Private equity the Private life

After a slow-burn evolution, the private equity sector in Australia is now in the midst of a boom. But is the bubble set to burst? Helen McCombie reports.

It wasn’t so long ago that private equity investment was a bit of a mystery to Australia’s financial community. According to Andrew Savage, director of mid-market management buyout and expansion capital specialist, CHAMP Ventures (part of the CHAMP Group, one of Australia’s largest private equity funds managers), ten years ago, private equity “was this ill-defined, mystical pool of capital that really didn’t command that much attention in the press”.

He says: “In 1995, it would take us half an hour to explain to investors, or business proprietors, or service providers what private equity was all about.”

Even five years ago, when Gresham Private Equity joint managing director, Roy McKelvie, arrived in Australia, the industry still had no profile.

“When I first came down here, talking to a managing director about private equity was frankly a struggle, because they didn’t really know about it, they didn’t know anybody who had been involved with a private equity firm, they didn’t know what the economics were like,” McKelvie explains.

In the United Kingdom, where McKelvie started his career, it was different.

“Everybody knew how private equity worked, everybody knew what a leveraged buyout was, everybody knew somebody in the golf club or a supplier or a customer who had gone through it, and where the management team had made a lot of money.”

It’s the investment successes of groups like Gresham and the CHAMP Group that have made corporate Australia sit up and pay attention to the virtues of private equity ownership. Savage points to some of CHAMP’s successes.

“We bought into Austar in 2001 at a very low price and we’ve watched that business be rejuvenated and recapitalised. Equally, we invested in SEEK in 1999, floated it in 2005 and reaped six and a half times our money. Bradken we floated last year – after buying out Smorgons – have invested in the business and plan to re-float it.”

Dealing with a cash deluge

The industry growth in private equity is highlighted in the latest figures from Thomson Venture Economics, which reports that, at June 2005, there were 164 funds, with a total investment of $12.2 billion, compared with $1.6 billion in 1995 shared among 26 funds.

Private equity investment has grown for a number of reasons.

First, there are the businesses like Pacific Brands (originally part of Pacific Dunlop) that attract private equity investment as a consequence of needing rehabilitation. Then there are also privately owned companies wanting to pursue rapid expansion. And finally, there are the private equity buyouts, driven largely by succession planning.

With the impressive returns already achieved, there has been a recent influx of global private equity funds into the Australian marketplace. Now, some industry observers are wondering how long the party can last.

Victor Bivell, editor of Australian Venture Capital Journal, is a long-term industry observer. He says he feels confident about the industry’s future growth – despite widespread speculation that private equity investment may soon fall foul of its own success.

“When I started as editor in 1992, there were only two buyout funds in Australia. Now, it’s a major growth industry.

“In recent years, funds under management have grown manifold. Serious and major institutions have come to the fore and this has meant that the long-term trend will now, I think, see an increased capability to undertake bigger and bigger deals,” says Bivell.

The art of war

McKelvie, on the other hand, remains circumspect about the future, acknowledging concerns that activity could plateau.

“However, I don’t see it being all ‘doom and gloom’ as a lot of people think,” he concedes. “There’s been a huge explosion in the number of firms over the last five years, and there are another couple of firms that are opening up soon.”

Although, McKelvie suspects that a number of the overseas firms now entering the market will retreat in the next year or two, “because they won’t find the deal flow, they’re not committed to the market and they don’t have the networks”.

He adds: “If you compare private equity penetration in North America and North Europe – especially in the United Kingdom – and compare it to Australia, then you’ve got a long way to go before it reaches anything like saturation level here.”

While the industry may still be maturing, Savage predicts private equity investment will undergo significant change. “You’ll find that there’ll be increasing stratification of the industry into dedicated early stage, dedicated expansion stage, smaller buyout investors, larger buyout investors, and those who will be prepared to wade into the public market and do public-to-privates or maybe even the odd hostile takeover,” he explains.

“You’ll find increased specialisation around deal size and type of investment, roll up plays, straight vanilla management buyouts.”

According to Ian Knight, KPMG’s head of Private Equity, this will be matched by more aggressive behaviour from private equity investment firms in the future.

“I think there will be a trend, like you saw with Allco and Baycorp, towards an increased number of hostile bids. Historically, private equity funds have only done friendly transactions in the form of public-to-private transactions. However, I think you’ll see more of that aggressive stance being taken as we move forward. That’s something we have seen overseas,” says Knight.

But will the deals get bigger?

Around town, McKelvie says there are already three to four firms that won’t look at deals under half a billion dollars, although he admits he is somewhat sceptical about the Australian market’s ability to deliver deals on such a scale.

“I think these firms are spending enough time chasing the mega deal that one will eventually happen, but the market is not big enough for it ever to be like Europe or the United States where there are billion dollar deals happening every month. It’s just not going to happen.

“You can do the math,” says McKelvie. “There’s only two half-a-billion dollar-plus deals ever been done in Australia.”

Setting a governance benchmark

In recent years, corporate governance has become a major focus for listed companies. So how does the corporate governance of private equity ownership stack up? 

KPMG’s Knight argues that it is a practice taken very seriously among private equity funds managers. “If you look at the top end of those fund managers, most of them appoint independent directors to the board – besides their own management team,” he says.

In addition, says Knight, most appoint a totally independent chairman and bring “an audit framework to the table”. Many are also extremely focused on probity, given that they view listing the company as an ultimate exit.

“Most of Australia’s private equity funds managers are cognisant of making sure that compliance and reporting issues are brought to the table,” he explains.

Savage agrees. “Speaking on behalf of the CHAMP Group, with CHAMP Ventures on the smaller deal side and CHAMP Private Equity on the larger controlled investments side, I can safely say that we try to run each of our businesses as though they were public companies – despite the fact that they’re privately operated. So there’s a board and proper levels of authority and there’s discipline in the form of strategic planning and regular business planning. Corporate governance is something we’re very strict on.”

While he believes it’s fair to say that directors of private companies are not performing their jobs any better than the directors of public companies, Savage does think that private equity investors are more particular about whom they appoint to a board.

He explains: “We want people that are relevant and cognisant of the key stakeholder interests, so there are three categories of directors. There are the private equity fund executive representatives and the senior management team. But we also, as a rule, tend to bring in people who have ‘been there, done that’…who have specific industry expertise.”

Savage calls them “the grey hairs” – those who can mentor and guide younger management team members. “It’s not simply a tap on the shoulder…They’ve got to be able to demonstrate to us, and to the managers, that they can add genuine value to the company,” he says.

Given the amount of activity in the sector and the focus on corporate governance in the public arena, the question arises: will the private equity investment industry find itself the target of a new round of corporate governance legislation?

McKelvie unequivocally rejects the idea as pointless, saying the reality is that corporate governance standards within private equity investment are streets ahead of what happens in public companies. “If there was going to be a new round of legislation, and I don’t think there will be, but if there was going to be, a government of whatever political hue would go after the public company rather than private equity,” he says.

“We’re actually much more rigorous in terms of the structures and rules and regulations that we put in place to make sure that governance actually works.”

Case study: UnderCoverWear

On the hunt for capital for expansion, UnderCoverWear stumbled across an unlikely investor in the form of John Everett – a man with no experience in the fashion industry. Now, Everett is testimony to the trials and triumphs of taking a private investment public.

Sydney businessman, John Everett, wasn’t thinking of a public float when he invested in UnderCoverWear – a company that sells women’s underwear via a party plan scheme. Instead, he liked the idea of a private investment, not subject to daily market scrutiny.

The business was started in 1981 by Kathy Hood, who experienced the direct selling of underwear at a party in the US and brought the idea back to Australia. Ten years later, when she needed capital for expansion, Hood brought in two investors – one of them was Everett.

Direct selling was not part of his expertise. He’d been chief executive of Whites Wires, which supplied wire to the hardware and rural industries, but very quickly learnt the basics of the party plan business.

A decade later, when Hood wanted out, she sold her shares to the Westpac Private Equity-managed venture capital fund, Quadrant Capital. Everett’s role became much more hands on. His investment turned into a full-time job, and with a new CEO, Elaine Vincent, who was elevated from her role as chief financial officer, the UnderCoverWear business prospered.

But Quadrant was never in it for the long haul, and four years later, it wanted out.

“I didn’t want to do anything,” says Everett. “I didn’t want to sell, I didn’t want to float. I said ‘what are we doing this for? We’ve got a good little company’.”

As the other two shareholders felt differently, it was decided the best option was a public listing, and UnderCoverWear was floated in June 2004.

As chairman, Everett found investor relations a challenging experience. “Because we’re the only direct selling company on the ASX, since listing, I’ve spent a considerable amount of time explaining to investors the differences between direct selling, party plan and traditional retailing,” says Everett.

With 16 million shares, Everett still owns a third of the company. He recently resigned as chairman, but remains a director.

Still keen to be involved, he wanted to take a step back, and was also sensitive to corporate governance concerns relating to the size of his shareholding. “There wasn’t too much pressure put on me from a corporate governance point of view, but the fact that I was executive chairman and the major shareholder didn’t look too good,” he explains.

The new chairman, David Hall, was previously managing director of Nutrimetics International for eight years, and brings a wealth of direct selling expertise and experience to the board table.

With UnderCoverWear shares listing at 50 cents, and the share price now around $1.60, and this year’s sales far exceeding the prospectus forecast, Everett somehow still finds the success of his investment astonishing. When he bought into the company, it had annual sales of $3 million. In 2004-05, UnderCoverWear hit $44 million.

“It’s been an incredible 18 months since listing,” says Everett. The company is cash positive, has no debt and virtually no capital expenditure. The net result is that the majority of profits generated will go to the shareholders.

“Compared with other investments I’ve been involved in, UnderCoverWear has been by far the most successful,” says Everett. “And the future growth is going to continue without the need for large cash injections.”