Bullseye: 2023 private capital outlook

Authored by Mark McNamara, Alex Elser & Genovieve Lajeunesse

It hardly bears repeating that there are significant macro headwinds in the global and Australian economies, including high inflation, rising interest rates and geopolitical instability.  Whilst those factors are significant headwinds for private capital as a whole, they do create new opportunities for public-to-private (P2P) acquisitions of listed companies, especially big ticket P2Ps – for evidence of this, you only have to look at the clear correlation between the significant interest rate increases from mid-2022 and broad re-rating of the price of ASX stocks at the same time (especially those that had traded at high valuations like larger tech companies, more on that below). 

These factors not only impact the market capitalisation of listed companies but also the attractiveness of public ownership relative to private ownership, especially for those listed companies that need relatively large amounts of growth capital and are better able to implement significant business changes outside the glare of the public markets and their myopic short-term focus (e.g. energy transition-focused companies).

The prospects of big ticket P2Ps getting away in 2023 is also likely to be bolstered by what we see as an increased willingness of private capital to partner with other private capital players such as Australian super funds and offshore pension funds and sovereign wealth funds.  In addition to increasing the total equity cheque available to secure the “mega deals”, we have also seen such partnerships used strategically to secure shareholder and stakeholder support for the acquisition of certain assets, especially those in “sensitive” sectors. 

Empirically, we also see financial sponsors having more success in recent times in successfully getting public company boards to engage.  Whilst trying to unlock the door to meaningful Board engagement has historically often been very difficult, we see target boards becoming more and more inclined to engage.  No doubt this is a combination of the factors above, as well as a general maturation of the Australian market. 

Aside from succeeding on premium to ASX trading price, we expect to see more financial sponsors giving serious consideration to pre-deal stakes to increase their chances of success on bigger P2Ps, whilst also better compensating their sunk costs if they get outbid.

Authored by Alex Elser

2023 will almost inevitably see a continued focus on sectors with underlying resilience in times of economic uncertainty and stable income and cash flows (and, ideally, an ability to pass through inflationary costs to the customer).  Expect to see this continue, with financial investors also focussing on industries and businesses with resilient financial models and contract terms which not only survive, but thrive, in the face of significant inflationary pressures and supply price increases. Industries with cost-plus models and fees and rebates based on percentage of revenues or sales, e.g. franchising and long-term government contracts, will be inevitable winners from the rising tide of inflation and pricing increases which are passed on to consumers.

We also expect to see the stable infra-like sectors continue to attract significant attention, including healthcare and adjacent healthcare industries/technology, which are underpinned in many cases by government financing and inelastic demand. The challenge for financial sponsors will be capturing the dollar gains of those price increases whilst managing input costs and labour supply challenges which have only increased post-COVID.

Authored by Will Stawell, Dan Flanagan & Yuen-Yee Cho

Distressed debt investors should have good buying opportunities in 2023, with more borrowers impacted by:

• higher base rates (causing serviceability issues for over-leveraged, under-hedged borrowers);
• rising input prices; and
• earnings pressure.

Affected borrowers could see their debt trading at deep discounts (to investors with a loan-to-own strategy) or face into other restructuring processes.

There will also be increased opportunities for those able to offer “flexible capital” solutions - with private capital investors providing bespoke instruments to meet funding needs outside the mandate or risk tolerance of “traditional” lenders (see more below).

There is plenty of supply with the growing private debt market increasing allocations to these strategies – and we have seen global firms directing people/attention to Australia and local firms continue to build their capabilities.  

Authored by Alex Elser & Anthony Boogert

The combination of market uncertainty and volatility, more special situations and non-controlling investments by financial sponsors and other “unconventional” investment and funding strategies is certain to see an increase in the use of bespoke equity, debt and hybrid instruments in 2023.

In the current investment environment where macro pressures such as input costs, inflation, interest rates and geopolitics are also colliding with legacy high price expectations from some vendors, we will also inevitably see these instruments becoming a useful tool for financial sponsors to bridge buyer/vendor valuation expectations/overly optimistic growth and earnings projections.

The magic of instruments such as convertible notes, shareholder loans paired with warrants, preference shares and other classes of shares with terms tailored for a specific investment is that they can be individualised to suit the exact investment profile, tolerance for risk, minimum return and/or downside protection requirements and governance / control rights.

Look for transactions and instruments which combine debt with an equity return (often via warrants, convertibles or similar instruments, but sometimes as direct ordinary or preferred equity).

Authored by Mark Bayliss

While the 2023 real estate sector is likely to present some challenges in a general sense, the trifecta of inflation protection, relative predictability of return (including yield) and portfolio diversification will continue to attract capital into (and drive activity in) the sector and present unique opportunities for private capital investors who can leverage sophisticated investment strategies and make focused investments in products which benefit from market conditions or have fundamental resilience.

The macroeconomic volatility of 2022 has sharpened investor focus on fundamentals, and also income growth profile and runway across asset classes, markets, and product types – and resulted in longer term (and lower risk) strategies and capital favouring higher-quality commercial office assets, and industrial assets and rental housing (the latter of which both continue to be supported by low vacancy rates and behavioural and demographic drivers of demand). Similarly, and for related reasons, a number of still institutionalising sectors (e.g. the broader ‘living’ sector and data centres) are still attracting strong flows of capital across the spectrum of risk.

As a corollary to the above, we expect that a key rationale of many new strategies and products that will launch during the early part of 2023 is the widening discounts for Grade B and Grade C assets and buildings (especially those with leasing risk and high capex requirements – related to increasing sustainability and energy efficiency demands of users). This delta, when coupled with high replacement costs, is creating repositioning and repurposing opportunities for value add and opportunistic capital – and in particular those with credible delivery capability or solutions.

We are also expecting opportunities to continue to emerge in public markets as the year unfolds, given the acute increase in implied cap rates relative to underlying private market values.

For further insights on the real estate sector, follow our flagship real estate sector publication “Investing Down Under” here.

Authored by Anthony Boogert

Whilst the bigger end of private capital has shown a lot of interest in larger tech companies outside of the growth capital space over the last two years, only a small percentage of these deals have gotten over the line as a result of the eyewatering COVID-induced valuations in 2021, the absence of tech hungry SPACs in the Australian market and high market volatility. 

The underlying financial sponsor appetite to invest in the larger end of the tech sector remains strong - not surprising given the opportunities for revenue growth through disruption and the generally capital-light nature of many tech businesses. Following the reset in valuations last year and the passage of time since 2021, we’re anticipating a higher success rate for tech transactions in 2023. Australia’s tech players have traditionally not been valued as well as those in other markets and with the heat coming out of listed stock prices, their valuations look even more viable for deals now. Of course, with the cost of debt finance generally increasing and market overexuberance giving way to more conservative valuations which are underpinned by more conservative growth forecasts, the deals that get done are likely to involve more mature companies that are already profitable or have a credible path to profitability in the near term.

Authored by Will Stawell, Dan Flanagan & Yuen-Yee Cho

Availability of debt financing on attractive terms will continue to be a key challenge which financial sponsors need to navigate in 2023 to ensure transactions can successfully get away.

As our LevFin team reported at the end of 2022:

• Term Loan Bs (“TLBs”) grew as a core product option for Australian LBOs from 2017 until early 2022 - particularly for larger transactions. However, they dried up in the second half of 2022, due to, among other factors, rising rates/inflation fears, the Ukraine war and relative value concerns. We’re hopeful this dislocation will clear in 2023, with relative value of new deals improving and investors needing to deploy capital.
• Unitranche and other direct lenders benefited from the TLB market pause, (re)gaining market share with their product being the only viable product choice for many deals.
• Bank debt remains the right option for some deals, particularly in the mid-market - and we expect the trend towards using more bank debt on larger deals will continue. Although there has been some loosening of terms in recent years due to competition from other products, financial sponsors will still not get the same level of leverage or flexibility offered by the other products.
• 2022 was otherwise famously a year of rising rates - both base rates and margins. Serviceability has come more acutely into focus and is putting downward pressure on leverage.
• These factors could result in Holdco PIK deals coming back into fashion - with the blended cost for Senior Bank + Holdco PIK deal starting to come close to unitranche pricing, but with a reduced cash servicing cost due to the PIK component.

Authored by Andrew Gray, Angela Weber & Sarah Mitchell

Following widespread media attention and cross-bench negotiations, landmark changes to industrial relations laws, with significant implications for financial sponsors in the Australian market, were passed December 2022. Together with the “Respect@Work” laws, the changes are the most extensive IR reform in decades. With an express purpose of job security for employees and closing the gender pay gap, the new laws are also designed to bring substantially more businesses into the enterprise bargaining system – if this objective is achieved, we’ll start to see enterprise agreements (and union influence) becoming much more common, particularly in sectors such as aged care and for smaller employers (like portfolio companies) without any previous history of enterprise bargaining.

Other key aspects of the reforms which will need to be actively addressed both by financial sponsors for themselves and by their portfolio companies include:

• a prohibition on pay secrecy clauses - employees will be able to disclose their remuneration to any person – including a competitor or future employer;
• the imposition of a positive duty to take “reasonable and proportionate measures” to eliminate sex discrimination, sexual and sex-based harassment, hostile work environments and victimisation as far as possible, including taking active steps to ensure appropriate prevention and response strategies;
• an ability for almost all workers and unions to negotiate industrial agreements across multiple employers with clearly identifiable common interests - designed to give employees better leverage in bargaining for industry-wide pay increases and improvements to working conditions; and
• a prohibition on contracts containing a fixed term in excess of two years.

Once the dust settles, we’re also anticipating more change is to come. The Government has signalled it intends to regulate the conditions of workers employed under labour hire and outsourced arrangements who perform the same work as employees (ie “same job, same pay”), up the ante on wage compliance by criminalising wage theft, increasing the regulation of “gig workers” and other similar forms of work and setting minimum standards of work for those in the transport industry.

Authored by Bryony Evans, Charles Davies & Genovieve Lajeunesse

Data and cybersecurity management has been a growing commercial focus and an increasingly sensitive topic over the past decade.  Almost all businesses across the full spectrum of industries stockpile customer data, often with a view to directly or indirectly monetising it but sometimes unintentionally.  As a core business asset, management of data for financial sponsors is essential to deriving and preserving its value, and limiting reputational, regulatory and contractual risk – it is not a “tech” issue, but a critical business risk for financial sponsors and the boards and executives of their portfolio companies to proactively manage.

The foundation of managing data and cybersecurity risk is basic good data hygiene, including:

(1) identifying what data is held and how it is stored. Large sensitive data sets can persist within IT systems long after they have stopped being actually used, their existence sometimes only coming to light when a data breach occurs.  Exacerbating the potential problems with those datasets is the fact that they’re often not being protected by the primary IT security controls of the business because they are not actively being used;

(2) making sure the business case for storing and using data is lawful and regularly re-assessing the ongoing justification for storing and using data; and

(3) destroying and/or de-identifying redundant data.  Relevant Australian legislation requires reasonable steps are taken to delete or de-identify personal information when there is no longer a lawful use for it, although in practice this can be difficult to do.

For financial sponsors and their portfolio companies, especially those with sensitive personal data, there are also specific considerations which need to be actively managed.  Those financial sponsors and their portfolio companies:

• may have the burden of navigating additional regulatory notifications and FIRB conditions. Data has been a significant focus point for FIRB for some time, with progressive strengthening of the FIRB conditions related to data security, storage and transfer and express requirements to report any data breach to FIRB and relevant affected persons;
• need to be conscious of the financial sponsor-wide implications of any data management issues or cybersecurity incidents, including vis-a-vis limited partners and investors. Some financial sponsors now have LP/investor notification obligations, with the result that a data breach or cybersecurity incident for an individual portfolio company can have far broader implications; and
• should be conscious of managing data and cybersecurity risks in the preparatory period for an exit and throughout the exit process. With the significant media focus on any data breach, the knock-on effects can be highly detrimental to value or result in shareholders having to agree to indemnities or other mechanisms to deal with any residual liabilities.

Authored by Caroline Coops & Genovieve Lajeunesse

Greenwashing risks are now flowing over into industries outside of the expected core suspects such as large emitters, proponents of net zero targets and the banks.  It’s a double whammy risk to be managed for private capital – first, the damage to the underlying portfolio company if a greenwashing allegation / claim is made; secondly, the impact on limited partner and other investor relations.  A greenwashing claim against a portfolio company can have flow on effects across a financial sponsor's funds and for future fundraising efforts as limited partners and other investors are increasingly focusing on ESG considerations as part of their own mandates, imposing responsible investment related reporting and compliance obligations on asset managers. 

The ACCC has warned that all sectors are under scrutiny, with a particular focus on claims of carbon neutrality in production processes and other industries will likely be targeted in the near future.  In addition to focusing on the energy and resources sectors, regulatory actions in Australia to date have targeted unsuspecting industries such as consumer goods (e.g. alleged misleading statements about the biodegradability of “eco” picnic products) and financial services (e.g. potentially misleading statements regarding the investment screens applied to certain retail investment products) and “green” related advertising. 

The risk for Australian portfolio companies is also global and not limited to the attention of an Australian regulators – Bondi Sands is a prime example: it currently faces a claim in the US alleging that its description of aerosol sunscreen as “reef friendly” is misleading.

Core guiding principles which financial sponsors and their portfolio companies need to adopt to mitigate greenwashing risks in advertising and communications include:

• being clear and specific;
• context is everything;
• don’t overstate positive environmental attributes or impacts;
• being wary of generic terms with ambiguous meanings such as “renewable” or “clean”;
• making sure you can substantiate your claims; and
• being extremely careful with aspirational claims. 

To read more on how financial sponsors and their portfolio companies can manage greenwashing risks see here.

Authored by Genovieve Lajeunesse

In looking at the enforceability of employee non-compete clauses, Australian law strives to strike a balance between protecting employee livelihood and protecting the legitimate interests and goodwill of the business which has the benefit of the non-compete. In the employment context, Australian law typically only allows a short period of post-employment restraint, flexing based on factors such as employee seniority, relevant industry dynamics, public policy considerations and the employee’s knowledge of non-public competitive information – Australian law generally tolerating only geographically-sensible restrictions.

The US Federal Trade Commission has recently proposed prohibiting non-compete clauses in employee contracts. It seems highly unlikely that Australia will follow the US lead. Given the balancing of protections for employers and employees – especially in the context of senior executives who often have the benefit of financially-rewarding incentive plans from financial sponsors - our view is that a blanket prohibition on non-competes would be a regulatory overshoot.

The proposed US prohibition is also a timely reminder for financial sponsors and their portfolio companies that post-employment restraints need to be carefully tailored to be enforceable and that not all jurisdictions permit post-employment restraints. Financial sponsors can also use a variety of staff retention methods and key person planning in connection with carefully structured restraints. The tool kit includes short and long-term incentive plans which are aligned not only to the individual’s role and responsibilities but the financial and non-financial objectives of the portfolio company and ultimately for financial sponsors, the metrics that drive exit valuations.

To read more on the FTC proposal see here.