Brian Gaynor: KiwiSavers should surf wave of cash

Australia's leveraged buyout approach didn't end well for Dick Smith, but New Zealand apple grower Scales is a success story for the local growth-oriented model. Photo / File

COMMENT: The world is awash with cash, and private equity (PE) funds are a clear example of this phenomenon.

Preqin, a provider of data for the alternative assets industry, recently reported that global PE funds have almost US$1.1 trillion ($1.6t) of dry powder, or uninvested cash, while Morningstar revealed that North American and European PE funds have 3.9 years of dry powder.

In other words, if these private equity firms stopped raising money, it would take 3.9 years to invest their available capital at current investment rates.

Asset owners, including sharemarket and private company investors, have been major beneficiaries of the PE boom. Nuplex and Trilogy, both listed on the NZX, were acquired by PE firms, as were the Auckland private colleges group ACG, My Food Bag and Manuka Health.

In recent weeks, a British PE firm announced it will purchase Orion Health's Rhapsody operations for $205 million, with these proceeds being used to buy back Orion shares, pay transaction costs and reinvest in Orion's remaining businesses.

The flip side to these purchases has been the listing of several poorly performing, formerly PE-owned companies, including the NZX's Intueri Education Group, Metro Performance Glass and Tegel Group Holdings.

Global sharemarkets have also benefited from PE takeover activity but there have also been dud private PE-initiated listings, including Dick Smith and Myer in Australia. Dick Smith went bust and Myer's shares are trading at only A41c, compared with their IPO issue price of A$4.10 in 2009.

Investors are attracted to PE funds because they have delivered superior returns compared with sharemarkets.

According to management consultancy Bain & Company, US buyout funds had an aggregate return of 9.7 per cent for the 10 years to June 2017 compared with 7.9 per cent for the S&P 500 index.

European PE funds returned 8.7 per cent for the same period compared with 3.6 per cent for the MSCI Europe index, while Asia-Pacific buyout and growth PE funds posted an annualised 10-year return of 10.5 per cent versus 4.5 per cent for the MSCI Asia-Pacific index.

Private equity funds have become increasingly popular in New Zealand but it is important to note that most of our PE funds are growth oriented, rather than the more traditional buyout PE funds that gave us Metro Performance Glass, Tegel, Dick Smith, Intueri Education and Myer.

A notable NZ exception was the highly- leveraged buyout of the Crown-owned Tranz Rail by the Fay, Richwhite consortium in the mid-1990s.

This was a disaster and the railway company is now back under full Government ownership.

Private equity is a medium or long-term equity investment in a company or several companies that are not listed on stock exchanges.

The investment period is generally three years or more, with most PE funds closing and distributing all funds to investors between eight and 14 years after establishment.

Private equity firms, particularly those involved in venture capital, can be traced back to the 19th century, when they funded the establishment of many US textile mills and railway companies.

In 1932, the Reconstruction Finance Corporation (RFC) was created by US President Herbert Hoover "to alleviate the financial crisis of the Great Depression".

The RFC was strongly supported by President Franklin D Roosevelt as growth-oriented companies were unable to raise capital through sharemarkets that remained depressed following the 1929 crash.

Nineteenth and early 20th century PE funds invested mainly in growth companies.

The PE sector changed direction in the 1950s and 1960s with the widespread move into leveraged buyouts (LBOs). An LBO is like a house purchase where the buyer provides equity but most of the funding is through debt.

A highly-leveraged $5m purchase would be where the buyer provided only $0.5m of equity and borrows the remaining $4.5m, while a less leveraged buyout would be where the purchaser provided $4m of equity and borrows only $1m.

Low US capital gains taxes and an abundance of bank funding, particularly through the issue of junk bonds, enabled the LBO-oriented PE sector to grow rapidly.

Leveraged buyouts moved into the mainstream in 1989 with the high-profile struggle for control of RJR Nabisco, the US tobacco and food conglomerate.

The takeover battle was brilliantly described in the best-selling book Barbarians at the Gate: The Fall of RJR Nabisco.

The chief executive of RJR Nabisco, Ross Johnson, planned to purchase all the shares in his company and sought advice from Henry Kravis and George Roberts. However, when Kravis and Roberts learned that Johnson no longer wanted their advice they decided to make an alternative offer.

Kravis and Roberts, under the name Kohlberg Kravis Roberts (KKR), won the fierce takeover battle and paid a record US$25 billion for the food and tobacco giant.
Kohlberg Kravis Roberts borrowed over 80 per cent of the purchase price and lost money on the deal.

Nevertheless, private equity buyout funds received a huge boost from the RJR Nabisco publicity and a plentiful supply of cheap loans.

Meanwhile, the New Zealand PE sector had its origins in the $25m Greenstone Fund, which was established in 1993 as a Government-private sector fund to invest in private companies.

The Government contributed $5m, Axa $5m, National Provident Fund $5m and AMP $10m.

The stars of the fund, which was managed by Pencarrow Private Equity and was liquidated in 2007, were NZX-listed Wellington Drive Technologies and Formway Furniture.

Direct Capital, which was established in 1994, was next off the block as far as New Zealand PE firms are concerned.

The company's website clearly explains its position: "The common perception of what's become known collectively as private equity is that all investors have the same style and business model. But the reality is very different.

"Some investors follow a 'leverage model', relying on debt to produce financial returns. This can be successful over short periods of the economic cycle but it doesn't work forever. Some investors are 'control' focused but that only works if you're also running the company.

"Our returns come from investing in growth creating permanent value. We invest and become partners with owners and management running good companies and we act the same whether we are a 20 per cent shareholder or an 80 per cent shareholder."

The failed Fay, Richwhite consortium/Tranz Rail leveraged buyout was essentially a one-off as far as New Zealand is concerned, as most of our PE funds now follow the Direct Capital model, the modestly-leveraged, growth-oriented approach.

The rest of the world, including Australia, continues to have a strong focus on leveraged buyouts, mainly because of a plentiful supply of bank debt.

Direct Capital's growth-oriented strategy has brought Ryman Healthcare, Scales and New Zealand King Salmon to the NZX, while the Australian leveraged buyout approach has given us Metro Performance Glass, Tegel, Dick Smith, Intueri Education and Myer.

The latest Cambridge Associates' Australasian Private Equity Overview and Performance Report shows that PE funds have realised NZ$25.9b in the two countries, with $4b, or 15 per cent, realised in New Zealand.

The report shows that these Australasian funds have outperformed the S&P/ASX 300 Index in the decade ended March 2017. The Cambridge Associates report also shows that 78 per cent of total New Zealand PE realisations have been from growth-oriented funds, 21 per cent from buyout funds and 1 per cent from venture capital.

New Zealand PE, which has a far more sustainable growth model than the leveraged buyout model that dominates in other countries, has grown rapidly in recent years.

However, the growth could have been far greater if more than a handful of KiwiSaver funds allocated funds to this asset class. Private equity's medium to longer-term investment horizon is ideally suited to KiwiSaver and the domestic PE sector would get a major boost if more KiwiSaver funds invested in this asset class.

The economy would also benefit if more KiwiSaver funds were diverted into domestic growth-oriented PE funds, rather than being sent offshore to invest in large cap United States and European passive sharemarket funds.

- Brian Gaynor is an executive director of Milford Asset Management and chairman of the Milford Private Equity Investment Committee.