3.2bn. In the process, a joint venture, Seven Media Group (valued at $4bn), was created.

Flight Centre and Pacific Equity Partners: Citing the short-term thinking of the market, Flight Centre founder and CEO Graham Turner and his partners worked out a $1.6bn deal with Pacific Equity Partners.

Cleanaway and KKR: Parent company Brambles sold Cleanaway Australia and New Zealand and Industrial Services Australia to KKR for $1.8bn.

Myer: After considerable speculation, Coles Myer decided to excise the second part of its name, selling Myer department stores and Myer Melbourne to a consortium consisting of Newbridge Capital, Texas Pacific Group and The Myer Family Company for $1.4bn.

Reference: February 2007, volume 77:01, p. 32-35

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