The environment has changed, but private equity, as specialised acquirers and managers of risk, have not closed shop. Instead, they are moving quickly and reinventing their approach to take advantage of the new landscape, says Gilbert + Tobin
For those involved in private equity transactions over the last few years, the world after the credit bubble of 2005–07, is very different. With at least two 'turns' of EBITDA gone from the leveraged buyout (LBO) debt packages being offered in late 2006, an effective cap on debt packages of around A$1bn, covenant-lite a distant memory and a rolled-in cost of senior debt of up to 12%, leveraged buyers and sellers of eligible businesses face significant challenges.
Expectations on price, timing and certainty are being tempered by volatility in the credit markets. Mezzanine finance is in demand to plug some of the gap caused by the retreat of senior financiers, but shallow local markets for mezzanine and high interest rates make it an expensive stop-gap. With their longer term perspective and flexible investment mandate, some private equity houses are considering acquiring debt in their portfolio companies which is being offered for sale at a discount.
PE firms eye distressed assets
So is anything happening in this environment? The answer is yes, but less – certainly less – than the frantic days of 18 months ago. For those who have helped PE funds acquire companies in the last few years, there is the usual work to do on those companies and their capital structures. There are also 'bolt-on' deals to be pursued – complementary acquisitions for existing portfolio companies – where the debt financing is conceptually easier and synergies are available.
There are also new opportunities, most interestingly the availability of distressed assets. For lawyers, advising on acquiring distressed assets requires a different mind set and approach compared to the structured environment of auction processes, with a verified IM, vendor due diligence reports and market-standard sale contract. In acquiring distressed assets uncertainty is pervasive and speed often critical: as creditors circle, the nature of the sale process, its timing, the participants, the commercial concerns of the seller or its directors, receiver, administrator are liable to change at any moment.
The financial distress also distracts all the stakeholders who are critical to providing clarity on risk and value at the very moment where their focus is most important given that warranty and indemnity comfort is next to worthless. And the uncommercial transaction, unfair preference and insolvent trading rulers need to be run over each component of the transaction and refreshed at each twist and turn.
Where the target or seller is a listed company or MIS, the complexities are even greater. The takeovers provisions and related takeovers panel guidance need consideration; the financial services regulations come into play; the related party provisions of the Corporations Act and the ASX Listing Rules are relevant to much of the structuring and class actions, based on Sons of Gwalia style claims, loom large.
In this environment, a couple of particular features we are likely to see in the short to medium term are acquisitions from groups struggling to meet their debt servicing obligations and a reconsideration of how private equity funds transactions.
Buying distressed assets
The dominant form of transaction we expect to see involving private equity and public companies is the sale of the public company’s business divisions. As with most acquisitions from distressed sellers, the initial strategic questions that a buyer should ask are: First, can the acquisition be successfully executed as an asset deal? Secondly, should the buyer wait until an administrator or receiver has been appointed and then purchase from them?
While these options may offer preferable outcomes from a price and legal risk point of view, so long as there is competition for the distressed assets, commercial pressure may force the acquisition of subsidiaries from an ailing but still solvent company, in which case the private equity house will need to carefully consider the risks involved.
The buyer will not be able to derive much comfort on warranty protection since any warranty claims are likely to end up subordinated to the group’s secured lenders. There will therefore be an increased emphasis on due diligence.
The diligence needs to give importance to viewing each company acquired as a separate entity and on identifying any liabilities, indemnities and cross guarantees between the group being sold and the retained group. However, by its very nature legal diligence can not cover everything, for example, undocumented or barely documented agreements, guarantees or intra group indemnities. The buyer will need to assess the risks involved and whether the price and advantages gained from buying subsidiaries from the listed entity justify the risk.
Although some under performing, debt laden public companies, might seem to provide an ideal opportunity for a public to private transaction, it will be difficult to convert these opportunities into concluded deals. In addition to challenging debt profiles and shareholder prejudice that private equity is trying to buy on the cheap, we are now in a world where class actions and litigation funders raise significant risks in buying a listed entity.
Where a company’s share price has fallen significantly it’s a fair bet that litigation funders will be looking carefully at its history to establish if there is any basis for a class action, giving rise to potentially significant liabilities as the recent experience of Aristocrat shows. If a private equity fund were to acquire the listed company it would also acquire its exposure to class actions, a danger which becomes more real once the company, refinanced by the private equity buyer, has funds to pay potential claims.
Reconsidering funding structures
With the steep increase in the cost of debt, the rate of return on mezzanine finance (and high yield debt in particular) is starting to look more like the threshold rates of return on equity. This will influence the finance structuring of transactions. Although mezzanine may be needed to cover the shortfall created by the increased price and lack of availability of senior debt, a private equity house may baulk at the concept of bringing in external mezzanine finance at what looks very like equity returns but which has priority over equity. Instead, we may see the mezzanine piece being picked up by the private equity house, either in the fund buying the equity or one of its other funds.
Where the private equity house is co-investing they may well consider the option of taking part of their investment in debt or mezzanine finance, rather than straight equity, as offering them an attractive and more secure investment profile. Indeed, if the investment is a stake in a distressed entity (maybe a portfolio company of another fund) we may well see fairly aggressive funding terms, similar to a wash out round in venture capital, with the incoming investor taking a preferred position to existing investors.
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CONTACT GILBERT + TOBIN
This article was written by partners Andrew Bullock, Bryan Pointon and Charles Bogle of Gilbert + Tobin. For more information please see contact details below.
Andrew Bullock (image: 036692)
Partner, Corporate Transactions Group
T: +61 2 9263 4126
Bryan Pointon (image: 036698)
Partner, Corporate Transactions Group
T: +61 2 9263 4286
Charles Bogle (in incoming folder)
Partner, Corporate Transactions Group
T: +61 2 9263 4367
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