The ongoing fragility of the global economic recovery and credit markets has continued to restrain deal flow in the Australian private equity market in 2011.
The year opened with high hopes for an opening in the IPO window. These hopes were dashed early by the near 10% fall in the All Ords from mid-February to March. The ensuing market volatility has kept the IPO window closed for most Australian PE houses.
Despite this, PE firms in Australia have continued to pursue exits, many with an overriding need to put runs on the board in support of their next fundraising. The exits have come through a combination of trade sales (eg Rebel, Manassen Foods, Cellarmasters) and an increasing proportion of sponsor-to-sponsor sales (eg MYOB, Quick Service Restaurants, Tegel Foods, Healthe Care Australia). This increased secondary activity also reflects the buy-side pressure on sponsors to put as yet uncalled committed capital to work before the investment period for that capital expires.
Leveraged debt has continued to be available in support of Australian PE deals, though at a price and reflecting several key developments which are the subject of this article.
LBO financiers are open for business but remain expensive
The $1b+ debt funding package for the acquisition of Healthscope by Carlyle and TPG in mid-2010 demonstrated what was still possible following the liquidity crunch of 2008. There was an expectation at the time that funding costs would come down as credit markets continued to stabilise. However, funding costs (both in terms of the upfront fees and margins) have remained at that level.
For the most part, margins are in the range of 400 – 450 bps for LBO deals; almost double the margins seen during the boom times leading up to 2007. There has also been increased divergence in the pricing offered by leveraged financiers. This reflects a combination of factors. Increased volatility inevitably means greater scope for divergent views on the credit risk of a borrower. There is also a varying degree of institutional appetite for exposure to PE reflecting an individual bank's capital constraints and outlook.
Syndication markets have opened up
A key change in 2011 has been the return to some degree of normality of the syndicated debt market. Whilst arrangers of leveraged debt were willing to underwrite syndications in 2010, this was generally viewed with some scepticism by sponsors due to the very wide market flex rights being required by underwriters. 'Market flex' provisions allow underwriters to alter deal terms to achieve a successful syndication where the primary syndication has failed.
In 2010, debt mandate and syndication letters typically contained market flex provisions that, if triggered, allowed arrangers to change pricing, terms and structure of the financing in relatively broad terms at the underwriter's discretion. This substantially cut across the certainty of the funding terms by introducing, for example, the risk of higher funding costs or additional conditions precedent to draw downs.
In 2011, banks have been willing to accept tighter provisions that limit market flex adjustments to a change in pricing up to an agreed cap (say 50 bps). This gives sponsors certainty of funding at a maximum specified price.
The shift back in favour of sponsors has not, however, gone so far as to allow borrowers to insist on objective criteria to limit the circumstances in which the market flex provisions can be invoked. This decision remains in the hands of the arranger having regard to soundings in the bank debt syndication market. Rather, sponsors will need to continue to rely on the strength of their banking relationships in order to manage this risk.
Re-emergence of mezzanine debt
The last 12 months has also seen the return of mezzanine financing for Australian PE deals. In the aftermath of credit markets seizing up in 2008/09, LBO deals were being executed with only senior financing. The resulting funding gap left by the absence of mezzanine financing had to be bridged by additional equity funding thereby stretching PE investors' expected return calculations.
Mezzanine funding is again being sourced from specialist funds (such as Intermediate Capital Group and Babson Capital) and global PE funds that have their own mezzanine debt funds (such as Goldman Sachs Private Equity and KKR).
The re-emergence of mezzanine financing for PE transactions has been accompanied by a renewed focus on intercreditor terms. Intercreditor deeds regulate the priorities, subordination and relative enforcement rights between senior and subordinated lenders. The negotiated outcome on intercreditor terms in 2011 has been competitive and reflected a shift back in favour of mezzanine financiers particularly in the area of mezzanine lender enforcement rights. It is now reasonably standard for mezzanine lenders to be given enforcement rights if a mezzanine default subsists for longer than 180 days.
These emerging themes may warrant closer scrutiny by PE firms in Australia. The increased presence and activism of specialist credit investors in distressed debt situations and so-called 'vulture funds' (see below) mean that sponsors need to be aware of potential areas for exploitation by credit investors who know what they are looking for in intercreditor terms. For example, any weaknesses under the intercreditor terms in senior lenders' ability to drag along subordinated lenders in giving effect to a debt restructure may be exploited by funds interested in adopting a 'green mail' position in a debt restructuring scenario.
Emergence of distressed credit investors in Australia impacting on debt restructures
Another shift in the Australian LBO finance market has been the greater willingness of senior lenders to sell out of impaired credit exposures at a discount rather than holding onto distressed loans (bearing the associated capital costs) and seeking to recover through a receivership process. The lessons learned by Australian banks following the spate of high profile corporate collapses in recent years have resulted in banks adopting a more pragmatic approach to handling distressed debt situations. This includes due recognition of the potentially value-destructive consequences of appointing a receiver.
An alternative to bank lenders waiting to recover an uncertain amount through a receiver-run fire sale is to take advantage of the increased appetite of global credit hedge funds and vulture funds for Australian distressed debt. Investors that specialise in distressed debt have the expertise, risk appetite and investor mandate to seek returns through working through a restructuring process and potentially recovering through a debt-for-equity swap.
Australian PE houses dealing with distressed portfolio companies have seen the composition of their banking syndicates shift rapidly, often with a deleterious impact on the dynamics of the debt restructuring negotiations and the prospects for a longer term workout solution. Suddenly, senior lenders with whom they have longstanding banking relationships can be replaced at the negotiating table by speculative hedge funds focused on aggressively pursuing a liquidity event within their investment horizon and sufficiently above their discounted entry price. Sponsors then have to deal with often diverging interests among the lending group in being able to agree any restructuring proposal.
As a consequence of the increased presence of specialist distressed credit investors in Australia, sponsors are now insisting on real protection in debt facility assignment clauses such that PE firms do not lose control over debt-related negotiations prior to an event of default. Senior banks have been willing to accept the exclusion of hedge funds, distressed debt funds and vulture funds from the permitted class of assignees other than where an event of default is subsisting.
In practice, sponsors will in any case be highly motivated to lead debt restructuring and refinancing discussions with senior lenders well in advance of triggering an event of default. Sponsors may then seek to negotiate equity cures and standstill agreements to defer any event of default that may otherwise trigger a rush for the exit by senior lenders and diminished prospects for a restructure that maximises equity value.
Leveraged financiers and sponsors alike are presently operating in a highly volatile macro environment subject to sudden shifts in currency, sentiment and macroeconomic policy settings. This operating environment places a premium on portfolio companies maintaining strong relationships through communication with their banking group whilst anticipating potential vulnerabilities in a default scenario. These vulnerabilities may arise from language that secondary debt investors may seek to exploit in debt documents or from insolvency event triggers in material contracts.
As always, there are opportunities for market participants who appreciate the risks and anticipate the trends to plan in advance for strategies available to de-risk existing investments or to pursue new investments with debt documentation reflecting best practice supported by rigorous due diligence.