Private Equity and Venture Capital

Full text

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The Private Equity Market in Australia – An Overview

The Private Equity

Market in Australia

– An Overview

SEPTEMBER 2008

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ABOUT AVCAL

AVCAL was established in 1992 as a forum for participants in the private equity and venture capital industry. AVCAL is the central voice of the Australian industry and its membership includes almost all the domestic, regional and global private equity and venture capital fi rms active in Australia.

ATTRIBUTES OF PRIVATE EQUITY

Private equity is investment typically in unquoted companies that are considered to have high growth potential. Private equity investments have the following important characteristics that set them apart from other forms of business ownership:

– Alignment of interest between owners and management. Each has a genuine stake in the business and is fi rmly focused on increasing its value.

– Long-term perspective. Private equity investment has a 3 to 5 year horizon and places long-term growth ahead of short-term profi t considerations.

– Detailed due diligence. Prior to investing in a business, a private equity manager conducts very thorough analysis to gain a detailed insight into the business’s strengths and weaknesses, its growth potential and the prerequisites for achieving this growth. It does not proceed unless it has a clear idea of how it can add value to the business.

– Flexibility to plan for growth. As new owners, private equity develops with management a

comprehensive and coherent long-term plan to grow the business and increase its value. The greater fl exibility and relative simplicity of raising funds from private equity compared to public equity is one of the main reasons for seeking private equity.

– A ctive stewardship. Private equity owners monitor progress against plan closely. Plans and strategies are constantly re-assessed to address changing market conditions.

PRIVATE EQUITY INCREASES EMPLOYMENT AND PRODUCTIVITY

Private equity delivers signifi cant benefi ts to the Australian economy. Private equity businesses invest in new employees much faster than comparable businesses. They also invest more in measures that improve business performance including capital expenditure and employee training. The resultant improvements in productivity help address economic issues arising from Australia’s ageing demographic.

PRIVATE EQUITY MAKES PORTFOLIO MANAGEMENT MORE EFFECTIVE

Sophisticated and institutional investors have come to realise the investment opportunities provided by private equity allow them to:

– Obtain superior long term return opportunities that are unavailable through investment in traditional stock and bond investments.

– Diversify traditional portfolios

PRIVATE EQUITY IMPROVES INVESTOR AND SUPERANNUATION RETURNS

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The Private Equity Market in Australia – An Overview

TRENDS IN PRIVATE EQUITY

Private equity is not a new phenomenon but, over the last few years, the level of private equity activity has increased signifi cantly in Australia, as it has in the US and the UK. Interest in a small number of well-known publicly listed Australian companies has led to the incorrect perception that private equity is a large part of the Australian economy. In fact, the value of businesses purchased by private equity in Australia in 2007 was less than 0.4% of the value of all businesses listed on the ASX.

PRIVATE EQUITY ENHANCES CAPITAL MARKETS

Private equity enhances Australian capital markets by providing fi nance to small-to-medium businesses looking to expand and helps many of them develop to a stage where they consider listing on the ASX. Private equity is also helping to address the issue of succession planning as many business owners approach retirement. The Reserve Bank of Australia stated in its Financial Stability Review, March 2007 that, “The exposure of the Australian banking sector to private equity is well contained, and both the leverage and the debt-servicing ratios for the corporate sector as a whole remain relatively low”. Private equity does typically use higher debt levels; however, there are no signs of undue stress. Less than 3% of total loan values by Australian banks are to private equity backed-businesses.

THE FUTURE

Private equity has played a signifi cant role in Australia’s economic development in recent years and is well placed to make an even greater contribution in the decades ahead. There is still signifi cant scope for growth. The total value of funds raised by private equity fi rms in the 9-year period to 2007 is still under 2% of ASX market capitalisation: less than the market capitalisation of the 10th largest ASX stock alone. Australian pension funds are currently the fastest growing in the world, and their continued growth should see substantial opportunities for increased allocations to private equity in the future.

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Productivity The labour productivity rate of private-equity backed fi rms is nearly double that of the comparable national fi gure.

Private companies owned by private equity fi rms are beginning to emerge among Australia’s top 100 private companies by revenue, e.g. retailer Ascendia (#59, Archer), fast-food group Quick Service (#66, Quadrant) and food importer/distributor Manassen (#89, CHAMP).

Employment Private equity backed companies employ an estimated 1 out of 13 jobs in the Australian private sector.

Innovation 72% of investee companies launched new products the previous year, compared to only 27% who did so in the year prior to the initial private equity investment.

Returns Over the last year, private equity has returned 0.8% p.a. compared to the -17.1% p.a. return on public equity.

Government returns Government agencies accounted for over 5% of total funds drawn down by private equity fi rms in FY07. The Future Fund also invests a small proportion of its funds in private equity.

Superannuation returns The benefi ts of private equity allocations are largely returned to Australian retirees. Although only about 1% of Australian superannuation is invested in private equity, domestic superannuation funds accounted for over half of private equity drawdowns in FY07.

Fundraising Australia is a major fundraising centre for private equity in the region. In 2007, private equity fund raising in Australia represented 38% of all private equity funds raised in the Asia-Pacifi c region.

There is still much scope for growth The total value of funds raised by private equity fi rms in the 9-year period to 2007 is still under 2% of ASX market cap. This is less than the market cap of the 10th largest ASX stock.

Australia has the largest pool of managed funds in the Asia Pacifi c (ahead of Japan and Hong Kong SAR) and the fourth largest in the world (behind the US, France, and Luxembourg). Also, Australian pension funds are currently the fastest growing in the world with an average CAGR of 27% (in USD) and 17% (in AUD) over 2002 – 2007. If this continues, there will be substantial growth opportunities for PE allocations.

Long-term approach Private equity investment typically involves ownership for 3 to 5 years. In comparison, only a fi fth of ASX investors potentially hold their investments longer than private equity fi rms.

Debt Private equity exposures amount to less than 3% of total loans in the Australian banking system.

Delistings Only 1 of the 47 companies that delisted (or 2% of all delistings) within the 6 months to March 08 did so as a result of a private equity transaction. Globally, delistings account for less than 7% of all private

Facts at a Glance

Productivity

Growth

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The Private Equity Market in Australia – An Overview

Executive Summary

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Facts at a Glance

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Table of Contents

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About AVCAL

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Private Equity – an overview

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1.1 Defi nitions

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1.2 Private Equity Funds

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1.3 Types of Private Equity Transactions

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1.4 How Private Equity Adds Value to Investors

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1.5 How Private Equity Adds Value to Businesses

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Benefi ts of Private Equity to the Australian Market

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2.1 Positive Effect on Employment

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2.2 Grows the Funds Management Industry

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2.3 Drives Productivity Growth and Innovation

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2.4 Increases Returns to Investors & Superannuation Funds

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2.5 Positive Effect on Business Performance

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Effect on the Capital Market

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3.1 Positive Effect on Small-To-Medium Enterprises

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3.2 Positive Effect on ASX

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3.3 Positive Effect on Debt Markets

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Trends in Private Equity

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4.1 Increase in Funds Raised

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4.2 Increase in Global Private Equity Buyout Activity

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4.3 Scope for Further Growth

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Table of Contents

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2

3

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The mission of The Australian Private Equity and Venture Capital Association (“AVCAL”) is to represent and promote the long-term interests of private equity and venture capital in Australia. AVCAL works to ensure a favourable environment for growth in equity investment and entrepreneurship.

AVCAL is the national association that represents domestic and international private equity and venture capital managers and investors who are active in this country. AVCAL was established in 1992 as a forum for industry participants to meet, to pursue topics of common interest, to promote the local industry and to encourage investment in growing business enterprises.

Since its formation, AVCAL has evolved to set industry standards, such as the AVCAL Valuation Guidelines and the AVCAL Reporting Guidelines, both of which were promulgated in 2004. These guidelines are consistent with global best practice and compliance with them is compulsory for all member fi rms. AVCAL also commissions independent research on investment returns and the economic impact of private equity and venture capital investments and provides training courses and networking events for industry participants.

Membership of AVCAL comprises venture capital fi rms, private equity fi rms, superannuation investors, banks, business incubators, ‘business angels’, corporate advisers, accountants, lawyers, government bodies, academic institutions, other service providers to the industry and individuals participating in the industry.

Investor membership is restricted to traditionally structured venture capital and private equity fi rms which raise funds primarily from institutional investors, such as superannuation funds, and do so for investment in unlisted business enterprises with a view to patient equity investment and strategic input to the business. Investor membership is not open to listed ‘cash boxes’ or hedge funds or companies who may conduct private equity style transactions using funds off their own balance sheet or from listed entities.

AVCAL’s investor membership comprises the vast majority of domestic, regional and global private equity and venture capital fi rms who are active in Australia. These fi rms provide capital for seed and pre-seed ventures, early stage companies, later stage expansion and fi nance for management buyouts of established companies. AVCAL estimates that its members represent over 90% of the private equity capital invested in Australia.

AVCAL is actively involved in an informal network of similar associations from around the world including the European Venture Capital Association and the British Venture Capital Association. AVCAL is located at Level 41, 1 Macquarie Place, Sydney NSW 2000 and at www.avcal.com.au. AVCAL may be contacted via Katherine Woodthorpe, CEO on (02) 8243 7000 or

katherine.woodthorpe@avcal.com.au.

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The Private Equity Market in Australia – An Overview

Defi nitions

In its broadest sense, private equity is equity investment in a business not quoted on a public exchange. This would include, for instance, equity investment in a private family company.

Private equity is more often used in a second, narrower sense to describe investment in unlisted businesses with the aim of building and improving them over a period of years and then selling them at an increased price.

Private equity investment of this type is frequently categorised according to the stage of development of the company being invested in. Expansion and buy-out stage investments are often termed ‘private equity’ investment whereas seed and early stage investments are termed ‘venture capital’ investment.

Stages of Private Equity

Private equity and venture capital have many common features despite the different development stages of the businesses invested in. Both involve:

– equity investment typically over a 3 to 5 year investment period in unquoted companies considered to have signifi cant growth potential

– active involvement by the investor in the governance and management of the investee business – considering, at the time of investment, the subsequent sale of the investment rather than the indefi nite

retention of it.

This report uses the term ‘private equity’ in its narrowest sense, although the views presented also apply in large part to venture capital.

Private Equity Funds

In Australia, and indeed other parts of the world such as the UK and US, almost all private equity and venture capital investment is conducted via investment funds formed specifi cally for this type of investment. The managers of the fund are typically described as ‘general partners’ in the fund because they manage the investment fund and are liable for its legal debts and obligations.

The investors are typically described as ‘limited partners’ in the fund as their liability for debts and obligations of the fund is limited to the amount of their investment in the fund.

Private equity investments, unlike venture capital investments, are fi nanced partly with debt from third party lenders, rather than exclusively using investment capital from the fund. The use of debt has two important consequences:

– a fund can make more investments with a given amount of investment capital; and – investors can receive a higher rate of return on the capital they have invested in the fund. To ensure ready access to potential investments, a manager develops and maintains a strong network of relationships in appropriate commercial or technical areas.

Private Equity

– an overview

1

1.1

1.2

VENTURE CAPITAL PRIVATE EQUITY

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Features of Private Equity Funds

Funds are ‘closed end’

Investors are sophisticated (rather than retail or ‘mum and dad’) investors

Investors utilise independent expert advisers

Each fund has a specifi c investment mandate Private equity funds only invest in a relatively small number of businesses

Management fees and capital gains

The legal documentation governing each fund contemplates that all investments of the fund will have been realised and the funds returned to the investors within a particular time-frame, usually 10 to 12 years. After a fund has closed (i.e. raised the funds that will be managed), the managers invest the fund’s capital across a set of investments that fi t the fund’s investment mandate or focus. Once this process is complete, typically after 3 to 5 years, the fund is said to be ‘fully invested’.

Before deciding to invest in a fund, these sophisticated investors undertake detailed due diligence on the fund manager – often over a number of years – during which the manager’s prior investment performance is monitored and assessed. The investors also rigorously review the fund documentation and have suffi cient bargaining power to negotiate terms with the managers of the fund. These investors include superannuation funds, insurance companies, banks and university endowments.

These expert advisers carry out a level of scrutiny and due diligence akin to that carried out by agencies such as Standard & Poor’s and Moody’s in other sectors of the economy.

Funds adopt a detailed and disciplined approach to matters such as the stage of the investments that are targeted, industries (and countries) that can be invested in, and the percentage of fund assets that can be allocated to any particular investment.

Over the life of a fund, the managers will assess hundreds of potential investments, conduct detailed due diligence on perhaps 10% of these but only actually invest in a small number, usually around 10 to 15. Competition for investments is fi erce and a fund manager’s bid will not always succeed, in which case the time and money expended on assessing an investment and preparing an offer is lost. Additionally, owners and managers of companies may reject approaches from private equity, as is their right.

Fund managers receive a management fee based on the size of the fund and also receive a share in the capital gains delivered to the fund’s investors. The management fee is usually calculated as a percentage of the funds originally invested in the fund. The percentage is negotiated between the investors and the manager at the time the funds are raised. An indicative fi gure is 2 to 2.5% p.a. for smaller venture capital funds and 1 to 2% for larger private equity funds. his fi gure covers the overheads of the business including salaries and the costs of conducting due diligence on investments.

The manager’s share of capital gains is around 20% in most funds globally and is calculated after all fees and expenses paid by the fund have been returned to the investors. The private equity manager only receives a share in capital gains if the fund has delivered a minimum return known as the ‘preferred return’. If the capital gains do not exceed the preferred return then the private equity manager receives no share in capital gains. The preferred return is usually similar to the long term bond rate, currently about 8% p.a.

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The Private Equity Market in Australia – An Overview

Types of Private Equity Transactions

Purchase of a private company

This type of private equity transaction is far more common than the purchase of a publicly listed company (or part of one) but examples are less frequently reported in the business press.

Owners of private businesses increasingly see private equity funds as an attractive source of expansion capital and management expertise that is needed to grow the business to a level where it will be suitable and ready for a trade sale or IPO. In such cases, the private equity manager invests capital for a stake in the business and also provides ongoing advice to management.

Many business owners who are looking to retire, after building up a business over many years, are selling to private equity managers. In Australia today there are a higher than ever number of business owners approaching retirement, due in part to the post-war immigration boom. For many of these owners, private equity offers the only possible exit and realisation of the capital they have built up in their business.

Purchase of a publicly listed company

Although a handful of recent acquisitions suggest otherwise, only about a dozen publicly listed companies in Australia have ever been taken private by private equity. Nevertheless, it is instructive to consider the benefi ts reported by publicly listed companies locally and offshore that have been taken private by private equity. These include:

– a board less driven by process and better able to make decisions on a timely basis;

– a chief executive who is able to devote to the business valuable time (up to 20%) that was previously spent representing the company to the investor community;

– a board and management team that is no longer fi xated on meeting short-term profi t expectations of the public market, analysts and the media and is instead able to concentrate fully on what will be of most long-term benefi t to the business (and its shareholders);

– a business now with an ownership and governance structure more conducive to resolving structural or strategic issues that may have troubled the business previously and which can only be solved by initiatives that may adversely affect profi ts and/or cash reserves in the short term; and

– fresh capital for investment.

Purchase of a division of a publicly listed company

Similar benefi ts have been reported in a far more common type of private equity investment, namely the purchase by a private equity fund of a division (rather than the whole) of a listed company. Often the listed company concerned describes the division being sold as ‘non-core’ and has, for some years, concentrated its attentions (and capital investment) on other divisions. Commentators have, from time to time, described such business divisions as ‘unloved’ or as ‘orphans’. New private equity owners of such businesses are better equipped than the previous publicly listed company owners, to unleash their entrepreneurial spirit and provide them with the additional resources and capital investment that they require.

Sales of businesses by private equity

All businesses bought by private equity are sold, generally via either a private sale or an initial public offering on the ASX or, in a small but growing percentage of cases, to another private equity fund.

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How Private Equity Adds Value to Investors

Sophisticated investors and institutional investors such as superannuation funds, endowment funds, government authorities and fi nancial institutions generally invest in private equity for two main reasons: superior returns and portfolio diversifi cation.

Superior returns

Australian private equity investment has generally achieved superior returns relative to public equity markets, as shown below.

Private Equity Returns – periods to end June 2008

Sources: Thomson Financial, Standards & Poor

Diversifi cation

Adding private equity to a portfolio of stocks and bonds is generally viewed as an important aspect of the diversifi cation strategies of managed funds. Such diversifi cation is aimed at increasing the returns of the portfolio and lowering the volatility of the portfolio’s returns. This is because the correlation between the returns of stocks and bonds is higher than both the correlation between private equity returns and stock returns and that between private equity returns and bond returns.

Investors invest in private equity because they understand it and are willing to take on the relatively higher risk of the investment – compared to less risky investments such as government bonds – in consideration of the higher potential returns offered by private equity.

In addition, the long-term approach of private equity managers is consistent with the long-term approach of such investors.

How Private Equity Adds Value to Businesses

A private equity fund ensures that each investment it makes has the following characteristics. These factors are the hallmarks of private equity investment.

Alignment of interest

The foundation of private equity’s ability to add value is an alignment of interest between owners and management. Each has a genuine stake in the business and is fi rmly focused on increasing its value.

Long-term focus

Private equity invests with a 3 to 5 year horizon and is not focused on short-term growth at the expense of long-term success. Private equity-backed companies are therefore able to invest in new products, new businesses and new employees without concern for short-term earnings effects. This is in contrast

1.4

1.5

STAGE 0.8 8.1 14.2 -17.1 7.1 11.4 0.6 7.3 12.4 1 yr (IRR p.a.) 3 yr (IRR p.a.) 5 yr (IRR p.a.) AUSTRALIA Private Equity AUSTRALIA

Private Equity & Venture Capital

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The Private Equity Market in Australia – An Overview

Detailed due diligence

Prior to investing in a business, a private equity manager conducts very thorough analysis to gain a detailed insight into the business’s strengths and weaknesses, its growth potential and the prerequisites for achieving this growth (e.g. change of strategy, operational improvements, capital expenditure). It does not proceed unless it has a clear idea of how it can add value to the business.

Flexibility to plan for growth

The insight from due diligence allows the private equity fund, as new owners of the business, to develop with management a comprehensive and coherent long-term plan to increase the value of the business. This plan will typically:

– stress the importance of sales growth as well as cost effi ciency; – emphasise cash as much as earnings;

– focus on a small number of essential performance metrics; – include a training and development program for employees; and

– include a capital expenditure program to ensure that the business has the plant and equipment necessary to meet its growth targets.

Active stewardship and clear performance targets

Performance metrics and progress against targets are monitored closely so that any remedial measures can be implemented promptly. Decisions are made swiftly and on a timely basis. Plans and strategies are constantly re-assessed to address changing market conditions.

Importantly, private equity adds value to businesses by facilitating the introduction of lower-cost capital structure, operational change, manager incentives and exit (investment realisation) options necessary to bring the company forward.1

A study commissioned by AVCAL in 2006 found that the main reasons for seeking private equity investment were:2

– the expert advice and guidance that accompanies it; and

– greater fl exibility relating to the funding structures available and the relative simplicity of the process, compared to raising public equity.

Main reasons for seeking the original PE Investment

Source: PriceWaterhouseCoopers and AVCAL survey, 2006

“Private equity-backed companies have concentrated and stable ownership and private equity owners hold at least one board seat (and often control the board) allowing for more effective engagement with management teams and the board if problems arise.”

Senate Standing Committee on Economics, Private Equity Investment in Australia, Aug 2007.

1

Source: Blundell-Wignall, The Private Equity Boom: Causes and Policy Issues, OECD Report 2007.

2

Source: PricewaterhouseCoopers, Economic Impact of Private Equity and Venture Capital in Australia, December 2006. .

Other reasons

Percentage of respondents PE expertise

Credibility boost Debt not available PE Flexibility

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Private equity delivers signifi cant benefi ts to the Australian economy. In particular, private equity: – increases employment;

– increases the funds management industry; – increases productivity and innovation;

– increases returns to investors and superannuation savings; and – has a positive effect on business performance

Positive Effect on Employment

In Australia, private equity backed companies are a major employer group. One study estimates that these companies provide jobs for up to 650,000 Australians, or 8% of total private sector employment. This is approximately 1 out of every 13 employees in the private sector.3

Businesses owned by private equity managers invest in additional employees at a signifi cantly faster rate than comparable companies. This is because private equity-backed businesses are actively managed and supported with new capital to grow strongly and so tend to increase their employee numbers more quickly than less dynamic businesses. According to the study cited above, 76% of the private equity-backed companies surveyed expected to hire additional workers in 2007 (the corresponding economy wide measure was 5%). The study also found that private equity backed fi rms had an average growth in headcount of 30% p.a.

A recent large-sample study of US private equity buyouts from 1985 – 2005 found that private equity generally results in net job creation over the medium-to longer term, reversing the usual trend of job cuts in target institutions prior to the buyout. More specifi cally:4

− Private equity backed fi rms engage in 6% more greenfi eld job creation than comparable non-private equity backed fi rms in the fi rst two post-buyout years. The study concluded that, “This result suggests that private equity groups accelerate the expansion of target fi rm activity in new, higher value directions.”

− Two years before a buyout, a target company cuts, on average, 4% more of its work force compared to its peers.

− After a buyout, acquired companies cut on average 7% of their work force over two years, but at the same time adds jobs – usually new positions and in new locations – at a pace of about 6%. By the fourth and fi fth years of private equity ownership, the growth of a company’s work force becomes similar to its public peers.

Employment growth though private equity ownership has been confi rmed in numerous studies conducted in countries around the world. For example:

− In the US, UK, Germany and other European countries, annual employment growth of private

Benefi ts of Private Equity to the

Australian Economy

2

3

Source: PricewaterhouseCoopers, Economic Impact of Private Equity and Venture Capital in Australia, December 2006.

4

Source: Davis, Haltiwanger, Harmin, Lerner and Miranda, “Private equity and Employment”, in The Global Economic Impact of Private Equity Report presented at the World Economic Forum, 2008. It should be noted that the study did not look at new or lost jobs abroad, or at potential further job losses had the buyout not occurred.

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The Private Equity Market in Australia – An Overview 0 8.4 PE US Growth (2002 – 2005) 5.5 US ave 1 2 3 4 5 6 7 8 9

Average annual employment growth of private equity backed fi rms versus traditional fi rms in selected regions

Sources: Shapiro and Pham (2008), BVCA/IE Consulting, EVCA, PWC/AIFI

Grows the Funds Management Industry

Australia’s funds management industry is the fourth largest in the world and is very highly regarded internationally. Australian private equity managers have played an important role in the industry’s development and are continuing to attract signifi cant fl ows of investment capital into Australia. In fact, 62% of Australian executives who responded to a 2008 EIU survey either agreed or strongly agreed that the infl ux of investment capital was a signifi cant benefi t of private equity ownership. Thomson Financial data shows that over the 10-year period to 2008, private equity funds raised over $31b. For the 2007 – 08 fi nancial year, a total of $6b of new capital commitments was raised.

Drives Productivity Growth and Innovation

The ageing of the population is increasing the importance of productivity growth and innovation to Australia’s future.

Private equity makes businesses more effi cient. The methods by which private equity adds value to a business have been discussed in Section 1.5 of this report. The increases in capital expenditure, marketing, training and research & development are often very signifi cant.

For Australian fi rms, an independent study commissioned in 2004 by AVCAL indicated that the labour productivity of private-equity backed fi rms increased over a period of two years by a total of 6.3% which was almost double the comparable national fi gure of 3.4%.5

5

Source: Meyrick and Associates, Labour Productivity Study, 2004.

2.2

2.3

0 10.1 PE 2.9 EU25 ave 4 2 6 8 10 12 A

ve. growth p.a. (1997 – 2004)

EU UK 0 8 PE 5.5 UK ave 1 2 3 4 5 6 7 8 9 A

ve. growth p.a. (2002 – 2006)

0 10.7 PE 1.1 Italian ave 4 2 6 8 10 12 A

ve. growth p.a. (2006 – 2004)

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Investment of buyout-fi nanced fi rms in Europe as a % of sales before versus after the buy-out

Source: EVCA/CMBOR

An EIU survey of nearly 300 Australian executives in December 2007 found that over three-quarters of respondents thought that private equity is a positive thing for Australian business.6

That proportion is constant across small, medium and large companies, although big-company executives were more emphatic.

– 79% of respondents thought that as a result of the arrival of private equity, companies are now more focused on effi ciency

– 68% thought strategic options have been expanded

– 66% see streamlined decision-making as a benefi t of private-equity ownership – 65% point to a clarity of business focus/objectives

A study of Australian private equity exits in 2007 found that in these fi rms:7

– Enterprise value grew by a CAGR of 21%: almost double that of public company benchmarks – EBITDA grew 2.5 times faster than public company benchmarks.

Increases Returns to Investors & Superannuation Funds

Private equity has historically contributed to increased returns to Australian investment portfolios (see section 1.4). These benefi ts fl ow directly to families, individuals and superannuation accounts. This in turn leads to more rapid growth in retirement savings among Australian households. Australian Bureau of Statistics data shows that superannuation funds accounted for over half of total funds invested in private equity in the 2006 – 07 fi nancial year.

Even so, only approximately 1% of superannuation funds is committed to private equity investment. This percentage represents a very low exposure to any risks inherent in private equity. It can also be considered a very low exposure to the increased returns delivered by private equity.

Private equity contributes positively to the Australian superannuation system by boosting returns. This is particularly important given that Australia’s compulsory superannuation scheme has resulted in the 4th largest pool of managed funds worldwide.

According to a 2008 survey of more than 40 Australian Superannuation funds, with $250 billion in funds under management, Australian superannuation funds have remained quite optimistic on private equity investments. Return and diversifi cation benefi ts were seen as the main objectives behind private equity

6

Source: EIU White Paper, “Private equity moves in: the impact on business in Australia”, 2008.

7

Source: Ernst and Young, How Do Private Equity Investors Create Value, 2008. Figure excludes two (positive) outliers.

2.4

“Australian technological innovation and R&D commercialisation are some of the main benefi ts of private equity investment.

Economic Impact of Private Equity and Venture Capital in Australia. PricewaterhouseCoopers, December 2006.

0 1 2 3 4 5 6

R&D +66%

Before the Buy-out After the Buy-out

+62%

Marketing CAPEX

+59%

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The Private Equity Market in Australia – An Overview

Allocations to private equity by any Australian superannuation fund are spread across a large number of private equity-backed businesses (AVCAL estimates at least 50 on average) because investments in private equity by superannuation funds are split across a number of private equity funds rather than a single fund. Each of these funds then further spreads the investment across a portfolio of businesses (approximately 10 to 15 per fund in most cases).

Australia’s sovereign wealth fund, the $60 billion Future Fund, is also beginning to invest in the private equity market. The fund was established to cover unfunded pension liabilities for retired bureaucrats, defence workers and politicians from 2020. It also manages the government’s Higher Education Endowment Fund and is among the world’s 10 largest sovereign wealth funds.

Superannuation funds’ expected investment returns from Private Equity

Source: Evans (2008)

Positive Effect on Business Performance

The effects of private equity investment on the performance of Australian fi rms have been strongly positive.

A study by PricewaterhouseCoopers in 2006 showed that the fi nancial effects of private equity investment are strongly positive, with businesses generally reporting improved fi nancial performance after the initial investment, particularly in terms of operational effi ciency. In addition, 59% of respondents indicated that cash fl ow improved as a result of the private equity investment. The study reported that 72% of investee companies launched new products in the previous year, while only 27% did so in the year prior to the initial private equity investment.

Similarly, private equity investments were found to have positively impacted the non-fi nancial aspects of investee companies’ operations.

Changes in the investees company’s fi nancial performance as a result of private equity investment

Source: PriceWaterhouseCoopers and AVCAL survey, 2006

Changes in the investees company’s non-fi nancial performance as a result of private equity investment

Source: PriceWaterhouseCoopers and AVCAL survey, 2006

2.5

0%

12%

Nominal return expectation

3%

Relative return expectation (vs. public equity) 6% 4% 2% 8% 10% 12% 14% 0% Sales Cost management Operational efficiency Cash flow 25% 50% 75% 100%

Changed for the better Not changed

Changed for the worse

% of respondents

Changed for the better Not changed

Changed for the worse

0% Exports Strategy 25% 50% 75% 100% Other recruitment Executive recruitment Marketing % of respondents

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Businesses owned by private equity managers also increase sales at a much higher rate than comparable businesses not owned by private equity managers. The superior sales growth of private equity-backed businesses has been confi rmed by studies in other countries e.g. the UK, Germany, France and Italy.

Comparative annual revenue growth

Sources: Deutsche Beteiligungs AG, Finance & BVCA 2004, INSEE & DIANE, AFI& PricewaterhouseCoopers

“Exports by private equity-backed companies grew by 6% p.a., compared with a national growth rate of just 2%.”

The Economic Impact of Private Equity in UK, IE Consulting, November 2006.

0% UK 11% 10% 7% 4% 4% 1% 10% 3%

Germany France Italy 2% 4% 6% 8% 10% 12%

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The Private Equity Market in Australia – An Overview

Effect on the Capital Market

3

Positive Effect on Small-To-Medium Enterprises

Private equity provides important assistance to small-to-medium enterprises (“SMEs”) by: – increasing the availability of capital to SMEs; and

– providing SME proprietors wishing to retire from their businesses with a staged and attractive method of doing so.

Availability of capital

For most SMEs raising funds from the stock market will be inappropriate or too expensive. Bank funding may be restricted due to perceived risk. Friends and family are typically limited in the amount of funding that they can provide. Non-fi nancial assistance from these sources is also limited. Private equity provides a viable alternative for those SMEs needing capital to grow as it not only provides funding but also, and more signifi cantly, valuable non-fi nancial assistance.

Succession

In view of Australia’s ageing demographic, succession planning in family businesses is an issue of growing importance for the economy. Again, private equity is playing a valuable role assisting owners to exit their businesses whilst improving rather than jeopardising the ongoing prospects of the businesses.

Positive Effect on ASX

Private equity complements and enhances the operation of the ASX by building many businesses to a stage where they can be listed.

At present, the level of private equity activity in Australia is small compared to the ASX (see Section 4.3). Private equity funds currently have around $5.7b of unused commitments available for investment in Australian businesses over the next 2 to 3 years.

– Hypothetically, this amount could be used to acquire businesses worth $19 billion, assuming an additional debt component of $13.3b (being 70% of the total amount).

– This amount equates to approximately 1.3% of total ASX market capitalisation.

Private equity investments are always sold after a period. When sales of private equity investments are via a public offering on the ASX, this returns the business to the listed market, usually with a more solid and profi table outlook. The larger the business the more likely it will be sold via public offering on the ASX.

Private equity also provides important assistance to underperforming and distressed listings by: – increasing capital availability and management fl exibility

– arresting the negative effects of underperforming businesses on the broader market and economy

3.1

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Availability of capital and management fl exibility

Businesses may underperform for a variety of reasons, such as tightened market conditions, loss of market share, poor management or costly capital structures. In such cases, such businesses will face higher cost of capital, and increased pressure on jobs and other cost bases. Private equity provides a lifeline for such businesses by providing an alternative form of capital to introduce greater effi ciencies, as well as to plan for further growth.

Arresting the effects of underperforming businesses on broader market and economy

Businesses that do not operate effi ciently will have a detrimental effect on investor confi dence, the overall economy and its growth prospects. A key benefi t of private equity acquisitions of underperforming businesses is that it enables management to focus its efforts on the group’s core activities, and minimise the risks and costs of dealing with poorly performing aspects of the business. Private equity managers typically only acquire a business when they have a clear idea of how they can turn the company around and unlock value. Clear fi nancial targets are set to return the business to fi nancial and operational strength, so that the private equity interests can stage a strategic exit in the subsequent years.

Contrary to popular perception, delistings of fi rms bought over by private equity are the exception rather than the norm

Globally, delistings account for less than 7% of all private equity transactions. In Australia, only 1 of the 47 companies that delisted (or 2% of all delistings) within the 6 months to March 2008 did so as a result of a private equity transaction, and only 4 companies did so in 2007. The total value of all companies that delisted as a result of a private equity buyout within the 18 months to mid-2008 amounted to less than 0.2% of total ASX market capitalisation.

Positive Effect on Debt Markets

Private equity has helped to develop the debt capital markets in Australia by attracting more international banks to participate in them. The entry of new lenders into the market has increased the availability of funding for all Australian businesses. In addition, private equity activity has helped to build in Australia a liquid market in subordinated debt. This market is accessible to all Australian businesses and investors. Both these effects have benefi ted Australian business and increased the effi ciency of Australia’s capital markets.

AVCAL’s research indicates that recent private equity acquisitions in Australia have had, on average, an equity component of 40% and a debt component of 60% of the total purchase price. This percentage of debt has stayed relatively constant throughout this decade even though transactions have grown in size. This is a key difference from the US in the 1980s when some private equity transactions had a debt component as high as 90 to 95%.

“Overall, private equity exposures amount to less than 3% of total loans in the Australian banking system. The exposure of the Australian banking sector to private equity is well contained, and both the leverage and the debt-servicing ratios for the corporate sector as a whole remain relatively low.”

Financial Stability Review, RBA, March 2007.

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The Private Equity Market in Australia – An Overview

Trends in Private Equity

4

Increase in Funds Raised

Australian private equity managers have reported a signifi cant increase in funds raised in the last few years. Several factors may explain this:

– the high returns delivered by private equity managers which have prompted institutional investors, such as superannuation funds, to increase their allocation to the sector;

– the global market for debt has grown which has resulted in private equity managers (and other borrowers) being able to borrow more; and

– strong growth in the level of superannuation savings in Australia which has made more money available for all categories of investment.

This growth has persisted despite tougher global fi nancing conditions following the collapse of the US sub-prime market in 2007.

Over the 10-year period to 2008, private equity funds raised over $31b.

4.1

Increase in Global Private Equity Buyout Activity

Globally, the value of leveraged buyouts increased to over US$800b in 2006. Nevertheless, this fi gure accounted for less than 2% of the total size of global debt and equity markets.

Aggregate buyout activity in Australia so far is still relatively small, but as an individual market Australia is a leader among the ex-North America and ex-Europe markets. Over the period 2001 – 2007, the total enterprise value of all large leveraged buyouts in Australia amounted to 1.3% of the global total: on par with the contribution of the entire African & Middle East region, and slightly higher than Eastern Europe (1%) and Latin America (1.2%) as a proportion of global buyout activity over that period.

4.2

Funds raised by fi scal year

Source: Thomson Financial

0 99 00 01 02 03 04 05 06 2,000 4,000 6,000 8,000 10,000 Financial year A$m 12,000 08 07

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Global leveraged buyout activity

Source: Reserve Bank of Australia

The increase in large private equity-led buyouts in recent years differs from the takeover boom in the late 1980s in the following ways:

– The private equity buyers are spread out among a broader investor base – including Australian superannuation funds and government funds – rather than driven by individual entrepreneurs as was the case in the 1980s

– Private equity funds aim to unlock value in underperforming businesses so that they can release their investments at a profi t, not to build business empires

– The relative value of recent buyouts is small at less than 2% of total equity market capitalisation, compared to buyouts valued at around 4% of total equity market capitalisation in 1989.

Scope for Further Growth

At present, the private equity industry in Australia is small relative to the size of the industry in the US and the UK. Private-equity buy-outs accounted for only 4% of total M&A deal value in 2007 (31% in the US, 30% in France and 21% in the UK).

Buyout activity in Australia is also small relative to total equity market capitalisation. The total value of funds raised by private equity fi rms in the 9-year period to 2007 is still under 2% of ASX market capitalisation. This amount is smaller than the market capitalisation of the 10th largest stock on the ASX. Private equity exposures amount to less than 3% of total loans in the Australian banking system. In addition, tighter credit conditions from mid-2007 have meant that many of the large leveraged buyouts reported in 2006 – 07 are unlikely to be repeated in the near to medium term. It is anticipated that deals will begin to move away from debt funding to a higher equity component.

Important (and still largely untapped) potential sources of growth in the provision of capital are Australian $1.1tr superannuation fund industry, university endowment funds including the $6b Higher Education Endowment Fund managed by the Future Fund, and the $60b Future Fund itself.

Overall, there is substantial opportunity for further growth in the Australian market. This is in line with the government’s longer-term aim to make Australia a regional fi nancial hub as well, as private equity generates growth in a range of professional services including corporate and legal advisory services, and funds management.

“I think it is important to keep in mind that the private equity fi nance we saw last year remains a very small part of the overall fi nancing that takes place in the economy. As such, our view is that these developments pose absolutely no risk to the stability of the fi nancial sector or the economy more generally.”

Mr. Ric Battellino, Deputy Governor, Reserve Bank of Australia, Offi cial Committee Hansard, Senate Standing Committee on Economics, Inquiry into private equity investment and its effects on capital markets and the Australian economy, 25 July 2007.

4.3

US$ b 0 100 200 300 400

North America Europe Other Australian

Figure

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References

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