M&A and Private Equity – the current state of the market

Australian M&A activity in the 12 months preceding the start of this year was driven by strong consumer spending, demand for natural resources and the emergence of larger private equity investors focused on local transactions. Activity levels within middle market transactions were also very strong, fuelled by the volume of funds supporting middle market private equity, the consistent low interest rate environment and the strong growth in most domestic sectors.

As a consequence of the 2007 credit crunch and the resultant tightening of debt markets worldwide, credit spreads have risen significantly and the appetite of lenders to provide facilities has reduced considerably. Whilst this is yet to translate into reduced vendor expectations spurring a renewal in transaction activity, we are starting to see this dynamic emerging as conditions moderate. To this point, the private equity houses are still busy trying to find quality assets. Whilst being more selective, they are still very much open for business, which we expect to result in an increase in activity levels in the next 12 months. 

Growth and evolution of the market in recent times

The emergence of international private equity firms over the last 18 months has definitely raised the profile of the asset class in Australia, particularly among retail investors given the several attempted high profile public to private transactions. Private equity was already an established feature of the market for middle market participants, however the quantum of recent funds raised and the number of participants chasing deals has certainly increased competition and consequently put upward pressure on prices achieved by vendors. Private equity is likely to continue to be a fixture in this market given the long term macroeconomic factors that are forecast to limit the damage from worldwide growth issues and the opportunities that exist to acquire companies with strong monopolistic characteristics in many sectors.

As the private equity assest class has increased in importance, the size and sophistication of leverage offerings from the local banks has increased. These changes were a major catalyst in the increase in activity levels pre the credit crunch.

A further major change in the domestic market has been directors becoming more aware of the potential of receiving an unsolicited bid and therefore focusing on building shareholder value as a defensive measure. Another change is greater awareness of the issues that arise on the receipt of a bid that involves executive management and the introduction of internal protocols to deal with such situations. As participants have become increasingly sophisticated at dealing with bids, difficulties could arise for private equity firms to compete in the future.

Recent times have seen a newly-emerged and unprecedented interest in public to privates, several of which involved significant local companies. This has created a considerable amount of press and public interest which initially focussed on the negatives of such transactions, however in the longer term will most likely benefit private equity from a market education aspect.

Overall, the general reaction to these high profile bids was one of caution and concern, over conflicts of interest that exist in these types of processes. From a shareholder’s perspective, the overall effect was to inflate valuations across the market for any company that may be an attractive target for private equity, many of which, such as Qantas, maintained the valuations for some time, despite bids not being successful. In terms of politicians and regulators, there was considerable caution in being seen to be involved in an open market transaction although their comments concentrated on the obligations of directors to act in the best interests of the company and to avoid conflicts of interest where executive management teams were involved. Likewise, the media also focused heavily on this issue.

Cross border M&A is another trend that has again been increasing in recent times. Given the recent appreciation of the Australian Dollar against many currencies, overseas acquisitions have become more attractive. We see many companies focusing on Asian based opportunities, particularly when considering moving components of their local business to lower cost countries.

The sectors that are experiencing the greatest level of activity at the moment include resources and mining due to strong demand for resources from China and increasingly, India. Other sectors include health due to the ageing population and government focus on increased spending, and environmental businesses that provide products linked to energy efficiency, renewable energy or water conservation due to the current drought conditions on Australia’s east coast and rising awareness of climate change issues. 

The tightening affect

The credit crunch has definitely had an affect on leveraged transactions, particularly for the mega deals. The increase in credit margins and the credit exposures of international investment banks has reduced the ability for private equity to bid to levels seen prior to the credit crunch. Likewise, the availability of funding for deals sourced through instruments such as commercial loan obligations decreased, reducing the ability of private equity to bid competitively. At the middle market level, the credit crunch has had less of an impact given the limited exposure of our domestic banks however debt funding availability has indeed been quarantined at various levels within the banks therefore reducing the availability of debt and increasing the requirements and costs requested by borrowers.

Characteristics of successful deals in the current market - such as companies with strong growth profiles, defensible market positions and a good depth of management expertise - are not far removed from historical considerations. Participants continue to require detailed financial, legal and commercial due diligence on prospects and processes and are generally taking longer than in normal circumstances.

In our experience, due diligence requirements have tightened and become broader. We’re seeing greater focus on commercial diligence procedures even at quite small deal sizes. Transaction documents and negotiations will continue to largely focus on warranties and indemnities provided by vendors and where uncertainty exists on future earnings, appropriately structured earn out agreements to minimise upfront risks for acquirers.

With leveraged loans under pressure, the balance of power has certainly shifted back towards corporate buyers given the recent increase in credit margins and the sophistication of market participants in competing against private equity players. To counter this, we have seen private equity looking to partner with industry participants to provide the synergy benefits required to ensure their bid is competitive. 

In summary

The outlook for deal making for the rest of 2008 in Australia remains moderate, boosted by the resources and mining, health, and environmental sectors. There remains risk in relation to further global credit issues, current capacity issues causing inflationary pressures or a slowdown in any of Australia’s major trading partners such as the US or China. However, the middle market activity levels should most likely rebound once business confidence and stability in debt markets return, given that the volume of investment funds that are available and seeking a home continue to accumulate.



Author: Paul Gooley

Paul Gooley is a new director in Grant Thornton’s Corporate Finance team in Sydney. His experience has involved over 12 years in providing corporate restructuring and corporate finance advice to mid market participants in a wide range of industries. Specialisms include advising private equity funds and management teams with buy out or development funding opportunities, advising on mergers and acquisitions and initial public offerings. Paul brings international expertise to his team having worked both in the UK and Australia in mid market corporate finance.

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