Asia’s Private Equity News Source avcj.com February 23 2016 Volume 29 Number 07

ANALYSIS FOCUS

Reputational risk?Dick Smith Electronics has placed Australian PE under scrutiny again Page 7

Beneath the radarDeal-by-deal in the lower middle market Page 10

Service with a smile GPs eye roll-ups in healthcare, education Page 16

Data f ile Page 19

AVCJ RESEARCH

PRE-CONFERENCE ISSUE AVCJ PRIVATE EQUITY AND VENTURE CAPITAL FORUM AUSTRALIA 2016

Archer’s Peter Wiggs on buyout opportunities

Page 15

INDUSTRY Q&A

Start-ups stand to gain from innovation push

Page 12

FOCUS

Australian GPs expect strong deal flow in 2016

Page 3

Anacacia, Advent, Ascendent, Bain, Blackstone, Frees Fund, GIC, Global Brain, Haitong, KKR, KV Asia, Lightstone, Matrix, SBI, Sequoia, TPG, VIG

Page 4

EDITOR’S VIEWPOINT

NEWS

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Number 07 | Volume 29 | February 23 2016 | avcj.com 3

EDITOR’S VIEWPOINTallen.lee@@avcj.com

STATISTICS-WISE, 2015 WAS A BIG YEAR for private equity in Australia. AVCJ Research has records of 79 investments totaling just over $24 billion, the highest annual total ever seen, and nearly three times the 2014 figure despite a one third drop in transaction numbers. Much like Asia as a whole – $137.8 billion was invested, also a record – the year was characterized by a number of very large deals.

At $6.3 billion, the acquisition of GE Capital’s Australia and New Zealand consumer lending business by KKR, Varde Partners and Deutsche Bank led the way. As those familiar with Australian private equity can attest, “normal” deals tend to be much smaller and are perhaps best classified as mid-size, coming in at $50-200 million in enterprise value.

To be fair, the market does see its fair share of abnormal deals but they tend to fall in the infrastructure space. And there was one of these in 2015 as well: A consortium featuring Hastings Fund Management, Caisse de dépôt et placement du Québec (CDPQ) and the Abu Dhabi Investment Authority (ADIA) agreed to pay $7.5 billion for Transgrid, part of the New South Wales government electricity transmission network.

So are the 2015 numbers indicative of what 2016 will bring? In a way yes. First of all, there could be some more bumper infrastructure deals with a slew of ports and pipeline businesses being lined up for privatization, as well as some more electricity assets. By selling off brownfield

infrastructure state governments can generate capital to invest in greenfield projects, or so the theory goes.

On a more general level, Australian fund managers are feeling positive, despite uncertainty in the global economy. Local GPs took advantage of the IPO window when it was open, exiting a record number of companies, and now they are looking to deploy more capital. Some already have dry powder at their disposal and several others are preparing to return to market with new funds.

With the spate of IPOs ending early last year, the investment environment has also improved. Company owners that were angling for public offerings – and would only entertain private equity bids at very high valuations – now see their options narrowing. Valuation expectations have also come down.

Meanwhile, the depreciating Australian dollar has restored delineation to the large cap and mid cap spaces. When the currency was strong, pan-regional players with US dollar-denominated funds found their capital didn’t go as far and so they started looking for middle-market deals and coming up against local GPs. This trend now appears to have abated.

Allen LeePublishing DirectorAsian Venture Capital Journal

Burgeoning buyouts

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No. of deals

Private equity investment in Australia

Source: AVCJ Research

25,000

20,000

15,000

10,000

5,000

0

150

120

90

60

US$

mill

ion

Dea

ls

Amount (US$m)

2009 20112010 20132012 2014 2015

avcj.com | February 23 2016 | Volume 29 | Number 074

GLOBAL

Global Brain in $13.1m round for YouAppiUS and Israel-based ad analytics start-up YouAppi has raised a $13.1 million Series B round from a group including Global Brain. YouAppi will use the capital to expand in Asia, improve its technology and move to San Francisco.

ASIA PACIFIC

Asian GPs want training from fund admins - surveyMore than a third of Asia-based GPs would like fund administrators to provide additional training services, according to a survey by Augentius. The next most requested services are regulatory reporting, investor reporting and tax services.

Ex-CLSA Capital Partners CEO joins TRG as partnerThe Rohatyn Group has hired former CLSA Capital Partners CEO Christopher Seaver as a partner based in Hong Kong. He will take responsibility for the firm’s initiatives in Asia. Seaver departed CLSA in 2014 to co-found Aequus Asia.

AUSTRALASIA

Bohai Industrial backs $950m Yancoal debt dealBohai Industrial Investment Fund, a PE firm controlled by Bank of China, participated in a $950 million debt funding round for Yancoal Australia, an Australia-listed subsidiary of state-owned Yanzhou Coal. The transaction is expected to close by the end of April.

Anacacia backs MBO of Australian timber playerAnacacia Capital has supported a management buyout of Australia’s Big River Group, one of the country’s largest privately-held timber suppliers. Anacacia will provide capital and expertise as Big River moves into its next stage of growth.

Blackstone buys New Zealand retirement villages The Blackstone Group has agreed to buy a portfolio of five New Zealand retirement villages

from property management group Lend Lease Group. The deal involves four fully-completed villages in Auckland and one in Mt. Maunganui. Terms were not disclosed.

GREATER CHINA

Frees Fund, Qihoo 360 lead Mobi Magic’s $100m round China-focused VC firm Frees Fund and Qihoo 360 Technology co-led a $100 million round for security app developer Mobi Magic. Frees Fund launched its debut fund last year with a target of

RMB1 billion ($160 million), seeking start-ups in the technology, media and telecom space.

Alpha Animation, Matrix invest in China VR start-upGuangdong Alpha Animation and Culture and Matrix Partners China have led an undisclosed Series A for VR game developer Time of Virtual Reality. The investment will support content development and advanced VR technology.

Perfect World launches fund for Universal moviesChina-based Perfect World Pictures has launched a fund to invest in a slate of Universal Pictures films. The GP and domestic fund-of-funds Shengjing each contributed RMB375 million ($57 million) to the fund, which targets RMB1.5 billion.

Fairchild rejects China Resources buyout offerUS-based Fairchild Semiconductor International has turned down a $2.6 billion take-private bid from China Resources Microelectronics and Hua Capital. Instead Fairchild endorsed an offer from competitor ON Semiconductor to buy all Fairchild outstanding shares at $20.00 apiece in cash, lower than the Chinese group’s $21.70 bid.

Ascendent sees 5x return on China rail investmentAscendent Capital Partners has exited high-speed train parts maker Nano Resources for a more than 5x return. The firm acquired a 40% stake in Nano for $31.8 million in 2012. Last year Nano agreed a RMB3.3 billion ($520 million).reverse merger with Shenzhen-listed Guangdong Kaiping Chunhui.

Private equity JV to exit Baicaowei to strategicHaitong-Fortis Private Equity, a JV between Haitong Securities and BNP Paribas Investment Partners, will exit Chinese snack food e-commerce platform Baicaowei to jujube product maker Haoxiangni for RMB960 million ($147 million) in cash and stock.

Sing Wang named CEO of China Minsheng FinancialSing Wang, a former co-chairman for Greater China at TPG Capital, has joined China Minsheng Financial Holding as CEO. He will expand the company’s financial services platforms in China and overseas.

Australia’s Asciano accepts $6.3b Qube-led takeoverThe board of Australian rail and port operator Asciano has accepted an A$8.8 billion ($6.3 billion) takeover bid by a Qube Holdings-led consortium that includes Canada Pension Plan Investment Board, China Investment Corporation and Global Infrastructure Partners.

The consortium is offering A$7.04 in cash, plus one Qube share, per Asciano share. Qube’s shares were trading at A$2.04 in afternoon trading on February 16, raising the total offering price to A$9.08 per Asciano share.

Qube will assume control of Asciano’s Patrick port business and get a 50% stake in Australian Amalgamated Terminals. The other consortium members will take the Bulk and Automotive Port Services and a 50% stake in ACFS Port Logistics.

Asciano will pay a break fee of A$88 million to Brookfield, which submitted a competing bid last year. Qube’s bid is still subject to approval by the Australian Competition and Consumer Commission, which may not make a final decision until late March.

Asciano has 8,000 employees in Australia and New Zealand. For the year ended 30 June 2015, the company reported A$3.8 billion, down from A$4 billion the year before. Over the same period profits rose from A$495 million to A$585 million.

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avcj.com | February 23 2016 | Volume 29 | Number 076

58 Daojia merges with VC-backed beauty appPE-backed local services platform 58 Daojia has merged with Dudumeijia.com, a manicure-booking app backed by Sequoia Capital and Source Code Capital. The companies will operate under their own brands.

Payment service Lakala to list in reverse mergerLakala, a Chinese third-party payment services provider owned by Legend Holdings, will list on the Shanghai Stock Exchange. Shell company Tibet Tourism will acquire Lakala for RMB11 billion ($1.7 billion) in cash and stock, financed through a RMB5.5 billion private placement.

NORTH ASIA

VIG set for 2.5x return from Burger King KoreaVIG Partners will sell the Burger King master franchise for Korea to Affinity Equity Partners. Affinity will pay KRW210 billion ($171 million) for the business, which VIG bought for KRW110 billion ($89 million), including debt, from conglomerate Doosan Group in late 2012.

GLP, CPPIB establish $877m Japan joint ventureThe Japanese arm of Global Logistics Properties and Canada Pension Plan Investment Board have created a joint venture to invest over JPY100 billion ($877 million) in logistics projects. The vehicle will begin construction this year. Commitments are split evenly.

South Korea’s Yello Mobile raises $30m from SBIJapanese internet finance group SBI Holdings has committed $30 million to Korean mobile internet platform Yello Mobile. The new capital will support the company’s mobile media and platform businesses and build up Yello’s pan-Asia mobile platform. The investment is the second close on a $43 million funding round led by Formation 8 that Yello announced in December.

Korea’s SEMA designates $125m for foreign PE funds Korea Scientists & Engineers Mutual-aid Association (SEMA) plans to invest half its KRW300 billion overseas allocation for 2016

in private equity, with a particular focus on US-based funds. The institution will approach GPs privately rather than issuing a public call for proposals.

Korea’s NPS appoints new CIOThe National Pension Service of Korea (NPS) has named former Meritz Asset Management CEO Myun-Wook Kang as its new chief investment officer. His appointment follows that of Hyung-Pyo Moon, former minister of health and welfare, as chairman of NPS. Kang has also worked for Schroder Investment Management, Shinhan BNP Baribas and ABN AMRO.

SOUTH ASIA

India’s Tracxn launches start-up exit platformIndia-based start-up data analytics platform Tracxn has launched an online platform to help angel investors find exit opportunities from start-ups. TracxnSecondary connects seed-stage investors who are looking to sell their stakes with prospective VC and institutional buyers in the VC and institutional. SAIF Capital invested $3.5 million in the company’s Series A round last April.

Bain, GIC, Advent invest in Quest GlobalBain Capital, GIC, and Advent International have bought a minority stake in Indian engineering services outsourcing firm Quest Global for $350 million. The deal includes the entire holding of Warburg Pincus, which bought its stake for $75 million in 2010. Media reports put the post-deal valuation of the company at about $1 billion.

KKR invests in India’s Max Financial ServicesKKR has bought a 10% stake in Max Financial Services, a spin-off of India’s Max Group that controls life insurance player Max Life. The firm bought the stake from a group of promoters including Analjit Singh, chairman emeritus of Max Group. Market filings indicate the value of the deal was INR9.5 billion ($139 million).

SOUTHEAST ASIA

KV Asia acquires Malaysia’s TF Value-MartKV Asia Capital has acquired a controlling stake in TF Value-Mart, a hypermarket chain that operates 18 locations in 5 states in Malaysia, for an undisclosed amount. The firm has brought in a new management team to develop the company.

Lightstone Ventures raises $50m Singapore fundLightstone Ventures has closed a $50 million fund, called Lightstone Singapore, aimed at investments in Singapore-based life sciences companies. LPs include Singapore government-backed investment group Temasek and EDBI, the VC arm of Singapore’s Economic Development Board.

Sequoia backs $1b take-private for China’s JumeiSequoia Capital is supporting a take-private for Chinese online beauty products retailer Jumei International that values the US-listed business at about $1 billion.

Jumei’s co-founders and Sequoia are willing to pay $7.00 in cash per share for all outstanding American Depository Shares. This represents a 19.8% premium to the February 16 close. Jumei’s stock closed up 8.22% at $6.32 on February 17.

The buyer group controls 54.4% of all shares. Other investors include K2 Partners and angel investor Xiaoping Xu.

Sequoia invested $4 million in the company through promissory notes in 2010 and 2011, which were fully discharged in the 2011 Series A round, when Sequoia and other investors committed $7.2 million. Jumei went public in May 2014, raising $245.1 million.

The company sells beauty products through an online shopping mall, curated sales and flash sales. It works with around 2,400 suppliers and third-party merchants and had approximately 13.3 million active customers in 2014.

Revenue came to $632.9 million in 2014, up from $482.9 million in 2013, while net income rose from $25 million to $65.9 million.

NEWS

Number 07 | Volume 29 | February 23 2016 | avcj.com 7

COVER STORYtim.burroughs@avcj.com

THE GROUPS MEET ABOUT ONCE A month, typically in Canberra, Melbourne or Sydney, to learn about the financial mechanics that enabled their preferred skin cream or sportswear line to come to market. For public sector employees, tax authority officials and representatives of the Department of Treasury alike it can be an eye-opening experience – finding out which brand names are owned by private equity.

This is a snapshot of the Australian Private Equity & Venture Capital Association’s (AVCAL) PE101 seminar series, intended to educate key stakeholders about the asset class, and perhaps knock down some preconceptions along the way. It is one facet of a broad-based outreach initiative, something that is perhaps more necessary in Australia than other Asian markets.

“We have invested a lot of time in informing the market, being more engaged and participating in public policy debate to ensure that new reforms deliver the right outcome in the marketplace,” says Yasser El-Ansary, AVCAL’s CEO. “Had we not built relationships with the likes of policy makers, MPs and regulators to the extent we have, perhaps a situation like the one we are confronting now would have been significantly more problematic for us.”

That situation involves Dick Smith Electronics, which Anchorage Capital Partners bought in 2012 for A$20 million ($14 million) plus a share of any upside resulting from an exit. Having turned around the distressed asset, the GP listed it in late 2013 at a valuation of A$520.3 million. In January, just over one year after Anchorage sold the last of its shares, Dick Smith entered receivership.

The swift demise prompted a public outcry: How could Dick Smith fall so far, so fast? A senate inquiry has been asked to find an answer. It will investigate the causes and consequences of the collapse of listed retailers in Australia, although some expect politicians to use it as a public platform from which to attack private equity. Once again, the industry could be held up to scrutiny, tasked with explaining why it does not pose a systemic threat to listed companies.

“I think it is politically opportunistic,” says one local LP. “It does look like an opportunity to have a crack at Dick Smith and the role of private equity within it, which is in some respects

shortsighted. Many other people play a role stewarding a company through a public offering process. It can be hard to pin everything back on what someone did several years earlier in a private equity context.”

A question of contextAVCAL would like to participate in a wide-ranging inquiry that allows the senate committee to develop a better understanding of PE. There are two reasons for this. First, the same committee, albeit with different members, conducted a thorough inquiry into private equity specifically in 2007 and concluded that the asset class makes a positive contribution to the economy. Second, and more importantly, Dick Smith is still under the control of administrators and it is up to them to determine what went wrong.

The most detailed and frequently repeated third-party critique of Anchorage’s behavior, put out by Forager Funds Management in late October, claims the GP engaged in accounting

trickery to dress up Dick Smith for an IPO at the expense of long-term sustainability. Anchorage has refuted these claims. Opinion within the PE community is mixed, although most acknowledge that retail presents a challenge.

Changes in the dynamics that govern discretionary spending, high fixed costs and tight inventory management can make things “get pretty dangerous pretty quickly,” as one manager observes. This is not solely a private equity issue – indeed, Australia has seen numerous blow-ups of non-PE backed businesses, in and outside of retail – but by the same token, as a turnaround investment in a high-risk sector, Dick Smith is not representative of the private equity mainstream.

It remains to be seen what prognosis the senate committee, the administrator or the securities regulator deliver. But for most LPs –

aware that private equity in Australia gets its share of negative publicity and not reading too much into it – the pressing question is what impact the Dick Smith situation will have on investor confidence in PE-backed IPOs.

“There is always a concern as to who is going to be the pariah, who is going to take a portfolio company public that doesn’t do well,” says Jonathan English, managing director at Portfolio Advisors. “There was some concern during the last window of IPO issuance in Australia as to when a newly listed company would underperform and disrupt the momentum. The opportunity for PE-backed IPOs is highly sensitive to negative press which may close the window for a prolonged period of time, resulting in a lack of near term liquidity.”

It is worth noting that private equity-backed IPOs generally perform well compared to the wider market. AVCAL and Rothschild track the performance of 67 PE-backed and non-PE backed companies that have listed in Australia since

2013 with a minimum offer size of A$100 million. The PE-backed contingent have generated an average return of 40.9%, versus 25.5% for non-PE backed, and account for eight of the top 10 performing offerings during this period. Meanwhile, Dick Smith is the only blow-up.

According to a separate analysis by Goldman Sachs, three quarters of the 25 largest PE-backed IPOs since 2013 have outperformed the ASX200 Index. Seven of these have bettered the index by more than 100%.

This generally strong stock performance up to three years after IPO appears to defy characterizations of private equity as a carpetbagger that doesn’t consider the health of businesses beyond the end of its holding period. It also offers an interesting perspective on calls for those holding periods to be lengthened with

Under the spotlightThe rapid descent of Dick Smith Electronics from a $500 million valuation to bankruptcy has led to sharp criticism of private equity. Once again, the industry must explain why it isn’t the bad guy

“More often than not, investors might not understand a business or they are mesmerized by the attraction of certain parts of the business without understanding the full risks” – Robert Pick

avcj.com | February 23 2016 | Volume 29 | Number 078

a view to reassuring public market investors that their interests are aligned with those of a company’s PE backers.

Time to sell?While retaining a portion of the stock post-offering is commonplace in the US and the UK, in Australia it has taken time to become the norm. The counter-argument that the overhang effect – weaker post-offering performance due to the presence of a substantial stake that investors know will dilute the stock when exited – still carries weight with buy-side investors in certain situations. For example, in 2013, Crescent Capital Partners was encouraged to sell its entire stake in LifeHealthcare’s IPO.

Industry participants place the origins of the shift from full to partial exit in 2009 and 2011, when first Myer and then Collins Foods swiftly dropped below their offering prices. The PE investors were not there to share in the pain.

“These offerings were the catalyst for investors to change their minds. They said, ‘We can deal with the overhang and would prefer to have an alignment of interest where there is enough money still on the table for PE to be concerned that it needs to hit the forecasts and not have a reputational issue.’ People are now setting strong forecasts but also leaving a few dollars on the table because they want to hit those targets and be trading to the upside,” says David Willis, head of Australia private equity at KPMG.

As a general rule, a private equity owner is expected to retain around 30% of a portfolio company for up to 18 months after the offering. This timing is linked to the earnings forecast periods set out in the IPO prospectus; once these have expired the PE investor is free to complete its exit, although if certain targets are met ahead of schedule there might be an early reprieve.

For example, Pacific Equity Partners (PEP) took cleaning and catering contractor Spotless Group public in May 2014. The private equity

firm and its co-investors retained about 40% of the business and this position was exited across three block trades between December 2014 and August 2015. By the time the last share was sold, Spotless had bettered its EBITDA projections for the 2014 and 2015 financial years.

However, as a result of slower new business growth, Spotless announced last December that EBITDA would be flat in 2016 while net profit is expected to fall year-on-year. The stock duly fell by half and remains below the IPO price. In terms of revenue, profit and margins, Spotless is said to be in a stronger position than it was on listing, but the announcement coincided with Dick Smith’s downward spiral. It was cited alongside the electronics retailer in news reports as an example of the damage PE can do.

Anchorage cut its stake in Dick Smith from 98% to 20% through the IPO in December 2013 and the GP completed its exit in September 2014. The earnings forecast for 2014 had been exceeded and the company posted year-on-year improvements for the 12 months ended June 2015. Up until mid-August, the stock was still trading close to its IPO price.

In his presentation at the annual general meeting in October, Dick Smith CEO Nick Abboud highlighted store openings, online expansion, growth in sales of private label products, and cost controls. He also announced a reduction in projected profit for 2016, and the stock dropped 30%. It turned out to be the beginning of the end.

The longer holdIf these investors’ post-IPO holding periods lengthen, how long is long enough? While LPs would like to see the industry behaving as a good corporate citizen, they also expect a return commensurate with the risk being taken. “A three-year lock-up seems a little overdone, but if there could be some sort of system based on hitting certain targets and exiting in tranches to

give public market investors piece of mind I’m open to that,” one LP observes.

In this respect, GPs have to balance the desire to avoid reputational risk arising from short hold and a sharp post-exit drop with their fiduciary responsibilities. A five-year escrow period, for example, is not a good fit for a fund with a 10-year life that starts considering realizations from around year four. Furthermore, the PE model is based on the premise that private ownership is a superior way to build businesses; if a company is public for half the holding period this could be seen to undermine the original rationale.

Quadrant waited two years to sell the last of its shares in New Zealand retirement village operator Summerset, having taking the business public in November 2011. This was due to limited liquidity in the local market, but the PE firm knew what it was getting into and retained a majority stake. The thinking was that if the holding period was going to be longer than usual, Quadrant should be in control for longer than usual; otherwise the GP would be working contrary to its typical approach and returns might suffer.

“We want to set companies up for 3-4 years but that isn’t directly linked to how long we retain the stock post-IPO,” says Marcus Darville, a managing partner at Quadrant. “Even if it’s a very good business, our investors aren’t paying private equity fees for us to hold on to it. We retain shares because it’s part of the exit process, and sometimes we will hold them for longer than we are obliged to hold them. I’m not certain that holding for, say, three years is necessary when it is a well-established and mature business.”

Numerous industry participants, while accepting that the chances of a full exit on IPO are slimmer than before, believe that holding until the prospectus forecasts have been met is appropriate. Several also observe that PE firms are not the sole actor in IPO processes. While the portfolio company board is ultimately responsible for the accuracy of disclosed

COVER STORYtim.burroughs@avcj.com

Post-IPO performance: PE-backed vs. non-PE backed

Average IPO returns Weighted average IPO returns No. of IPOs

Source: AVCAL, Rothschild

0 40 %302010 0 40 %302010 0 40 %302010

PE-backed Non-PE backed

One-year performance (2013 & 2014 IPOs)

One-year performance (2013 & 2014 IPOs)

One-month performance (2013, 2014 & 2015 IPOs)

One-week performance (2013, 2014 & 2015 IPOs)

One-month performance (2013, 2014 & 2015 IPOs)

One-week performance (2013, 2014 & 2015 IPOs)

2013 & 2014

2013, 2014 & 2015

2013, 2014 & 2015

Number 07 | Volume 29 | February 23 2016 | avcj.com 9

COVER STORYtim.burroughs@avcj.com

information, various third parties play a role in vetting it, and then public market investors ultimately decided whether or not to buy.

“Apart from a couple of relatively minor circumstances there has not been a lot of action against companies for defective prospectuses,” says Robert Pick, a partner at Allens who specializes in capital markets. “More often than not, investors might not understand a business or

they are mesmerized by the attraction of certain parts of the business without understanding the full risks.”

Neither is it in the interests of private equity investors to see companies falter, even after exit. Quadrant has been involved in five IPOs since 2013, PEP has done four, Crescent three and Anchorage two. It remains to be seen how long a shadow Dick Smith casts over the private equity

industry, but a sponsor that leaves its fingerprints on a string of failures is less likely to win over investors next time around.

“When we get into a business we are looking at it with a 10-year mindset,” says Tim Martin, a partner at Crescent. “Even if you exit after 4-5 years you still have to be thinking about the story 4-5 years beyond that. We have to ask about the long-term risks and opportunities because when we exit, having done the first phase of that you still need that next level of the growth story ahead.”

This attitude is apparent, for example, in approaches to staff retention. There is a phenomenon in Australian private equity of the repeat CEO – an executive who is familiar with PE investors and likes the professional challenge, financial incentives and clear goals that are part and parcel of a turnaround or rapid growth play. These individuals are not always interested in staying on once the goals have been achieved and a company is public.

It is possible to shape contracts so they commit key management team members to a certain length of post-IPO tenure, but equally private equity firms must look at succession planning. When the CEO of LifeHealthcare departed two years after the company went public his successor was ready and waiting, having spent the last three years with the company as a general manager.

This brings the issue back to whether the public perception of private equity tallies with the reality. Most industry participants do not expect the inquiry to result in a crackdown on the asset class, noting the broadening of the terms of reference to include several questions about consumer protection that do not relate to PE as evidence of wiser heads prevailing over an initial knee-jerk response.

They also point to part of the conclusion to the report from the 2007 inquiry: “The committee views private equity as an opportunity to reinvigorate underperforming public companies, which will subsequently benefit Australian consumers, shareholders and workers.”

At the same time, an appreciation of the need for private equity to communicate more consistently and effectively with stakeholders is tempered by a feeling among GPs that the prevailing view in certain constituencies might never be fully swayed.

“Making the connection points across our industry more visible to people – explaining the role of superannuation funds as investors in PE funds that deploy capital into Australian businesses – that task will never be complete,” adds AVCAL’s El-Ansary. “When we are sick of saying it there are people on the other end of our message that are only just starting to hear it.”

Retail risks It should come as little surprise that Anchorage Capital’s acquisition of Dick Smith Electronics

constituted a turnaround deal. AVCJ Research has records of fewer than 20 private equity buyouts in Australia’s retail sector since 2012. Half of these were wholesalers. Of the handful that involved genuine high street retailers, several have required some kind of triage.

The issues these businesses have faced vary enormously, from fall-outs between investment partners over the best way to achieve growth to GPs providing capital to companies with existing PE backers at times when getting fresh funding is difficult. However, their collective travails and the hesitancy of investors to get new exposure underline the challenges presented by the industry.

“Australia has a very high cost base for traditional retail. We have high concentration of ownership amongst the landlords, which translates into high rents compared to similar places around the world, and we have a highly unionized workforce, which translates into high hourly rates,” says Peter Wiggs, CEO at Archer Capital. “Then you throw in the fact that technology makes it easier for people not to leave their homes if they want to shop. I am happy the current retailers are sorting through these issues before we dive back in.”

Archer’s last retail investment was Rebel Sports in 2004, which was sold to a trade buyer seven years later. The thesis was supported by a consolidation strategy specific to sports retail that changed the dynamic between the company and its suppliers, leading to increased profit.

If particular angles or general market trends do not work in a retailer’s favor, difficulties can escalate rapidly. Several PE-backed retailers went under in the wake of the global financial crisis when nervous consumers increased their savings ratios from 2% of household income to 12% in the space of nine months. Revenues retracted and companies could no longer service their debts.

In December 2009, REDGroup Retail – a Pacific Equity Partners portfolio company that owned the local master franchiser for Angus & Robertson and Borders – was said to be among the most profitable bookstore chains in the world. Four months later profit had slumped to zero and the business went into administration in 2011. According to a source familiar with the situation, a 15% reduction in REDGroup’s revenue ate into what was a 50% gross margin and a 7% net margin.

“In retail you have large fixed costs and long operating leverage. Everyday businesses with low discretion are distinctly different, but the ones with high margins are a death trap if you get any tremor at all in the discretionary spending Geiger counter,” the source adds.

REDGroup wasn’t helped by a swing in the exchange rate. It was legally obliged to source books in Australia, but suddenly consumers could buy them more cheaply overseas. That inability to choose lower cost suppliers compounded the company’s difficulties because it couldn’t adapt to narrowing gross margins by altering costs.

Speed and agility are often highlighted by Brian Harris, a managing director at Alvarez & Marsal, when advising retailers on supply chain management. These qualities are particularly relevant to retail segments such as apparel and consumer electronics because the latest products are superseded by the next season. Consumer electronics was also among the first to be overwhelmed by digital channels, which sway purchasing decisions towards price and availability.

“Most groups you see fall from a place of margin stability are either missing the market with their assortment strategy, being forced to match prices of lower cost competitors, or allocating inventory sub-optimally, resulting in too much inventory in the wrong places,” says Harris. “If it’s the latter, a retailer has no choice but to cut prices and clear inventory, which is painful from a margins perspective. If you can’t move this season’s winter sweaters, you can’t hold on to them and sell them next year – the lifecycle of merchandise is accelerating so quickly.”

avcj.com | February 23 2016 | Volume 29 | Number 0710

ANALYSISholden.mann@avcj.com

IN 2010 YORKWAY CAPITAL PARTNERS didn’t have a fund, a portfolio, or a history in the private equity market. But the firm did have a plan to tackle a group of investors that had so far been reluctant to commit capital to the asset class.

“We saw a trend, particularly in the high net worth and family office part of the market, where they were not really as concerned about the fees,” says Paul Batchelor, principal and co-founder at Yorkway. “They’d pay fees for what they thought was good performance, but they were less inclined to actually give any PE house their money for 10 years and wait to get it back.”

The firm has built a business around these underserved investors, eschewing the traditional private equity fundraising approach for a deal-by-deal model that allows greater flexibility. Having made co-investments with major PE houses over the past six years, Yorkway is now preparing to make its own majority investments, still on a deal-by-deal basis.

It is one of several GPs that have filled a niche following unconventional investment models in the country’s lower middle market. While many industry players view these firms as special cases, and unlikely to represent a significant part of the market going forward, there is also widespread recognition that they can play an important role in the industry.

Moving marketThe emergence of this strategy is not necessarily a function of choice. For several years, a number of larger superannuation funds have been moving away from lower middle market managers due to constraints imposed by their own growing asset bases. On one hand, they have a bigger minimum check size; on the other, they are usually not allowed to comprise too much of an individual fund. This has created a fundraising squeeze for smaller managers, so they have begun to target different sub-sets of domestic LPs.

Industry players point to a similar trend among GPs as well. Several private equity firms established themselves in the lower middle market and went on to raise larger funds. Naturally, they now write bigger checks and are interested in larger companies.

Nevertheless, participants still consider the

lower middle market to be a good bet. GPs note that while some domestic investors have left the lower middle market space, others show no signs of departing. In addition, increasing interest from international LPs in Australia offers local fund managers another source of funding – one that they may prefer to superannuation funds due to more relaxed expectations regarding fees and returns.

“It comes down to a situation where if the GPs can raise that capital offshore they will,” says an investment manager at one Australian LP. “If you can raise dumb money from overseas that doesn’t ask questions and expects a lower return for a higher fee why not do it? That is exactly what they have done at the big end of the spectrum.”

From an investment perspective, activity in Australia’s lower middle market has fluctuated in recent years. AVCJ Research data show both the number of deals between $50 million and $200 million, and the total value of those deals, follow

a pattern of peaks and troughs: 10 deals worth $1.1 billion in 2015 represents the lowest point for both measures since 2009. However, in 2013 investors completed 22 deals for a total of $2 billion, the highest point for both since 2008.

Despite this fluctuation, industry players say the lower middle market continues to provide plenty of opportunities for investments and exits. Traditionally, deal flow has focused on small businesses, whose founders are looking to exit. With its wealth of small and medium-sized enterprises, Australia represents a particularly attractive market and some GPs have generated strong returns.

The issue, then, is not with the availability of deals, but the availability of investors with the capital to take on those deals. Even GPs that are active in the space say things have gotten tighter

in some regards. For example, one manager has noted a decrease in the availability of co-investment capital, and a growing reluctance on the part of LPs to pay fees and interest on this capital.

“It’s an increasingly focused and concentrated market,” says Yorkway’s Batchelor. “The crème de la crème can still find the money, but some highly-rated long-term managers with good performance over many years are not finding it that simple, even from the international players, for reasons like the fees that are being charged.”

With shrinking amounts of capital concentrated in ever-smaller numbers of funds, some industry participants have looked to unconventional fund models as a means of entry. Deal-by-deal fundraising is one such approach; though not all participants consider it a viable long-term option, its proponents feel that it offers hidden benefits.

Fundamental to the deal-by-deal model as practiced by Yorkway is the belief that there is a

pool of capital that is willing to get involved in private equity but has not been presented with the right opportunity. In this case, that means the high net worth individuals and family offices with which Yorkway’s founders had built contacts in their years in leadership roles at financial institutions.

So far the firm has looked for opportunities to invest its clients’ money alongside established private equity funds. Last year, for example, it set up an investment in quantity surveying company BMT Tax Depreciation, buying a 70% stake in the company at a valuation of A$65 million ($50.3 million) alongside CHAMP Ventures, which took the larger portion of their purchase.

“Deals are too small for institutional capital in that segment, but it’s sort of accessing a different pool of capital into private equity investing,” says

Early adoptersWhile Australia’s lower middle market still offers opportunities for conventional GPs, some managers see growing potential in alternate fund models. Skepticism is strong among their peers

“The crème de la crème can still find the money, but even highly rated long term funds with good performance over many years are not finding it that simple, even from the international players” – Paul Batchelor

Number 07 | Volume 29 | February 23 2016 | avcj.com 11

ANALYSISholden.mann@avcj.com

Gareth Banks, a director at CHAMP Ventures. “It’s not a bad thing; it’s giving these high net worth individuals access to come into some of these smaller sized but growing businesses.”

Unique qualitiesIndustry players identify several factors that make an unconventional fund structure attractive. For one, the model offers managers flexibility in investing. As they are not limited by their fund size, they can theoretically commit as much or as often as they want, provided they can locate the capital.

On the side of the LPs, high net worth individuals – such as the retired business founders who form many of Yorkway’s clients – and family offices might gravitate toward a

fund with an unconventional structure, rather than a traditional blind pool, because of its more accommodating risk and fee structure. Since investors can choose what they invest in, they are not exposed to risk from every deal as in a conventional 10-year fund, they can see returns much sooner than with a conventional fund, and they do not have to pay fees on un-invested capital either.

“Because the average life of what we invest in is 4-6 years and you only pay fees during that life, the fees are much lower over the life of an investment than they are in a traditional PE fund,” says Batchelor.

In addition, the model does not have to exclude conventional private equity LPs. Catalyst Direct Capital Management (CDCM), launched by Catalyst Investment Management founder Trent Peterson, set up a 2015 buyout alongside Canada’s OPTrust in Melbourne’s SkyBus, valued between A$50-100 million. The firm pitched itself as a direct investment by LPs in target companies, with Peterson arranging the deals and managing the assets.

However, CDCM’s experience also points up

some of the reasons why GPs on the whole are skeptical about working deal-by-deal. A common view in the industry is that this approach is a transitional stage in the life of a GP, rather than a model that can serve as the foundation for a long-term strategy. By this reading, operating on a deal-by-deal basis is either a stepping stone to raising a conventional fund or what one manager calls “a second best option for firms that can’t raise another fund.”

Peterson himself acknowledges the challenges of the approach. CDCM had the advantage of the Catalyst pedigree when it started, but it still must go through the fundraising cycle every time it wants to do a deal, and it must complete all of its pre-investment homework before it can raise any capital.

“It is very difficult to do and clearly a sub-optimal model. More often than not, it arises from necessity, not as a preference,” says Peterson. “The guys that do succeed might charge 2/20 or sometimes higher. Investors can get their heads around that, but it has to be a materially completed deal; due diligence is done, terms have been negotiated, agreed and documented. So it’s ‘cherry pick’ participation for the investors, with little risk on deal completion.”

Despite the difficulty of the deal-by-deal approach, its proponents do feel that, if managed well, it can serve as a successful strategy. Yorkway points to its five years of operational history as a sign that an experienced and practical manager can make the model work.

Both practitioners of the model and more conventional GPs acknowledge that it can also play a unique role in the private equity community. For instance, those with a non-traditional approach act as originators of deals, something Yorkway has done several times.

In addition to the BMT investment and the purchase of Ansett Aviation Training, also with CHAMP Ventures, the firm has done several deals

with Quadrant Private Equity, including the 2010 buyout of media monitoring service iSentia and the purchase last year of oncology service provider Icon Cancer Care, a deal that Yorkway holds up as an example of its ability to match the right investor with the right opportunity.

“The most important thing with that investment was that we saw the opportunity to consolidate the market and to grow quite aggressively through acquisitions and investment in businesses in the same space, or in adjacencies strategically. And that’s something that Quadrant’s very good at,” says Batchelor.

Niche operatorsYorkway’s confidence in its strategy is reflected by the fact that it plans to continue to follow its deal-by-deal model when it begins making investments on its own. The firm is currently working on several potential deals and plans to complete three or four this year, seeking stakes of 50-70% at check sizes from $10-$50 million.

While disagreement persists on the proper place of a deal-by-deal approach in a firm’s tool kit, players concur that the strategy is not likely to become a major part of the industry. The dominant view is still that the traditional fundraising approach is most likely to be successful.

For one thing, raising a fund only needs to be done once, rather than every time a GP wants to make a commitment. Having its own source of capital also means that the GP can readily cover broken deal costs and fees, rather than having to eat those costs itself.

“It is now very difficult to raise a fund as a cold start-up. How do you do it if you don’t have a track record?” says Tim Martin, a partner at Crescent Capital Partners. “It’s a long hard road. You need to get 3-4 deals successfully done and exited – so if you start deal by deal it’s potentially an 8-9 year road before you can raise your first fund. You might do it faster if you have some pedigree from elsewhere.”

Some players feel that the deal-by-deal model will slowly become more popular as market players become more aware of the remaining untapped capital pools. However, most agree that the most likely result is that the model will retain its current role.

“That good PE operator with a strong personal track record and network might not be initially backable on their own for a A$200-300 million fund, but if the alignment’s right, the investors will certainly back someone to do deal-by-deal,” says CHAMP Ventures’ Banks. “You would then imagine that after a few of those deals, they can progress that investor support to being able to raise their own fund of commitments. It’s a model that has occurred overseas.

Australia PE deals of $50-200 million in enterprise value

Source: AVCJ Research

2,500

2,000

1,500

1,000

500

0

25

20

15

10

5

US$

mill

ion

Dea

ls

No. of deals2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

Total value (US$m)

avcj.com | February 23 2016 | Volume 29 | Number 0712

FOCUSwinnie.liu@avcj.com

IN HIS FIRST MAJOR POLICY ADDRESS since being appointed prime minister of Australia, Malcolm Turnbull reaffirmed his commitment to innovation. He had also prepared an appropriate soundbite: “Unlike the mining boom, it’s a boom that can continue forever.”

Turnbull’s words were followed by the launch of the National Innovation & Science Agenda towards the end of December. The document is regarded as the most comprehensive set of innovation policies that Australia has ever seen – a shot in the arm for a country that has fallen behind its peers in terms of math and science teaching, collaboration between academia and industry, and businesses taking risks.

It is likely to facilitate about A$1.1 billion ($795 million) in investment over the next four years, in part due to tax and regulatory measures designed to encourage commitments to start-ups.

“If you have a prime minister who in his very first public comments starts talking about the importance of innovation, entrepreneurship and seeding businesses to creating new growth corridors, that narrative permeates through the business sector and through to investors,” says Yasser EI-Ansary, CEO of Australia Private Equity & Venture Capital Association (AVCAL). “This has played a large part in making them confident that the government is supportive of policies that help drive entrepreneurship.”

While industry participants generally welcome the initiative, they see it as a starting point, not the finished article. Much rests on the government’s ability to adapt its policies during the implantation phase.

Framework debateGroups, including AVCAL, have been providing input to the government since last year on what a comprehensive policy framework to support innovation might look like. They covered a broad range of issues, including recalibrating the current tax system and making it easier for early and later-stage VC firms to raise capital.

In March 2015, these efforts began to bear fruit. First, the employee share scheme (ESS) was reformed to remove an upfront tax liability that was hampering the ability of local start-ups to retain talent. Second, the significant investor visa (SIV) program recalibrated so that 20% of the minimum A$5 million applicants must invest

locally as a condition of entry now has to be deployed in VC funds.

The innovation agenda features incentives intended to drive further capital into the start-up community. Taking reference from measures introduced in the UK, the government said that early-stage investors can claim a 20% non-refundable tax offset based on the amount committed to a start-up or a VC fund, capped at A$200,000 per investor, per year. Capital gains generated on the disposal of these investments will generally be tax exempt.

In addition to that, the government has loosened eligibility requirements for participation in existing early stage and venture capital limited partnership (ES/VCLP) structures. For example, foreign fund-of-funds can hold more than 30% of an ES/VCLP, while trust companies are now allowed to invest as well. GPs can also raise more money, with the maximum fund size rising from A$100 million to A$200 million. All investors will qualify for a 10% tax offset on capital invested.

More importantly, an ES/VCLP will no longer have to divest a portfolio company once its total assets exceed A$250 million – the threshold above which flow-through tax treatment no longer applies. “This was requested by a group of VC investors; we are happy becoming liable for taxation when a company reaches that asset value, but we don’t necessary want to sell our investment out of the scheme,” says Rick Baker, co-founder of Blackbird Ventures. “Now they have changed that. It’s really about making sure that the ES/VCLP program runs smoothly.”

He adds that the overall tax incentives could open up a flood of capital from angel investors in Australia. These individuals have increased their commitments in recent years but more recently the pace of investment has slowed due to uncertainty – about the performance of investee companies and the growth prospects of the industry. However, the recent public market slowdown has led to an easing of valuations on

the private market side, so investors might be persuaded to return.

“The later-stage private market has been hit hard, and valuations are starting to come down. It’s probably a good time to provide these tax incentives now the market is suffering a little bit. You don’t want to provide a lot of tax incentives when the market is really booming,” says Baker.

Later-stage gapWhile there is sufficient early-stage capital – predominately seed and Series A rounds – available in the system, Australia still lacks Series B and C investors. A recent AVCAL report identified an “urgent need” to address the gap between seed and later stage, with only 23%, or A$85 million, of total VC funding dedicated to bigger start-ups. It wants GPs to be able to tap domestic sources of capital in greater depth, but there are taxation obstacles.

Returns on investments made by certain classes of investor, such as superannuation funds,

are taxed under the capital account and treated as a capital gain. For other investors, notably family offices and high net worth individuals, returns might be treated as income, which means a higher tax levy. AVCAL advocates adopting the Board of Taxation’s 2011 recommendation to provide capital gains tax treatment for all domestic investors in VCLP programs, which currently only target foreign investors.

“What happens at the moment is a subset of domestic investors are given a particular tax outcome while another subset gets a different outcome,” says EI-Ansary. “There is an immediate and long-running disconnect in the tax system that draws a distinction between different classes of domestic investors. Our message to the government is we need a solution that helps drive greater interest from institutional investors in later-stage venture funds.”

However, some VC investors say this is putting the chicken before the egg. They want to see

Policy powerAustralia’s innovation agenda is intended to serve as the foundation stone of a technology-driven economy. Do the promises made to start-ups address areas where they want to see change?

“We need a solution that helps drive greater interest from institutional investors in later-stage venture funds” – Yasser El-Ansary

FOCUSwinnie.liu@avcj.com

more policies encouraging entrepreneurs to come up with ideas. The innovation agenda includes measures aimed at reducing risk-aversion in the start-up community. Bankruptcy legislation changes mean that founders in a failed venture will only have to wait one year, instead of three, before creating a new start-up. There are also subsidy programs aimed at companies founded in global technology hubs.

“I don’t think it is the government’s job to fill the later-stage funding gap. What it should do is to ensure the current platforms in Australia can produce exciting start-ups. They have to focus on what the barriers are to producing these companies. Investors will put more money into the system if they can get good returns from early-stage investments,” says Craig Blair, co-founder of AirTree Ventures.

Having said that, it makes sense for the government to target industries that face particularly steep development barriers. For example, the costs of commercialization for a biotech company are usually far higher than for counterparts elsewhere in the tech sector, and the commercialization process itself takes longer. The innovation agenda announced the A$200m CSIRO Innovation Fund, which will co-invest in spin-offs and start-ups from Australian research institutions, while the A$250 million

Biomedical Translation Fund will invest alongside biomedical-focused GPs in certain deals.

They do not represent Australia’s first attempt at co-investment funds. In 1997, the Innovation Investment Fund (IIF) was created to invest in start-ups backed by licensed fund managers, matching capital provided by private sector LPs. The program was discontinued in the 2014-2015 budget. Michelle Deaker, CEO of OneVentures, a former IIF recipient, says the government is not simply retracing its former steps.

“If anything, the funding has returned in a more targeted fashion,” she explains. “The Biomedical Translation Fund will likely leverage the IIF program infrastructure but it exists to address the VC funding gap in terms of getting biomedical companies commercialized and incentivizing investors around this.”

Confidence boosterThe innovation agenda is still under consultation and is expected to come into effect from July. Investors are currently holding back, wary of changes post-consultation, but the government insists that “this is not a one-off statement.” Indeed, it has indicated a willingness to modify policies over time if existing approaches are not delivering the desired outcome.

Some see this as a means of encouraging

large institutional investors to participate in venture capital. With this in mind, Blue Sky Venture Capital and Square Peg Capital both recently launched A$200 million funds aimed at LPs that write bigger checks.

“We still focus on late-stage venture capital and it will be our first institution-focused VC fund,” says Elaine Stead, investment director at Blue Sky. “We see a lot of smaller companies coming through the pipeline in Australia as a result of policy support over the last decade. Now they need a large quantum of capital, so we need a larger fund in order to capture that.”

First State Super has already started investing more heavily in venture capital. After backing domestic funds launched by Blackbird and Brandon Capital – both of which offer co-investment opportunities to meet the needs of larger LPs – it now plans to deploy A$250m into financial technology companies managed by H2 Ventures, in line with the government announcing the Agenda.

“The government’s goal is that, in five years’ time, Australia will have seen a significant reset of its economy around several key areas, such as financial technology, agriculture technology and biotech,” says Ben Heap, founding partner of H2 Ventures. “Collaborating with the industry is a smart way of tackling this; it’s a good first step.”

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Number 07 | Volume 29 | February 23 2016 | avcj.com 15

Q: The pace of deployment for Fund V was initially slow. How has it picked up?

A: Fund V is now 71% invested and on track to be fully deployed in five years, and we will look to launch Fund VI in the final quarter of this year. Conditions for deployment in Australia have improved markedly in the last 12 months or so. The IPO market was the biggest constraint in terms of getting deals done – we were looking at opportunities that were priced 20-30% above what we thought they should be – but following the volatility in March-April of last year that option has disappeared for most vendors. We are in discussions over a couple of assets that were slated for IPO but now the vendors realize that if an offering happens at all it will be at a deep discount. The weakness of the Australian dollar also means there is less of an overlap between us and the pan-regional guys who are managing US dollar-denominated funds. In 2014, they were happy to come down into the mid-market, but now a A$200 million check is a US$140 million check, so they are looking at opportunities larger than we are.

Q: Education and healthcare both feature prominently in Fund V. Why is this?

A: There has been massive under-investment in both education and healthcare by different levels of government and they are looking for the private sector to solve that under-supply. While education and healthcare are defensive sectors, solving that under-supply is going to play out over 15-20 years. Education – and to a lesser extent healthcare

– is also partly export-driven. As a result of the strong Australian dollar, the attractiveness of Australia versus the UK or US was halved, and we saw the intake of offshore students decline 20-30%. Now that is rectifying itself and there is strong growth in the education sector.

Q: What other themes are likely to be strong in Fund VI?

A: Business systems deals like Dun & Bradstreet and MYOB. Financial services is interesting given the one-stop-shop integrated model is being regulated out of existence. They are looking at separating distribution and sales, so that financial advisors can’t be tied to the people who provide products. That will provide a lot of opportunities. I would also be surprised if we didn’t do at least one food or agribusiness deal in Fund VI; we might even do one at the end of Fund V because we’ve still got two deals to go. The rest is serendipitous. It is easier to say what we won’t be doing. I would be very surprised in the next five years if we did a mining services deal or a retail deal.

Q: The aforementioned IPO boom was unprecedented in terms of PE involvement. Do you see this phase being repeated?

A: Yes. The time before that when the IPO market was running hot in Australia, which was 2006-2007, we didn’t have the private equity inventory out there. Most of the offerings to hit the market in 2014 and early 2015 were by companies bought in 2009-2011. Every time the IPO window opens a larger percentage of the offerings will be financial sponsor-backed. We

are becoming a bigger part of the M&A pie in Australia.

Q: And yet Archer was one of few Australian GPs not to tap the IPO market during this period…

A: We didn’t have any companies to sell – we were down to four companies at one stage and they were pretty much brand new. Also, given the choice, an IPO is the last thing I want to do; I much prefer a trade sale or a secondary. IPOs are painful processes. They are uncertain, and fairly or unfairly there is a

reputational risk that follows you for several years afterwards that you don’t need. With Healthe Care [which Archer recently agreed to sell to China’s Luye Pharma] we had a view for several years on who the buyer set would be and had been methodically engaging with people. When we decided it was time to press the button on a sale process we had a fairly educated view on who the likely buyers were and what values they would contemplate.

Q: Archer Growth, the firm’s lower mid-market affiliate, has spun out as The Growth Fund. What was behind the separation?

A: It was always a three-fund deal. In 2006, I reached an agreement with Craig Cartner - who was the initial partner at Archer Growth - and we laid out Funds I, II and III in terms of what the economics and governance would be. For Fund III, we would still have carried interest but other than that they would be 100% independent. When you are trying to start a fund there are synergies to being part of a larger group and the brand name was helpful to them. Now they have built up their own reputation, which is completely independent of Archer, and so they can raise a fund without the Archer brand name. I’m a great believer in commercial relationships being based on the underlying economics of the deal. If there is no additional value accruing to them of using the Archer name then why would they provide me with any economics? And if they are not doing that, why would I let them use the Archer name?

PETER WIGGS | INDUSTRY Q&A tim.burroughs@avcj.com

Deployment modePeter Wiggs, CEO of Archer Capital, on why the IPO slowdown has helped PE deal flow, the attractiveness of education and healthcare, and recently spun-out Archer Growth

“I would also be surprised if we didn’t do at least one food or agribusiness deal in Fund VI; we might even do one at the end of Fund V, because we’ve still got two deals to go”

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avcj.com | February 23 2016 | Volume 29 | Number 0716

FOCUStim.burroughs@avcj.com

THE ACQUISITION OF DB DENTAL EARLIER in February took National Dental Care’s (NDC) footprint to more than 60 practices with around 200 dentists. Three years ago the business, started by Crescent Capital Partners, did not exist.

The objective is to bring consolidation, standardization of services and economies of scale to an industry that is estimated to be worth A$8.7 billion ($6.3 billion) a year but remains

highly fragmented. According to Pacific Smiles Group, one of the larger listed players, there were more than 13,000 dental practices nationwide in 2014. Bupa was the largest individual provider with a market share of less than 5%.

DB Dental is a fairly typical target for NDC – formed 30 years ago by dental practitioners who remain active in the business. For NDC, the acquisition represents an opportunity to enter Western Australia, adding 17 practices that fill a gap in the company’s geographic footprint. For the founders of DB Dental, it means capital and expertise to further expand the business.

“There has been a big shift in the last 20 years,” says Tim Martin, a partner at Crescent. “Many practitioners don’t want the headache of running small businesses and that leads to consolidation. If you do it properly it means better standards of care because practitioners focus on patients rather than worrying about the business side. You can also invest in technology and systems to make businesses run more efficiently.”

This corporatization opportunity doesn’t

just apply to dentistry. It has driven investments by Crescent in audiology and skin cancer care, while other GPs are pursuing similar strategies in healthcare and also in education. The services sector has traditionally accounted for the bulk of middle market private equity investment in Australia. However, recent activity is taking place against the backdrop of structural change and a broader economic rebalancing, which means the

impact could be even more meaningful.

Rebalancing actWhen the commodities boom peaked in 2011-2012, mining – chiefly investment in capacity – accounted for over half of the 3.5% expansion in GDP. The sector still accounts for more than half of total exports, despite the cycle turning as demand from Asia slows down, but it is only responsible for 10% of the overall economy. The boom saw that figure double over the course of a decade, but now the trajectory is flat. As a pure growth driver, it has been supplanted by services.

Providing 70% of Australia’s GDP, the services sector has a strong domestic bedrock. However, Paul Bloxham, chief economist for Australia and New Zealand at HSBC, sees a significant shift in export-driven services. Three years ago, the balance of services imports and exports was a half percentage point drag on GDP growth; now it is responsible for one percentage point of the country’s 2.5% GDP growth.

The weakening of the Australian dollar is

crucial to this. Not only are more Australians now choosing to holiday at home rather than abroad, but there has also been an influx of visitors from overseas – tourists and students.

“Unlike most developed economies, Australia’s major trading partners are developing economies in Asia,” Bloxham says. “We started off exporting commodities because that’s what these economies needed to build housing and infrastructure. Now we are starting to provide more of what they will need next, which is services and high-quality food products.”

Healthcare, education, agribusiness, business services – these are routinely cited by Australian GPs as being of interest. The ability to remain strong in the face of economic adversity is a key consideration. “In volatile times there is a strong interest in defensive areas, and healthcare and premium food would be counted as such,” says Marcus Darville, a managing partner== at Quadrant Private Equity. “Not everything we do is defensive, but it’s a large proportion.”

A cancer care clinic chain, a data center business, and premium food services – one company aimed a humans and another at pets – are among Quadrant’s most recent investments. Pacific Equity Partners’ two most recent investments comprise an education business and a specialist health foods producer. Meanwhile, Archer Capital’s portfolio includes a consumer and commercial credit bureau, an aged care business, and a tertiary education provider.

Currency depreciation was a factor in the latter investment: according to Australian Education International, overseas student enrolments surpassed 630,000 in 2009 when the Australian dollar was around $1.50; they dropped to 515,000 in 2012 when the currency slipped below $1.00, and then rebounded last year, with the Australian dollar back around $1.40.

New Zealand has seen similar exchange rate-linked peaks and troughs. In late 2015, Archer combined five New Zealand institutions to form Aspire2 Group with a view to creating the country’s largest provider of vocational education services to international students.

However, there are also ambitions to become a significant player in the domestic training market, and these are tied to structural change in the sector rather than currency movements. In addition to its international students, Aspire2

Roll-up rapportAs Australia rebalances its economy in the wake of the commodities downturn, services are coming to the fore. Private equity investors continue to see consolidation opportunities

Australia’s GDP, employment by sector

Source: Australian Bureau of Statistics

Share of GDP Share of employment

%

100

80

60

40

20

0

ConstructionMining Others

ManufacturingBusiness services Household servicesRetail & wholesale

FOCUStim.burroughs@avcj.com

serves 7,000 clients through a state-funded youth services program. When the investment was made, approximately one third of the company’s revenue came from government sources.

As such, Peter Wiggs, CEO of Archer Capital, places the education opportunity in the context of governments that have under-invested in the sector and are unable to redress the balance, in part due to the fiscal challenges they face. Rather, they want the private sector to step in and lead the build-out. A similar dynamic is at work in Australian healthcare, notably aged care, where changing demographics are driving demand for services and private sector providers are expected to ramp up supply.

“While education and healthcare are defensive sectors, solving that under-supply is going to play out over 15-20 years,” Wiggs adds.

Risk factorsWhile Crescent’s consolidation agenda with NDC is predicated on generational change and founder-operators no longer wanting to go it alone, for others it is the passivity – or withdrawal – of state providers that could see previously niche private sector players build meaningful scale. However, a roll-up strategy is not always the best way to go.

Australia’s childcare sector is fragmented,

with companies managing 25 facilities or more accounting for just 1% of the for-profit segment, but consolidation efforts have delivered mixed results. G8 Education has achieved scale, reaching nearly 500 centers through a combination of organic growth and M&A. Yet the specter of ABC Learning, which expanded aggressively before collapsing under the weight of its debt in 2008, still looms large over the industry.

A successful roll-up must amount to more than the sum of its individual parts – in terms of the customer value proposition as well as the customer numbers. “Bigger is generally better but it is not always the case,” says Crescent’s Martin. “If the aim is to buy cheap and sell at a much higher multiple but not do anything to improve the business, it might be a short-term way of creating a quick flip to a seller but no value is being created. You are playing with numbers, not creating something sustainable.”

Consolidation can also be challenging to execute on a practical level. In cases where the founders of an acquired company agree to stay on in a management capacity, they need to be incentivized to keep operating at the same level. A group that makes a string of purchases without putting in place the systems to run them risks seeing a drop in performance that is too widespread to be offset quickly.

Indeed, Archer made one large bolt-on acquisition following its acquisition of Lend Lease’s Australia aged care business but is now focusing on the development or existing facilities and the construction of new ones. Wiggs explains that the industry has already seen a degree of consolidation and the assets still available command such high prices that an acquisition would not be accretive.

Striking a balance between the valuation one is willing to pay for an attractive consolidation opportunity and the challenges involved in making it work therefore lies at the heart of these investment decisions. Partners Group, for example, was willing to take on Guardian Early Learning – becoming the third PE owner in three years of the fast-growing childcare business – because it thought it could bring its industry experience and cross-border coverage to bear.

Cyrus Driver, head of Asia PE at Partners Group, suggests this could be one of several deals in the services sector. “A lot of analysts initially expected the impact of depressed commodity prices on the Australian economy to be much more severe, but the growth of services has diversified the economy more effectively than those of other commodity exporters,” he says. “We see the services sector in Australia it as a resilient space to invest and operate in.”

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Customized Research ReportPRIVATE EQUITY DATA FILE | AVCJ RESEARCH

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PRIVATE EQUITY IN AUSTRALIA

Australia PE&VC Summary (2006 to 2015)

Year No of Deals Amount (US$m.)

2006 208 16,736

2007 193 16,097.9

2008 168 7,699.4

2009 113 7,115.2

2010 135 17,392.2

2011 132 8,935.9

2012 129 9,020.1

2013 132 14,282.7

2014 126 8,812.8

2015 79 24,022.8

TOTAL 1,415 130,115

TOP FIVE PE INVESTMENTS IN AUSTRALIA (2015)Caisse de dAcpA’t et placement du QuAcbec $7,406.7 mlnDeal BriefHastings Fund Management, Caisse de depot et placement du Quebec, Abu Dhabi Investment Authority, Kuwait Investment Authority and Spark Infrastructure have won the bid to acquire 100% stake in TransGrid, the New South Wales government electricity transmission network from the New South Wales government. The total transaction amount was A$10.3 billion.

Deutsche Bank AG - Sydney Branch $6,277.4 mlnDeal BriefGE Capital has sold its Australia and New Zealand Consumer Lending Business to a consortium of investors, including Varde Partners, KKR & Co. and Deutsche Bank, for a consideration of A$8.2 billion. The business sold provides GE-branded credit cards and personal loans in the Australasia region.

Canada Pension Plan Investment Board (CPPIB) $1,700 mlnDeal BriefQube, together with Canada Pension Plan Investment Board (CPPIB) and Global Infrastructure Partners (GIP), has acquired a combined 19.9% stake in Asciano, a port operator in Australia, for approximately $1.7 billion.

Macquarie Funds Group - Macquarie Infrastructure and Real Assets $1,600 mlnDeal BriefA consortium lead by Macquarie has acquired the Australian unit of wireless towers of Crown Castle International Corp for approximately $1.6 billion. The consortium comprises of Macquarie Infrastructure and Real Assets (MIRA), Unisuper and the UBS International Infrastructure Fund II.

Macquarie Funds Group - Macquarie Infrastructure and Real Assets $1,428.1 mlnDeal BriefApache Corporation has sold its Australian subsidiary Apache Energy to a consortium of private equity funds managed by Macquarie Capital Group and Brookfield Asset Management, for cash payment of $1.9 billion, net of $225 million in customary post-closing adjustment. Apache Energy operates as an oil producing company in Australia.

TransGrid

Country Australia

Sector Utilities

Founded 1950

GE Capital - Australia & New Zealand Consumer Lending Business Country AustraliaSector Financial servicesFounded –

Asciano Group Country AustraliaSector InfrastructureFounded 2007

Crown Castle International Corp. - Australian Wireless Tower AssetCountry AustraliaSector TelecommunicationsFounded –

Apache Energy Ltd.Country AustraliaSector Mining and metalsFounded 1988

y Aberdeen Asset Management y Adveq Investment Management (Beijing) Co., Ltd.

y Allstate Investments y Asia Alpha family office y Asian Development Bank y Axiom Asia y BIMB Investment y BlackRock Private Equity Partners y Canada Pension Plan Investment Board

y Capital Dynamics y CDB Capital y CDPQ China y China Investment Corporation y China Investment Corporation - CIC Capital

y China Life Investment Holding Company Limited

y China Life Insurance y China Pacific Insurance (Group) Co., Ltd

y China Re Asset Management y Compagnie d’Investissements et de Gestion Privée (Hong Kong) Ltd

y Development Bank of Japan y Eagle Asia Partners y GIC (Beijing) Co Ltd y HarbourVest Investments Consulting

yHermes GPE (Singapore) Pte Ltd y Hong Kong Monetary Authority y IFC

y Industrial Trust y Jade Invest y Khazanah Nasional y LACERA Investment Office yMassMutual Life Insurance Company

yMitsui & Co. yMorgan Creek Capital Management

yMorgan Stanley Alternative Investment Partners

y Northern Trust y National Social Security Fund (NSSF)

y Noah Holdings (Hong Kong) Limited

y Norinchukin Bank

y North-East Private Equity Asia y NZ Super Fund y Ontario Teachers’ Pension Plan y Pathway Capital Management (HK) Limited

y Phillips Academy y Ping An Life Insurance Co. y Ping An Trust Co., Ltd y Ping An P&C Insurance y PRE Management China y Prosnav Capital y QIC y Sagamore Investment Management

y Saplings Alternative Advisors y SBI Brunei (Ministry of Finance Brunei)

y Shanghai Jiading Venture Capital Management Co., Ltd.

y StepStone y Surfview Capital y Tai Kang Asset Management y The Rockefeller University y Varma Mutual Pension Insurance Company

y Verti Capital yWilshire Private Markets y YiMei Capital

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List of limited partners (LP) attending:

GLOBAL PERSPECTIVE, LOCAL OPPORTUNITY

15th Annual Private Equity & Venture Forum

China 20169-10 March • China World Summit Wing, Beijing

Simultaneous translation is available

Mao ZhirongManaging Director and Head of Mainland AffairsHONG KONG EXCHANGES AND CLEARING LIMITED

And many more...

Sean LuManaging DirectorTHE CARLYLE GROUP; China Head, CARLYLE ASIA GROWTH PARTNERS

David LiuCo-head, KKR ASIA PRIVATE EQUITYCEO, KKR GREATER CHINA

Xiangming FangManaging DirectorCHINA RE ASSET MANAGEMENT COMPANY LTD

David WeiChairman and Founding PartnerVISION KNIGHT CAPITAL

Eric XinSenior Managing Director, China Private EquityCITIC CAPITAL

Kyle ShawFounder and Managing DirectorSHAW KWEI & PARTNERS

Stephanie HuiHead of Merchant Banking Division, Asia Pacific (Ex-Japan) GOLDMAN SACHS

Olivia OuyangDirectorONTARIO TEACHERS’ PENSION PLAN

Patrick ZhongSenior Managing Director, FOSUN GROUP;President, CHINA MOMENTUM FUND, L.P.

Keep up-to-date with confirmed speakers at avcjchina.com

AVCJ China Forum: Private equity in turbulent timesConfirmed Speakers Include:

Yang XiaojunDeputy ChairmanSHANGHAI LUJIAZUI INTER-NATIONAL FINANCIAL ASSET EXCHANGE CO., LTD. (LUFAX)

EXECUTIVE ADDRESS

Andrew YanManaging PartnerSAIF PARTNERS

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