Lexology GTDT Market Intelligence provides a unique perspective on evolving legal and regulatory landscapes. This interview is taken from the Private Equity volume featuring discussion and analysis of emerging trends and hot topics within key jurisdictions worldwide.
1 What trends are you seeing in overall activity levels for private equity buyouts and investments in your jurisdiction during the past year or so?
Mark Malinas and Tom Story: In the past 12 months we have witnessed continued strong investment activity from financial sponsors, with traditional buyouts accounting for the vast majority of that activity. The first half of 2019 has still been active, especially on the buy-side, which is being driven by a number of factors, including positive fundraising conditions, plenty of available committed capital needing to be invested and the announcement of a number of large and high profile-transactions, which is building broader momentum. However, as a result of the relative ease which most quality managers have experienced in being able to successfully raise new funds, the private equity (PE) landscape is looking increasingly crowded. Cashed-up funds, limited opportunities and fierce competition from corporates has resulted in vendors materially increasing their price expectations, thereby resulting in higher entry-point valuations for financial sponsors.
Although the number of privately held companies in Australia far outweighs the number of public companies, the largest companies in Australia are typically public and often trade on the Australian Securities Exchange (ASX). The ASX 200, a float-adjusted index representing the largest 200 Australian companies is heavily weighted towards a select number of banking and resources companies that, given their size and sector, have historically been difficult acquisition targets for PE. This, combined with the relatively small size of the domestic M&A market, means that there are generally fewer opportunities for financial sponsors to deploy significant equity cheques for large-scale transactions. As such, PE activity in Australia has historically been centred on mid-market transactions (ie, between A$100 million and A$500 million). Larger global funds have, however, shown a willingness to lower their thresholds to participate in these mid-market opportunities (eg, KKR’s Australian Venue Co’s A$200 million joint venture with Coles being a recent deal in the mid-market space). The total buyout value for PE funds shot up by 10 per cent last year, and a number of PE funds continue to seek out public-to-private transactions. We have seen an uptick in the announcement of large and high-profile transactions by PE (albeit with mixed success). The battle for the A$4 billon private hospital operator, Healthscope, is a recent example of twist and turns that resulted in Brookfield, the Canadian asset manager, ultimately trumping an offer from a consortium led by BGH Capital, one of Australia’s largest PE funds. The transaction attracted a lot of coverage largely as a result of BGH Capital’s strategy of entering into an exclusivity arrangement with Healthscope’s largest shareholder. It will be interesting to see whether these types of deals and similar approaches by PE firms become more prevalent going forward.
2 Looking at types of investments and transactions, are private equity firms primarily pursuing straight buyouts, or are other opportunities, such as minority-stake investments, partnerships or add-on acquisitions, also being explored?
MM & TS: As the Australian PE market continues to grow, financial sponsors are diversifying their capital deployment strategies. Although traditional buyouts account for the vast majority of transaction activity, we are also seeing financial sponsors invest in distressed and special situation opportunities and increasingly in venture capital and growth equity in the form of minority stakes. Sponsors are having to become increasingly creative and flexible in their capital deployment strategies. Australia’s largest PE investor, the Australian Future Fund, is among those funds targeting tech start-ups and investments in early stage opportunities.
In the past couple of years, we have seen the ‘buy-and-build’ strategy become the PE value creation strategy of choice. These transactions are structured either as an add-on to an existing portfolio company (eg, following Navis Capital’s acquisition of Modern Star, the educational resources company, in 2014, it has grown the business via bolt-on acquisitions and now includes brands such as Modern Teaching Aids, Modern Brands and Zart in Australia) or a ‘platform acquisition’, where a target company is acquired for the purpose of being used as a growth platform through an international roll-out or bolt- on acquisitions (eg, Permira’s acquisition of i-MED Radiology is a good example of a platform asset where the investment thesis is predicated on an international roll-out, particularly throughout Asia).
Although financial sponsors in Australia are generally perceived as sector agnostic, the key sectors where financial sponsors are showing the most appetite are healthcare, food, agriculture and technology. The appeal of Australian assets that operate in staple sectors continues to attract interest from both global (primarily North American and Asian funds) and domestic players who are either growing investments through market consolidation or seeking opportunities to rationalise existing businesses and take advantage of favourable global demographic trends by penetrating new markets (eg, Carlyle’s acquisition of Accolade Wines in 2018). Technology businesses (particularly cyber-related or data-rich businesses) continue to remain high in demand. For example, Advent International acquired a majority stake in Transaction Services Group (TSG) in June, a leading provider of business management software and integrated payments solutions to the health and fitness and childcare sectors in partnership with TSG’s management team and its founder.
Given the large number of sponsors active in the Australian market, with each having a unique investment strategy, it is difficult to make general, sweeping statements about the types of investments pursued by sponsors in the Australian market. With that said, as a general observation, it could be said that, given the sustained stretch of economic growth in Australia, a stable regulatory environment and an abundance of domestic and international capital, financial sponsors who invest in Australia are, almost by definition, investing in lower-risk businesses (eg, when compared to managers who focus on opportunities in high-growth or emerging markets). Therefore a lower return on investment may be acceptable given the lower level of risk that the investment carries.
3 What were the recent keynote deals? And what made them stand out?
MM & TS: This year has seen a continued focus on public-to-private transactions, driven by a number of factors including fierce competition and limited opportunities for unlisted assets and over A$7 billion of undeployed capital.
Recent deals include the A$2.3 billion acquisition of Navitas by BGH Capital, which resulted in a subsequent price increase from the purchaser after the initial offer price was rejected by the Navitas board.
Outside the educational space, the food sector remains an attractive target, highlighted most recently by KKR’s pursuit of the Arnott’s biscuit business from Campbell Soup Company. Furthermore, the healthcare and cosmetics sectors remain attractive targets, with TPG acquiring a meaningful stake in Safe Work Laboratories’ pathology business in February and Pacific Equity Partners acquiring Evolution Healthcare, a private hospital operator, in March. This followed Pacific Equity Partners’ take private of LifeHealthcare Group, a medical devices distributor, in 2018.
Resources and infrastructure opportunities have also drawn interest from sponsors seeking asset-backed investments with stable revenue streams. In this context, notable acquisitions are Morgan Stanley Infrastructure Partners’ acquisition, alongside consortium members Link Administration Holdings Limited and Commonwealth Bank of Australia, of Property Exchange Australia Limited (PEXA), the national real estate transaction settlements exchange. Further the A$1 billion ‘secure assets fund’ raised by one of Australia’s largest PE managers, Pacific Equity Partners, this follows the trend we have seen in other markets, where traditional PE sponsors have raised separate ‘special opportunity’‑type funds alongside their main buyout funds, in order to pursue opportunities that have a different return profile and exit horizon to traditional PE investments.
4 Does private equity M&A tend to be cross-border? What are some of the typical challenges legal advisers in your jurisdiction face in a multi-jurisdictional deal? How are those challenges evolving?
MM & TS: Global funds that have a presence in Australia have accounted for some of the largest announced PE transactions in the past 12 months; for example, Blackstone’s bid for Investa Office Fund, Carlyle’s acquisition of Accolade Wines and Bain Capital’s acquisition of BWX (structured as a management-led buyout).
Given that some of the largest institutional PE investors consist of sovereign wealth funds, pension funds and other foreign government-related investors, cross-border investment into Australia will generally require Foreign Investment Review Board (FIRB) approval and navigating Australia’s complex foreign investment laws, but this requirement is not necessarily confined to global funds. Investments by Australian-based sponsors will also typically require FIRB approval for the same reasons.
New reporting requirements for critical infrastructure (including electricity generation and transmission assets as well as port assets) came into force in July 2018, adding an extra regulatory dimension for funds investing in Australian infrastructure assets and in the past 24 months, a key area of focus for FIRB has been data security.
5 What are some of the current trends in financing for private equity transactions? Have there been any notable developments in the availability or the terms of debt financing for buyers over the past year or so?
Mark Kidston: The Australian leveraged finance debt market continues to mature and diversify. While the past 24 months has seen wide use of the unitranche debt product, the most notable trend over the past 12 months has been the rise in accessibility to the unitranche and term loan B (TLB) markets and other innovative financing solutions available from institutional investors and private debt funds, particularly for bulge bracket acquisition financings.
The unitranche facility is a funding structure that enables funds and other institutional monies to lend directly to PE bidding vehicles with a single financial covenant (net leverage ratio) structure, often bullet repayment profile and slightly looser styles of undertakings than a conventional bank loan. It has proved attractive to sponsors and unitranche funding solutions are now very common in bid proposals, though historically its accessibility was constrained to the appetite of a handful of institutional market participants with investment mandates permitting large-scale single asset exposures to provide this direct lend. Investment banks, buoyed by the now permanent deep pool of liquidity with institutional investors and private debt funds, are scaling up underwriting opportunities for unitranche event-driven financings. Sponsors will accept the pricing premium for distribution risk borne by investment banks in exchange for the execution certainty of a financing solution with these attractive financing terms.
An equally significant development has been the increasing use of TLB financings in Australia, including the increasing availability of TLB facilities denominated in Australian dollars. Previously primarily used as a refinancing solution, we have seen TLB financings increasingly used as the initial acquisition facility. Traditionally a US dollar-denominated debt product, Australian borrowers previously had to swap US dollar TLB proceeds into Australian dollars. With the growth of institutional lending in Australia, the past 12 months has seen an increase in pure Australian dollar TLB facilities and the start of Australian law-governed TLB transactions. We have also witnessed the use of ‘European TLB’ lenders and documents. The US dollar denominated debt product distributed into the US remains the most prevalent form of TLB (most recently in KKR’s acquisition of Arnott’s biscuits from American Campbell Soup Company) given the ability to raise on a ‘cov-lite’ basis. Although we now see a growing participation in Australian denominated TLB facilities, which are distributed to institutional investors and private debt funds active in the Australian leveraged finance debt market, albeit on a ‘cov-loose’ basis. Given the need for distribution, TLBs will often need pricing flexibility and, of course, a rating.
We have also started to see the use of high yield bond structures on refinancings in Australia. The growth of these debt solutions reflects the continued increase in the availability of institutional lending in Australia, but banks remain active in the space also and continue to be the natural providers of revolving and working capital facilities. Sponsors have been leveraging the market liquidity in these debt solutions and accessibility to this now permanent pool of institutional lending by arbitraging terms across debt finance products. Banks are acutely aware of this and remain active in the space by delivering innovative financing solutions and are starting to challenge the traditional bank loan notions on leverage, financial covenant and credit preservation terms. We are witnessing, as a result, ongoing ‘convergence’ as the bank loan market rises to the challenge of institutional lending.
6 How has the legal, regulatory and policy landscape changed during the past few years in your jurisdiction?
MM, TS and Joseph Power: Australian foreign investment approval has been necessary for most (offshore and local) financial sponsors (and, by extension, their portfolio companies) investing in Australia either on the basis that the PE fund includes a sufficient proportion of commitments from sovereign wealth funds and state-owned pension or other funds to constitute a foreign government investor, or because the acquisition is sufficiently material or in a sensitive sector. Substantial reforms to Australia’s foreign investment regulatory regime were introduced at the end of 2016 with some welcome changes; however, the changes generally have not narrowed the scope of transactions by PE requiring approval from FIRB. Notwithstanding this, more recently and following calls from stakeholders in the local PE industry, the government has introduced an ‘exemption certificates’ regime for non-sensitive business acquisitions that allows sponsors and their portfolio companies, as well as others, to seek pre-approval for multiple acquisitions in non-sensitive sectors within a defined period. These certificates will certainly facilitate the speedier execution of bolt-on acquisitions by portfolio companies.
In the past 12 months, we have seen foreign investors (including PE) be subject to additional regulatory scrutiny, both from a foreign investment and merger control perspective. In relation to foreign investment regulation, we are seeing greater intergovernmental coordination between FIRB (which advises the Treasury) and other governmental agencies, in particular the Australian Taxation Office (ATO). Broadly, the role of the ATO is to assess the potential Australian tax impact of foreign investment proposals. In assessing tax risk, the ATO will assign a risk rating to the investment proposal based on matters such as, amongst other things, whether the investment proposal complies with Australia’s tax laws, the compliance history of the applicant taxpayer and whether the features of the proposal fall within any high risk parameters identified in public guidance material published by the ATO. By coordinating with FIRB, the ATO has been able to review investment structures before implementation and enforce its tax compliance initiatives through the imposition of a suite of standard (and sometimes more onerous) tax conditions as a part of FIRB approval. Non-compliance with such conditions may have severe consequences, including penalties and potential divestment of the acquired investment. More generally, we have seen PE bidders are increasingly required to deal with a more proactive and focused ATO. For example, the ATO’s broader campaign on transfer pricing (which has seen the ATO successfully pursue billions of dollars in tax from the mispricing of related party arrangements) has meant that sponsors seeking FIRB approval have been required to respond to (and substantiate) detailed questions from the ATO regarding the structure and terms of any related party financing arrangements relevant to the investment proposal.
Although PE funds should be mindful of the additional scrutiny and disclosure obligations that are being imposed by FIRB, the reality is that for most financial sponsors who have either previously invested in Australia or otherwise have a good reputation as a responsible investor, any approval from FIRB should be a question of timing and process and not pose any real completion risks. However, where higher risk tax structures are involved, there is the risk of ongoing ATO scrutiny of an investment, even after FIRB approval with conditions has been obtained.
In relation to merger control, we have seen Australia’s antitrust regulator, the Australian Competition and Consumer Commission (ACCC), more closely scrutinise and impose conditions on bolt-on acquisitions by portfolio companies, particularly where there is community or political sensitivity to the aggregation play. The ACCC will also go as far as blocking a proposed transaction entirely if it has material competition concerns, particularly if the proposed acquisition results in potential horizontal or vertical overlaps with an existing portfolio company.
Financial sponsors should therefore seek to understand early in any acquisition plans whether their existing portfolio companies (including in any affiliated funds), or any pursuit of bolt-on acquisitions in a sector, could raise merger control concerns.
7 What are the current attitudes towards private equity among policymakers and the public? Does shareholder activism play a significant role in your jurisdiction?
MM & TS: Although many Australians have indirect exposure to PE investments through compulsory superannuation, most members of the public are unlikely to have more than a limited knowledge of PE activity.
Similarly, among policymakers, outside sensitive sectors such as agriculture, defence and media, there is unlikely to be much differentiation between PE and other acquirers of Australian businesses. We are, however, seeing a growing recognition of the need for legislation to be tailored and relevant in the PE context, as Australian regulators become more familiar with sponsor investment structures. For example, since July 2017, Australia’s foreign investment laws have allowed investors to seek pre-approval in the form of an exemption certificate for multiple acquisitions in non-sensitive industries, including bolt-on acquisitions. There are also higher de minimis thresholds so that FIRB approval is not required for foreign-to-foreign acquisitions where a foreign target’s Australian assets are valued at less than A$55 million and represent less than 5 per cent of its total assets. The previous thresholds were A$10 million and 1 per cent respectively.
Following on from the activist investor Elliot Management’s play on BHP in 2017, 2018 saw listed alternative investment fund manager Blue Sky in the spotlight. In that case, Glaucus published its thesis, which has seen Blue Sky shares lose more than 80 per cent of their value. For very little equity exposure, the activist in this case was able to have disproportionate influence over the company. This strategy follows more closely the strategies used by activists in the United States, where holders of very small stakes are able to pressure public company boards to take certain decisions – these decisions can include departures of senior management employees and directors, and entry into transactions including divestments or capital management such as buy-backs. This strategy adopts a far less capital-intensive way of exerting some control over a listed organisation than via a typical control transaction.
As we approach the start of the annual general meeting season, we expect to see shareholders placing a continued focus on environment and sustainability initiatives and reporting, as well as a spotlight on potential misconduct by directors and management in the aftermath of the Royal Commission into Financial Services.
8 What levels of exit activity have you been seeing? Which exit route is the most common? Which exits have caught your eye recently, and why?
MM & TS: Trade sales continue to be the most popular exit strategy for PE funds in Australia. In 2017, of the 14 divestments completed for the year, only four sponsors decided to exit via an initial public offering (IPO). Whether PE funds continue to run dual‑track processes to maintain price competition and to retain optionality remains to be seen. In an IPO market where institutions are not buying, any price competition or optionality that the dual track process introduces risks being seen as a smokescreen, rather than a genuine strategy, and may, in fact, be more distracting for senior management of the company. The preference for trade sales is probably a combination of favourable exit conditions for trade sales and the relatively ‘clean’ exit that financial sponsors are able to achieve through a trade sale by avoiding lengthy lock-up arrangements by having large stakes placed in escrow for a specified period. To some extent, it could also be explained by an industry preference to avoid public exit processes after several high-profile failures, most notably the collapse of electronic retailer Dick Smith after being floated by Anchorage Capital Partners for A$344 million.
Several potential, and highly publicised, IPO exits have previously been withdrawn because of waning institutional investor interest and were subsequently completed via trade sale. This trend is not solely attributable to sponsors, but more broadly Australia’s IPO market has seen a ‘valuation gap’ between sellers and investors and this difference in pricing expectations will likely ensure that trade sales will, at least in the short term, remain the exit strategy of choice for PE funds. Furthermore, 2018 was uncharacteristically busy in the area of equity capital markets regulation. Going forward, issuers, sponsors, underwriters and others involved in IPO processes will need to have an eye on the ACCC’s position on cartel conduct, the Australian Securities and Investments Commission’s (ASIC) report in late December 2018 on allocations in equity raising transactions, the ASIC’s sell‑side research regulatory guide and ASX’s proposed revision of a number of Listing Rules and Guidance. It will be interesting to see how these changes affect future exit strategies.
9 Looking at funds and fundraising, does the market currently favour investors or sponsors? What are fundraising levels like now relative to the past few years?
MM, TS & JK: We think that the market as it currently stands favours sponsors. A low interest rate environment helped fundraising activity remain strong in financial year 2018 and 2019 has seen a declining interest rate environment with Australian bond rates at an all-time low. The fundraising activity of Australia-based fund managers in 2018 surpassed the levels seen in recent years and looks to remain strong. Assets managed by general partners on behalf of their investors grew to almost A$26 billion at the end of 2018. A number of established firms also reached financial close on new funds including TPG Capital Asia VII fund, which closed earlier this year with commitments worth just over A$6.5 billion.
In contrast to previous years, there were notable changes to the mix of underlying investors in 2018, with Australian funds accounting for a greater percentage of equity funding compared to foreign funds. This largely reflects greater interest from the superannuation industry chasing strong returns from sponsors with an established investment track record. This has developed in parallel with PE bidders being increasingly prepared to form consortia with other PE players, superannuation funds or cashed‑up corporates, making it easier to acquire larger listed targets, which is perceived by some as the beginning of a new phase in the Australian PE world.
10 Talk us through a typical fundraising. What are the timelines, structures and the key contractual points? What are the most significant legal issues specific to your jurisdiction?
JK: Fund formation in Australia is, in many ways, consistent with the global institutional funds market, with the fundraising process, timelines and key commercial issues being familiar themes to those encountered in other major funds jurisdictions. A substantial fundraising can take anywhere from six to 18 months, with the timetable varying depending on a range of factors, including the reputation and track record of the manager and general investor demand.
Australian PE funds have historically been established in the form of a unit trust. However, the Australian fund landscape has changed in the past decade and we now see different PE fund vehicles, most commonly venture capital limited partnerships (VCLP), early stage venture capital limited partnerships (ESVCLP) and, most recently, managed investment trusts. Each of these structures has advantages and disadvantages, ranging from taxation treatment to the vehicle characteristics and investment activities.
In addition, while the legislative process has slowed somewhat over the past 12 months, Australian lawmakers are continuing to develop a range of new investment vehicles, including a new corporate cell company structure (similar to a segregated cell company used in other jurisdictions) and a new limited partnership structure. While the expectation is that the segregated cell company is unlikely to be attractive to institutional fund managers, there is optimism that the limited partnership structure (while still some years off) may gain popularity as an institutional fund structure of choice, given it will likely prove more familiar to foreign investors than traditional Australian trust structures.
The key points in the fundraising process again largely follow global wholesale fundraising patterns, with issues such as fund structure, key investor protections (including governance and sponsor removal rights, reporting and disclosure and key man protections), fund economics and side letter terms being a primary source of investor attention. In addition, given the superannuation-heavy nature of the investor market in Australia, Australian superannuation-specific side letter requests in relation to reporting, regulatory disclosures, transfer rights and other regulatorydriven requests are becoming an increased focus of side letter negotiations.
11 How closely are private equity sponsors supervised in your jurisdiction? Does this supervision impact the day-to-day business?
JK: An Australian PE manager is typically required to hold an Australian Financial Services Licence (AFSL), unless a specific exemption applies in the circumstances. AFSL holders are subject to supervision by the ASIC. They are required to comply with ongoing obligations relating to matters such as:
- capital requirements;
- organisational competence and expertise;
- risk management;
- professional indemnity insurance;
- conflicts of interest;
- client money rules; and
- conduct rules (including broad obligations to provide financial services honestly, efficiently and fairly).
AFSL holders are also required to report significant breaches of their AFSL conditions, or other financial services laws, to the ASIC, which has powers to request information from AFSL holders and to undertake surveillance visits to determine whether the AFSL holder is complying with its obligations.
Although funds should be mindful of the ongoing compliance and reporting obligations, ASIC’s supervision does not typically have a material impact on the day-to-day business of a PE fund.
12 What effect has the AIFMD had on fundraising in your jurisdiction?
JK: As is the case for all non-European Economic Area (EEA) managers, AIFMD has obviously imposed additional regulatory hurdles for the managers of Australian alternative investment funds, including PE funds, seeking to raise capital from wholesale investors in Europe. That said, this has not necessarily prevented the larger Australian managers from successfully raising capital in Europe, which demonstrates the hurdles are not insurmountable.
One of the complications has been that, in implementing the AIFMD in national law, certain jurisdictions (notably Germany and Denmark) have gold-plated the requirements and those requirements differ between the various EEA jurisdictions, which has brought with it a need to consider technical issues on a jurisdiction-by-jurisdiction basis, which can cause inefficiencies and complexity in structuring a fund. When AIFMD was first introduced, the intention was to open up the AIFMD marketing passport to managers outside the EEA (currently, Australian and other non-EEA managers cannot take advantage of the passport). However, that has yet to happen and appears to be some way off (if indeed it happens at all).
13 What are the major tax issues that private equity faces in your jurisdiction? How is carried interest taxed? Do you see the current treatment potentially changing in the near future?
JP: There are a number of Australian tax issues that PE investors must be aware of when considering an investment in Australia.
A major tax issue affecting PE continues to be the tax characterisation of gains made by PE funds on the disposal of the underlying investments of the fund. The tax characterisation of such gains may also impact how investors in the fund are subject to Australian tax. The ATO’s view is that gains made by a PE fund from an investment should generally be treated on revenue account (as opposed to capital account) where the fund intends to profit from the sale (or partial sale) of its investment. In contrast, for example, where a fund acquires an investment for the long term with the view to deriving income from that investment, gains on the disposal of such an investment could be treated on capital account.
Generally, for Australian tax purposes, foreign resident investors can disregard capital gains from assets other than ‘taxable Australian property’. Relevantly, ‘taxable Australian property’ would include an interest held by a foreign resident investor in a PE fund where the associate inclusive interest held by the investor in the fund is equal to or greater 10 per cent and where the majority of assets of the fund are attributable to Australian real property interests (including mining assets). In contrast, foreign resident investors would generally be subject to tax in respect of Australian sourced revenue gains (even if those gains do not relate to ‘taxable Australian property’). However, depending on the tax residency of the foreign investor, potential relief may be available under an applicable double tax treaty.
Some of these issues were considered in a decision of the Full Federal Court of Australia earlier this year. The much anticipated decision of the court involved the sale by a PE group of funds (Resource Capital Fund IV and Fund V (RCF), each a Cayman Islands limited partnership) of their interests in an Australian mining company, Talison Lithium. The decision has important implications for PE investors.
In the case, the Full Federal Court overturned the decision of the Federal Court at first instance. In doing so, it ruled that each limited partnership was a ‘taxable entity’ under Australian tax law rather than, as was held at first instance, the limited partners. This meant that the limited partnerships rather than limited partners were required to establish any rights to benefits under the Australia–United States double tax treaty. The court ruled that neither limited partnership was a ‘resident’ of the United States for the purposes of the double tax treaty on the basis that neither partnership was ‘subject to tax in the United States’, and as such, they could not rely on the benefits offered by the treaty to exempt what was otherwise Australian sourced income derived by the limited partnerships. The court’s determination that the income was sourced in Australia was based on a number of factual matters, perhaps most importantly that the investment was managed in Australia and the sale transaction was effected using an Australian court approved scheme of arrangement. However, notwithstanding these matters, the court ruled that the Commissioner of Taxation’s public Taxation Determination (in TD 2011/25, concerning the application of the ‘business profits’ article in Australia’s tax treaties to a fiscally transparent limited partnership) could be relied upon by each limited partnership, provided that the ‘alienation of property’ article in the Australia–United States tax treaty did not apply to allow Australia to tax the profits of either limited partnership. The court found that Australia could tax the profits of the limited partnerships under the alienation of property article on the basis that the interests held by each limited partnership were ‘taxable Australian property’.
Overall, the Full Federal Court’s decision, while clarifying a number of technical issues under Australian domestic law and tax treaties, also highlights a number of uncertainties in the use of limited partnerships investing in Australia. RCF has sought special leave to appeal the Full Federal Court’s decision to the High Court and we now await the outcome of the special leave application.
Another major tax issue affecting PE funds in Australia is the financing of investments and the tax issues arising out of its chosen financing strategy. For example, foreign-controlled PE funds that utilise debt finance may be subject to Australia’s thin capitalisation regime, which may operate to disallow certain interest deductions for certain entities where those entities are regarded as excessively geared.
Another financing-related tax issue that PE funds need to be aware of is the Australian debt equity regime, which aims to reclassify interests for tax purposes as either debt or equity according to their economic substance rather than their legal form. This may have important flow-on consequences both in terms of the tax treatment of returns from any interests that are reclassified under the tax rules, as well as how those reclassified interests may interact with other statutory regimes (eg, the thin capitalisation regime).
A recent development in this context has been the introduction of ‘hybrid mismatch’ rules into Australia’s tax laws in accordance with the Organisation for Economic Co-operation and Development base erosion and profit shifting action items. The new rules are intended to neutralise the effects of ‘hybrid mismatch’ arrangements by either disallowing a deduction or including an amount in the assessable income of an Australian taxpayer that is a party to an arrangement producing a ‘hybrid mismatch’.
Finally, PE investors should be aware that there are generous concessions available to qualifying PE funds operating as VCLPs and ESVCLPs. Relevantly, a foreign qualifying investor in a VCLP is generally not subject to tax on its share of any gain (whether on revenue or capital account) arising on the disposal of an ‘eligible venture capital investment’ by the VCLP, provided (among other conditions) the VCLP holds the asset at risk and for at least 12 months. This concession is not available to Australian investors. An investor (whether resident or foreign) in an ESVCLP is entitled to tax exemptions for both income and capital gains on its share of any gains arising on the disposal of ‘eligible venture capital investments’ by the ESVCLP, as well as a non-refundable carry-forward tax offset of up to 10 per cent of their eligible contributions. Further, the carried interest of the general partner of either a VCLP or an ESVCLP (excluding any management fee or any distribution attributable to an equity investment by the partner) will generally have deemed capital account treatment. This capital gain can also be subject to the capital gains discount (where eligibility requirements are satisfied). We do not see any change on the horizon in relation to the taxation of carried interest generally or under these structures.
14 Looking ahead, what can we expect? What might be the main themes in the next 12 months for both private equity deal activity and fundraising?
MM, TS, MK, JK & JP: We anticipate that the next 12 months will be very strong for PE, particularly on the buy-side. Consistent with previous years, we think that financial sponsors will be interested in the health, education, technology and food sectors. We also anticipate that the fierce competition for unlisted assets will force sponsors to continue to look at listed opportunities where the investment thesis is workable. The interest of PE in public market acquisition is likely to continue with typical PE deal considerations, such as warranty and indemnity insurance coming into play, fuelled by the desire of public companies to avoid management distractions and given directors’ limited appetite for risk. However, the increasingly complex regulatory regime that PE bidders are required to navigate remains a material execution risk. Additionally, in a period of abundant capital and supportive debt markets, we expect competition for assets to remain fierce, which will, in turn, require managers to participate in ultra-competitive auction processes and, on the sell-side, encourage exits via trade sale.
Although fundraising conditions are likely to remain positive, the growing PE market in Australia means that managers will find it increasingly difficult to secure commitments. Limited partners will have a natural preference to back established managers and dealmakers with a proven track record, many of which have recently raised new funds. Finally, as sponsors shift their focus from fundraising to capital deployment, we would not be surprised if the level of fundraising decreases overall. Of course, this will be driven by a variety of both micro and macro factors that are difficult to predict with much precision.
We foresee that the Australian leveraged finance debt market will continue in its evolution with increasing convergence in terms across local debt products and perhaps even from global debt markets. The bank market is likely to continue its response to the rise of institutional funding solutions. Accessibility and liquidity will continue to grow and will support our perceived shift in the PE life cycle from fundraising to capital deployment.
The Inside Track
What factors make private equity practice in your jurisdiction unique?
A sustained period of economic growth, coupled with supportive debt markets and a robust regulatory regime means that there is generally no shortage of capital-pursuing quality assets. The upward pressure on valuations means that PE funds need to find effective ways of executing deals and applying value through innovative value creation models to ensure that they differentiate themselves in a crowded market. Notwithstanding the challenges, PE funds with an interest in Australian assets have historically made a significant contribution to the broader M&A market and shown a solid track history of being able to deliver exceptional returns for their investors.
What should a client consider when choosing counsel for a complex private equity transaction in your jurisdiction?
Ensure your local counsel has a dedicated PE team who understand the market and can cut through the process quickly. Also, it is important to have an adviser in your corner whom you can depend on to give you the right commercial advice and put you in a competitive advantage in any transaction process.
What interesting or unusual issues have you come across in recent matters?
First, while the buy-and-build strategy continues to be a popular investment strategy for financial sponsors, it often carries significant regulatory risks, particularly in the area of merger control. Despite this, sponsors often view potential antitrust risks as a secondary issue to the main objective of identifying industries and businesses that are appropriate for the buy-and-build strategy. Financial sponsors pursuing this strategy are encouraged to do a thorough antitrust analysis early and, if significant risks are prevalent, have a credible back-up strategy to the primary investment thesis should that form part of the analysis.
Second, an interesting feature of Australia’s recent public-to-private market has been the prevalence of fierce competition from multiple PE bidders. These contested M&A transactions show the immense pressure that sponsors are under to put large amounts of capital to work and are a timely reminder that sponsors who see opportunities in listed targets should not be surprised if they face competition from rival funds.
