Dancing to the tune of private equity

As private equity funds adopt a more aggressive role in Australian business, Janine Mace looks at a new breed of corporate raider

In a repeat of the trend occurring in many countries, the flood of investment dollars sloshing around international markets has seen Australia’s international airline Qantas and its largest retail conglomerate, the Coles Group, receive private equity buyout offers.

The A$11.1bn private equity bid for Qantas by a group of Australian and international investors led by Macquarie Bank made headlines around the country. (Macquarie Bank is a one-time bidder for the London Stock Exchange.)

The deal to take Qantas private represents a major recasting of the Australian business scene, with the company moving from government to public and now private ownership.

The bid is also creating political headaches for the Australian Government over foreign ownership and protection for rural routes, while trade unions are up in arms over the potential for job losses. Despite this, the audacious bid looks set to pass the various regulatory hurdles and reach completion, unlike some of its predecessors.

In mid-2006 the A$18.2bn bid for Australia’s largest retailer, the Coles Group, by one of the major international private equity firms Kohlberg, Kravis and Roberts (KKR) was rebuffed, but not without considerable hand wringing and debate about ‘the national interest’.

This bid followed an earlier A$1.4bn sale of the iconic department store chain Myer by the Coles Group to another private equity firm, Newbridge Capital, which is an offshoot of Texas Pacific Group, a key player in the Qantas deal.

KKR had already been active in the local market, setting a then Australian private equity transaction record (A$1.83bn) early in 2006 when it snapped up the Cleanaway Australia waste disposal company. The firm has also succeeded in buying a A$4bn stake in the Channel 7 television network.

This influx of private equity dollars is garnering attention at all levels, with even the governor of the Reserve Bank of Australia, Glenn Stevens, referring to it in a recent speech.

He said ‘the increasing prominence of private equity and leveraged buyout activity will be a point of interest’ in the future and is likely to ‘continue for some time’ in Australia.

Much of the rationale for Stevens’ view relates to the easy availability of cheap credit, both in Australia and internationally. Like most countries, one of the key drivers of the current local private equity boom is the huge pool of cash looking for suitable investments.

While this flood of investment dollars is a global phenomenon, the problem in Australia is made more acute by the relatively small size of local equity markets.

Pensions

This is further exacerbated by the rapid growth in assets being enjoyed by local pension plans, or superannuation funds as they are called in Australia. Due to the compulsory nature of Australia’s private pension system, local superannuation funds are sitting on large pools of rapidly growing capital needing investment across a wide range of asset classes.

The latest figures from the Australian Prudential Regulation Authority (APRA) show total superannuation assets rose 16.6% over the 12 months to September 2006, and have almost breached the A$1 trillion mark. Much of this ongoing asset growth is driven by compulsory contributions, with employers contributing A$11.9bn during the September quarter alone.

This constant influx of money from both employers and employees needs to be invested somewhere, and a significant proportion is flowing into private equity investment funds as superannuation trustees seek to diversify across a range of asset sectors.

Many Australian superannuation funds are extremely sophisticated in their investment processes and have been quick to follow the lead of top institutional investors such as the Harvard and Yale Endowment Funds. The move by these US endowments into alternative asset classes such as private equity has blazed the trail for other institutional investors and has proved to be stunningly successful.

The US$18bn Yale Endowment Fund entered the private equity sector in 1973 and has around 17% of the fund allocated to the sector, while the Harvard fund has around 13%. These allocations are well above those normally recommended in traditional asset allocation models, but over the past 10 years the results speak for themselves, with the Yale fund achieving a 39.5% average annual return on equity.

Australian superannuation funds have taken note and have moved to embrace private equity, according to global investment and superannuation specialist Russell Investment Group.

According to Russell’s director of alternative assets and strategies, Dr Andrew Goddard, his firm’s clients are continuing to build their allocations to alternative assets and this is not confined to large corporate defined benefit funds. ‘We’re working with corporate funds who have allocations of up to 40% in private equity… but the trend is also evident in leading industry funds… and public sector funds,’ he says.

Goddard says pension funds are attracted by the expected returns and relatively low expected volatility these assets can provide.

All this has led to boom times for private equity investment firms. As KPMG’s Capital Markets Survey 2005-2006 noted, total private equity funds under management in Australia were predicted to exceed A$14.5bn by the end of 2006, making it a ‘landmark year’ for private equity specialists dreaming up new investment deals.

Australian superannuation funds are not alone in their attraction to private equity. In November 2006 the UK regulator, the Financial Services Authority (FSA), released a discussion paper on private equity. This review noted overseas pension funds were the largest single capital contributor (providing £7.2bn or 26%) of funds raised by UK private equity firms, with commitments by UK pension funds also rising.

Concern

Given the dramatic growth in private equity investment, some people – including bankers – are starting to express concern about the rash of deals.

The chief executive of Australia’s largest bank, National Australia Bank (NAB), is among the critics warning the private equity boom could turn into a bust.

NAB’s John Stewart was widely quoted recently when he said it would only take the failure of one banking syndicate involved in the takeover frenzy for the entire private equity market to unravel. ‘Everyone feels private equity is going to end up in tears,’ he told a group of Australian business leaders.

The comments echoed an earlier call for caution on private equity financing by the CEO of Westpac, another of the four major Australian banks, who expressed concern about the level of leverage inherent in many of the current crop of private equity deals.

This was one of the risks from private equity highlighted in the FSA paper. It warned about the ‘high’ risks relating to market abuse and conflicts of interest, together with ‘medium high’ risks relating to excessive leverage and unclear ownership of economic risk.

The FSA has also expressed concern that the level of leverage in some private equity deals means if one goes sour, it will be difficult to tell who will be left holding the debt.

As the FSA’s Rebecca Jones told ABC Radio National: ‘The risk is really being dispersed out into a very wide network… [so] if a company does default, then it’s no longer a question of just being able to get four or five bankers around a table and have them hammer out an agreement.’

Despite these concerns, it seems while the private equity music keeps playing, no one wants to be caught sitting out the dance.

Janine Mace is an Australian freelance finance and business journalist.