Immaturity may be LBO mart’s strength

  • 17 Sep 2007
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While the Australian leveraged finance market has proved it is not immune to the global credit crisis, optimism is high that it will rebound and resume its transformation of the Australian corporate landscape. Being a market that is much less dependant on institutional investors than its European and US counterparts will surely speed the recovery.

Much like a number of European markets, Australia has been in the grip of a leveraged buy-out boom of unprecedented magnitude. "Leveraged finance is probably the hottest sector that we’ve seen in our Australian business over the last 18 months," says Stephen Williams, managing director and head of global banking and markets at the Sydney office of Royal Bank of Scotland.

The statistics speak for themselves. According to Fitch, the value of announced private equity bids in Australia in 2006 was $27bn, compared with an annual average in the previous five years of $1.7bn.

Granted, much of that figure was accounted for by the failed $8.7bn bid by a consortium that included Macquarie and Texas Pacific for Australia’s flagship airline, Qantas.

Another jumbo buy-out that fell foul of shareholders was the A$18.2bn bid for the leading retailer, Coles, by a consortium led by Kohlberg Kravis Roberts (KKR).

Nevertheless, today’s volumes make the Australian buy-out market unrecognisable from a decade ago. Since then, says David Graham, head of syndicated and leveraged finance at JP Morgan in Sydney, private equity has been transformed from what he calls a "cottage industry" to one that is attracting a who’s-who of private equity sponsors and leveraged finance players. "A few years ago the market was clearing three or four deals a year," he says. " Now it’s more like 20."

The size of the deals that the market can accommodate has also exploded in recent years. "We didn’t have a billion dollar buy-out until 2006," says Julian Knights, managing partner at Ironbridge Capital in Sydney, which focuses on mid-market buy-outs. "Last year we had six, although two of those were one-off transactions driven by a change in our local media ownership laws allowing CVC and KKR to make major acquisitions in the broadcasting sector."

Even after the surge in activity over the last 18 months, private equity-sponsored buy-outs still have a much smaller influence on Australia’s economy and capital market than they do in the US and the UK.

Knights says that in 2006 private equity deals accounted for about 20% of all M&A volume in Australia, sharply up from 3% in 2004 and 8% in 2005, but still considerably behind the share of between 30% and 35% that it now claims on an annual basis in the UK or the US. Another indicator of the modest size of the Australian market, says Knights, is that the total enterprise value of all buy-outs completed last year amounted to about 1.5% of the market capitalisation of the ASX.

It seems improbable that those statistics will change much over the very near term, given the global upheavals in the credit market that have put paid to a number of high profile mega-buyouts.

Nevertheless, the longer term trend is clear, and is one that has put companies and bondholders on notice that very few companies are off the radar for private equity sponsors with deep pockets and voracious appetites. "Outside the banks there is no Australian listed company safe from a hostile takeover," says Wayne Green, head of syndications at BNP Paribas in Sydney.

Much the same is also true in New Zealand’s buy-out market, which has seen one of the largest and most highly leveraged transactions in recent years. The multiple on the total debt supporting this year’s NZ$2.24bn buy-out by CCMP Capital Asia and Teachers’ Private Capital of the New Zealand Yellow Pages directory business was around nine times Ebitda, which bankers say was reasonable given the defensive nature of the company. "In a country like New Zealand it is hard to see how a company like Yellow Pages could be undermined by a new competitor," says Andrew Baume, director of cross markets structuring at Deutsche Bank, one of the leads on the Yellow Pages financing.

"New Zealand has been a very active place for transaction flow over the last two years," says Knights, whose Ironbridge Capital has completed four deals there. Others share that view. "The activity coming out of New Zealand has surprised me," says Alun Lewis, head of leveraged finance at RBS in Sydney. "New Zealand doesn’t have many international companies but it does have a lot of successful home-grown, family-owned business and the principal exit option they’ve had historically has been the NZSE. The development of private equity over the last two or three years has given them an alternative solution."

Private equity homes in on Australia

It is Australia, however, that has attracted the most attention from many of the world’s leading private equity houses, which as Knights says were alerted to the potential of the market by the mega-deals in the broadcasting sector. He says that while some — such as KKR and CVC — have already completed transactions, a host of others including Blackstone, Carlyle, Cerberus and Permira are all looking to do the same. "So we probably have at least a dozen, maybe 15 regional and global firms that have at least looked at assets in Australia," says Knights.

Below that stratum, he adds, are the medium-sized firms such as Archer, Pacific Equity Partners (PEP) and Ironbridge that will typically focus on deals with an enterprise value below A$1bn.

Peter Jolly, head of research at nabCapital in Sydney, says that there have been three main reasons explaining the popularity of Australia as a target for private equity firms: phenomenal earnings, which at listed and unlisted companies have been growing by 10.5% a year for the last five years; balance sheets heavily loaded with cash; and extremely low leverage rates following a period of de-gearing between 2002 and 2005.

Michael Bush, head of credit research at nabCapital in Melbourne, says that the list of potential targets can be extended to any company that appears to be undervalued and where private equity firms think they can extract value. "I’d put Qantas into that category," he says, "because it did not have a particularly conservative balance sheet when you take into account its aircraft leases and volatile cashflow. What distinguished Qantas was that it traded at a discount to the market, and it was that as much as anything else that attracted the private equity bid. That is also the reason why some of the mining companies are being spoken about as potential targets — with BHP [Billiton] for example trading at a prospective p/e of 11 times."

While international private equity houses and investment banks have imported a number of global financing techniques to the Australian acquisition finance market, they have not yet brought some of the excesses of leverage that have characterised other regions, say some participants.

"With the exception of Qantas or Coles — had they happened — we are not yet in the frothy part of the debt spectrum," says Knights. "We haven’t tried to push the envelope anything like as far as the it’s been pushed in some of the more highly leveraged European deals."

Pricing holds up in market turmoil

How long that will last is open to question. "The Australian market tends to follow the US and the UK," says Lewis at RBS. "It is probably fair to say that the sort of leverage structures that are now being applied to deals in Australia are similar to those we were seeing in the US and the UK 12 or 18 months ago. We have seen leverage multiples rise as more liquidity has come into the market."

According to data published by Fitch, total debt to Ebitda ratios reached 7.2 times in the A$5.714bn buy-out by CVC Asia Pacific of PBL Media in November 2006; 7.6 times in the A$2.7bn buy-out by the same buyer of the DCA Group in September 2006; and a more toppy 8.6 times in KKR’s A$3.97bn purchase in November last year of Seven Media. In those three deals the equity component was 34%, 35% and 37% respectively.

Although leverage multiples may be inching up, pricing of debt in acquisition finance has not collapsed as it has elsewhere. "We probably saw senior debt pricing drop here by 25bp, rather than by 50bp to 75bp as it did for comparable deals in the US and Europe," says Lewis. "The result is that we’re not going through the same sort of pricing readjustment that we’ve been seeing recently in the US and Europe."

"It’s the one area of the market where pricing has held up," says JP Morgan’s Graham. "In the investment grade loans space we’ve seen massive compression in margins which have become wafer thin. That’s why there has been so much interest in the leverage phenomenon, and why so many banks are investing in leverage personnel."

While pricing has not fallen as far as in other markets, nor has the strength of covenants. Indeed, the Qantas buy-out was to have been the first in the Australian market to have used a covenant-lite loan package with no regular maintenance covenants, only a restriction on the amount of additional debt taken on beyond an agreed leverage threshold.

"Qantas was a bit different from other deals because it was to have been distributed to the US rather than the domestic market," says Lewis at RBS, one of the six arrangers of the debt finance for the aborted buy-out alongside Calyon, Citigroup, Deutsche, Goldman Sachs and Morgan Stanley.

Lewis says that one reason explaining why covenants have managed to resist becoming as diluted as much as they have in the US market is the structure of the acquisition finance market in Australia.

"A key difference is that we still don’t have much institutional investment in the market," he says. "This is still very much a bank market. When we syndicate deals 90% goes to other banks largely in Australia and Asia, and there are now probably about 50 banks with offices across the region that are active players in this market. That is very different from the US where about 90% of the debt goes to CLOs and other funds, and Europe where 60% or 70% of the market is now institutional."

At Credit Suisse in Sydney, head of Australian leveraged finance Lyndon Hsu says that institutions are exerting more of an influence on the local leveraged finance market than ever before. He says that it was transactions like the PBL Media and Seven Network buy-outs that kicked off CLO participation in the Australian market, which he says is one outcome of the progressive application of US and European-style acquisition finance technology to the buy-out market in Australia.

"We’ve probably had a dozen visits in the last four or five months from European and US-based CLOs compared with zero before that," he says. "CLOs are clearly becoming more switched on to what the Australian and New Zealand markets are all about."

Institutional market emerges

Others say that the broader institutional market for senior leveraged debt is expanding. "In the last few deals we have seen more Australian institutions coming into the acquisition finance market," says Simon Maidment, head of fixed income at UBS in Sydney, "and all of that has been real institutional investment, rather than investors running CLO funds. I think over time that will continue."

Part of the growth of institutional investment in the Australian leveraged finance market is explained by the fact that there has been no exact equivalent of the high yield bond market that oils the wheels of so much private equity business in the US and, increasingly, Europe. There is, however, what JP Morgan’s Graham and others describe as a "de facto high yield market" in the form of listed subordinated retail notes which carry an equity conversion option.

At Credit Suisse, head of Asia Pacific leveraged finance Michael Tierney explains that a typical retail note will give holders an option to convert a certain percentage of their noteholding into equity in an IPO at a small discount. "These don’t always appeal to institutions because there might not necessarily be an IPO," says Tierney. "There may be a trade sale or a recap. But they are attractive to retail investors who like the concept of being offered IPO allocations at a discount."

At RBS, Lewis says that institutional interest in this market is principally focused on the higher yielding subordinated debt. "Historically, the majority of demand for subordinated debt has tended to come from retail investors attracted by the high fixed rate coupons which are typically 4% over the cost of funds," he says. "At RBS our focus is on distribution to institutions, from which there has been a slowly growing source of liquidity, albeit at a higher yield than that historically demanded by retail investors — which could indicate that the retail instruments are mispriced." Institutional participation in this market is growing rapidly. "A trend is that institutional investors have been following retail into the listed subordinated note market, and in some recent deals we’ve seen anything up to 50% participation from institutions," says Maidment.

Hsu agrees, saying that since 2001, Credit Suisse has spearheaded the institutionalisation of the listed subordinated note market, arranging transactions in support of a number of buy-outs. These listed notes are seldom rated, although Hsu says that the notes’ implied ratings are almost always single-B, anchoring them firmly in high yield territory.

Pricing, meanwhile, will typically come at 50bp to 100bp inside the private placement institutional market, says Hsu, which reflects both the demand from retail investors and the liquidity that arises from the listing of the notes. "Typically you may see retail listed notes price at about 400bp to 500bp over BBSW, whereas the institutional subordinated debt market would be in the 550bp to 650bp range," he says.

As in other markets where household names have become the subject of private equity bids, something of a public debate has broken out in Australia over the socio-economic desirability of private equity. But if the present hiatus in activity is extended over the coming weeks or months, say bankers, that will be a reflection of the fragility in global credit markets and the widening of spreads in Australia rather than the product of public opposition or structural deficiencies within the Australian market. "The market is still robust and the liquidity that has fired activity is still there," says JP Morgan’s Graham.

At nabCapital, Bush agrees. "The LBO threat seems to be receding at the moment with wider credit spreads leading potential bidders to retreat," he says. "The question is: is that a permanent retreat or a temporary one? We think it is probably temporary."

  • 17 Sep 2007

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