Inside the enigmatic world of private equity
Pacific Equity Partners managing director and co-founder Tim Sims accepts that the private equity industry is, to most people, an enigma, and one that stirs a range of strong emotions.
"There is the view that it is some sort of strange alchemy and not a legitimate activity. Good companies are bought and you hear things like asset-stripping and profit-promoting," the normally media-shy Sims says.
"And then there is a school of thought where private equity can do no wrong and books are published on ‘doing things the PE way'.
"There is this substantial schizophrenia in the market that seems to feed off the uncertainty about what private equity really does."
So the head of Australia's biggest private equity firm - with A$6 billion in equity funds under management - is willing to be interviewed about what private equity does.
The soft-spoken Sims and his team are in the middle of a purple patch. In the past month alone, PEP has listed cleaning contractor Spotless in an A$1.8 billion float, sold ice-cream maker Peter's to R&R Ice Cream for around A$450 million and tabled a A$1.1b bid for embattled standards group SAI Global.
Rival private equiteers have also brought big household names such as Nine Entertainment and Dick Smith back to public markets in a rush of initial public offerings on the ASX.
It was only two years ago that PE was twiddling its thumbs and fighting a tide of negative sentiment after TPG's Myer float in 2009. Myer shares have never traded above their A$4.10 offer price.
It doesn't help that the Australian Taxation Office waged a lengthy public battle with TPG for a A$739m bill on the A$1.5b profit from the float.
Those kinds of stories, and a general perception that PE levers companies up with debt, rips out costs, and then takes home spectacular profits, means PE is heavily scrutinised. But Sims says that looking past the negative stories, there are reasons PE makes big sums of cash for its investors.
He says the ability to choose the assets it operates, a culture of deep due diligence, the capacity to properly align management incentives to business performance, and a long investment horizon with greater risk tolerance, all give PE "strong structural advantages".
"Private equity is the natural and constructive sister for public equity. Where do you go for a business if you have enormous risk-based change to go through, or if the cost of capital is very high?" he says.
The hive of recent IPO activity has put PE firms firmly back on centre stage and brought back memories of the sector's big moments like the A$5.60-a-share bid for Qantas in 2007 and CVC's disastrous A$5.6b acquisition of Nine Entertainment.
But Sims is quick to hose down talk of a frothy market: "There is space in the market for good-quality companies being brought forward, and we've certainly benefited from that. What we don't see is markets at the peak valuation levels we've seen in other parts of the world."
The former Bain & Co management consultant thinks there's more positive momentum behind the Australian market to come, and argues it is more a return to normalcy than a boom.
"There have been quite a lot of IPOs that have been repriced or cancelled. Has the market become irrationally exuberant? No. During the darkest days of the GFC, the low-to-no-risk return on cash deposits was so high there was a lack of structural support for risky assets. The situation today seems to be back to normal," he says.
Sustained strong performance in the local sharemarket will be critical for PEP, which is preparing cinema group Hoyts for a A$500 million IPO and has rebranded female hygiene business SCA Hygiene under the name Asaleo in preparation for a float.
All the wheeling and dealing can be a lucrative business. PEP listed Spotless at more than twice the price it paid to take it private in August 2012.
From the float PEP and its co-investors realised A$237m from their investment, while fees to bankers and other advisers, including a A$24.6m fee to PEP, totalled almost A$60m.
The big fees and lack of liquidity - PE investors lock up their funds for years at a time - has seen many Australian super funds shy away from the asset class.
Sims says there has been a lot of focus on fees and less focus on net returns.
He says PEP's average net return across all funds over the past 15 years is north of 20 per cent. PEP targets gross returns that are 5 per cent above long-run public-equity returns, including dividends.
He adds that PE is constrained by the "back-end waterfall" which means PE managers don't draw performance profit until investors have received a cumulative return of 8 or 9 per cent.
Collectively, PEP and its businesses employ 40,000 people and generate more than A$1b in profits.
Sims says he sees PEP's role as a capital provider that sets a broad strategy and then gets out of the way of talented managers, allowing them to reshape the business.
He says the defining feature of the good managers he has worked with is the ability to make good decisions and correct bad ones, and the rate at which they are able to do so.
"There are lots of corporate cultures that are reluctant to make changes, and they punish bad decisions, which, in turn, makes people reluctant to make decisions," he says.
Some of the numbers are impressive. PEP's companies delivered earnings before interest, tax, depreciation and amortisation (Ebitda) growth of 22 per cent last year compared with 6 per cent Ebitda growth for public companies. In the case of Spotless,the numbers were too good to be true for some fund managers. In 18 months of PEP ownership, Spotless doubled its Ebitda to A$250m.
Sims says that the Australian market is sophisticated, and he views a lot of the negative commentary around IPOs as part of a negotiation process.
"In a negotiation, naturally, people are inclined to remind you of less positive experiences they've had participating in the past," he says.
"[But] you have to separate invective and negotiation from actual behaviour and delivered outcomes."
He also admits that PE doesn't always get it right. The 2011 collapse of Red Group, which owned book stores Borders and Angus & Robertson, is seared into the PEP team.
"The economic circumstances that we assumed as a context for the investment changed rapidly," he says.
"Learning is critical. And failure is so painful, believe me, it's very confronting and you spend a lot of time reflecting."
PACIFIC EQUITY PARTNERS INVESTMENTS
PEP's investment portfolio includes a number of companies with New Zealand operations:
Veda: A leading provider of consumer and commercial credit checking in Australia and New Zealand. PEP acquired it in July 2007. It then had an enterprise value of A$974 million.
Griffin's Foods: New Zealand's leading biscuit and snack foods manufacturer. Acquired by PEP in June 2006. The enterprise value at that time was NZ$385m.
Hoyts Group: The region's second-largest cinema operator in Australia and New Zealand, including Val Morgan, the biggest provider of cinema advertising in both countries.
PEP acquired it in December 2007.
At the time it had an enterprise value of A$400 million.
Spotless: Outsourced facilities management and services in Australia and New Zealand. Acquired by PEP in August 2012. It then had an enterprise value of A$1.1 billion.
SCA Hygiene: (Since renamed Asaleo Care and is about to be listed on the ASX) Produces the best-selling toilet-paper brand in New Zealand, Purex, and the second-biggest nappies brand, Treasures. Acquired by PEP in January, 2012. It then had an enterprise value of A$570m.