Hunt for cash puts pressure on private equity for asset sales

The nation’s $100bn private equity industry is caught in a squeeze that could trigger a revival in asset sales as firms look to monetise their holdings.

Private equity firms have sat on the sidelines for almost two years waiting for interest rates to stabilise instead of offloading assets at lower prices.

The nation’s $100bn private equity industry is getting squeezed between a growing need to return capital to investors and a looming glut of mature portfolio companies, creating a need for cash that could trigger a revival in asset sales.

Plummeting distributions amid a sales slump is testing investors’ patience, as private equity firms have sat on the sidelines for almost two years waiting for interest rates to stabilise instead of offloading assets at lower prices.

So-called “limited partners”, or LPs – the pension funds, insurance companies and high-net-worth individuals that invest in Australian private equity funds – received less than $US500m in the first three quarters of 2023 amid a freeze in exit activity that is slowly thawing.

The distributions are only a fraction of the roughly $US3bn in cash that was paid out to LPs in 2022, when the Reserve Bank began aggressively lifting rates, according to a Bain & Co analysis. It is also a sharp fall from the $US4bn distributed a decade ago.

“There is no doubt that LPs are putting a premium on liquidity at the moment,” Justin Dwyer, the head of financial sponsors at Barrenjoey Capital Partners, told The Australian.

“There is an increasing focus on DPI or distributions-to-paid-in-capital,” he said, referring to a measure reflecting how much cash a fund has returned to the investor relative to what was put in.

In total, 258 companies bought by private equity funds are in or beyond their fourth year of ownership.

James Viles, head of Bain & Co’s Australian Private Equity practice, said those likely to come out first included those that faced challenges securing their desired valuations and were scrapped in recent years.

That could include Guardian Early Learning, a childcare provider co-owned by Partners Group. While a sale process was initiated last year, it was ultimately shelved due to a disconnect between seller expectations and buyer offers.

A similar fate befell Loscam – a logistics company owned by China Merchants, Trustar Capital and FountainVest – and TEG, the Silver Lake-owned parent company of Ticketek, which last year scrapped a sale process, reportedly due to a mismatch in price expectations.

Some companies also saw their IPO aspirations dashed by shifting investor sentiment. All eyes will be on Bain Capital over a ­potential listing of its airline Virgin Australia this year, after its move to shelve the IPO last year.

Barrenjoey Capital’s Justin Dwyer. Picture: Hollie Adams

Provided volatility remains in check, other mooted candidates that could jump the gun for a listing include the Macquarie-backed data centre operator AirTrunk, TPG Capital-backed pet goods retailer Greencross, American Industrial Partners-owned Molycop, and Barrenjoey-backed Mexican food chain Guzman Y Gomez.

Private equity funds usually prefer other return measures such as money multiples and internal rate of returns, although some criticise the latter as potentially misleading due to its continuous compounding assump­tions.

But with higher borrowing costs squeezing returns, liquidity is more valuable and cash distributions are becoming almost urgent. This is turning up the heat on PE firms to monetise their assets. They are not necessarily forced sellers yet, but are increasingly incentivised to tap into available liquidity by offloading portfolio companies.

Even private equity funds’ preferred internal rate of return comes down as time goes by. And their ageing company portfolios are also intensifying the pressure to pursue exits.

“With Covid-19 and other dislocation, the average hold period of certain portfolio companies is now longer than usual,” Mr Dywer said. “Based on this and the discussions we are having with clients, we expect to see an uptick in asset sales by domestic and global sponsors in 2024.”

About 102 companies acquired by private equity firms in 2018 and 2019 remain unsold, equivalent to more than 70 per cent of those vintages, according to Mergermarket data analysed by Bain & Co.

The analysis also shows close to 60 per cent of companies in the 2017 vintage and more than half private equity’s 2016 investments have not been monetised. That means those companies are now in their seventh and eight years of ownership, respectively.

Market uncertainty, including the pandemic, subsequent inflationary pressures, aggressive interest rate rises, and geopolitical instability has created a challenging environment for private equity firms. For most of last year, the funds responded by adopting a wait-and-see approach in expectation of more stable conditions with potentially lower interest rates and higher valuations from 2024 onwards.

Private equity deal values plummeted 47 per cent in 2023 to $US12.8bn, the lowest level in five years, the data shows. Exits accounted for 44 per cent of that deal flow, after exit volumes fell by a similar magnitude.

With a still-large divide between the price expectations of buyers and sellers and the lack of an IPO market, several funds fixed the problem by simply selling companies to themselves.

For the first time ever, secondary deals became the largest source of exits in Australia last year, as trade sales also plummeted, Bain’s analysis shows.

Several funds, including Pac­ific Equity Partners and Crescent Capital Partners, have even used so-called “continuation funds” to fix the liquidity issue with the co-operation of some investors.

The technique involves private equity firms selling assets from a maturing fund, in which investors are nearing their return deadline, to a newer fund where investors won’t see their money returned for several more years.

Valuation questions emerge in such processes, but if it is done in a transparent and fair way, investors can support such processes.

The trade-off between valuations and liquidity is now tilting, and firms may struggle to raise fresh funds if they haven’t yet returned capital from their older funds through exits and distributions.

“We see this pressure on getting money back to LPs as being driven by the fundraising cycle,” says Mr Viles.

Mr Viles estimates the value of PE investments at the price paid for them is close to $100bn.

“If you look at the number of businesses that are over four years old, and therefore are coming to the end of the fund deployment cycle … you’ll find that people simply will have to exit some of those businesses.”

Fundraising activity by private equity funds targeting Australian companies also plummeted last year to only $US1.4bn, down from $US5.9bn in 2022 and $US2.1bn in 2021, according to Bain.

Still, PE firms have accumulated a record dry powder worth more than $14bn for investments excluding real estate, distressed debt investments, and funds of funds.

No doubt liquidity-rich firms will be circling those maturing private equity assets.