Megadeals as the market rebounds. Deal activity following the COVID-19 pandemic has been very strong, with the PE sector capitalising on opportunities as the economy rebounded, supported by record low interest rates (see BDO Australia: Private Equity in Review 2021 (BDO Review)). Most of the megadeals have been in sectors like technology that benefited from the pandemic and resulting disruptions; for example, BGH Capital's AUD1.3 billion proposed take private of Australian Stock Exchange (ASX)-listed Hansen Technologies Limited, and the sale of Mercury Capital-backed MessageMedia for AUD1.7 billion to Swedish software giant, Sinch. However, record valuations for these assets are challenging for PE managers competing against a soaring public equity market and strong competition from trade buyers on the private side.

Dominant sectors. Dominant sectors for PE are natural resources, healthcare, and energy. One of the busiest sectors is infrastructure and core-plus (where managers build on a core base of holdings, within a specified-objective portfolio, with instruments that have greater risk and greater potential return), in which there has been a run of mega deals involving PE and other financial sponsor acquirers, including a consortium led by IFM Investors making a AUD22 billion bid for Sydney Airport (subsequently rejected by the target board), the sale of a 49% stake in Telstra's InfraCo Towers business to a consortium comprised of Future Fund, Commonwealth Superannuation Corporation and Sunsuper (managed by Morrison & Co) for AUD2.8 billion, Morgan Stanley Infrastructure Partners' sale of its 40% stake in PEXA as part of the initial public offering (IPO), valuing PEXA at AUD3.3 billion, and the proposed AUD5 billion take private of Spark Infrastructure by KKR and Ontario Teachers Pension Plan (see Allens, PE Horizons 2021: Market Update). The consumer discretionary sector had the lowest deals volume in 2021, below 10%, dropping from a high of 52% of all buyout deals in 2020 (BDO Review).

IPOs. Throughout 2021, the number of IPOs reached 174: a 23% increase on the number of IPOs in 2020. The aggregate value of IPOs doubled to AUD10.6 billion. Some of the largest IPOs in 2021 were PEXA Group Limited (AUD1.1 billion), APM Human Services (AUD985 million) and Judo Capital Holdings Ltd (AUD650 million). With weak global equity markets in 2022, share in companies which undertook IPOs last year have sunk below their offer price, creating opportunities to buy them cheaper on market. The ten largest IPOs from 2021 are trading at a median 10% below their issue price (see Australian Financial Review, 2 February 2022).

Buyouts. Australasian PE funds continue to favour buyouts, with buyout funds representing 23% of funds closed and 62% of total private capital raised in the 2021 financial year (FY) (BDO Review).

Stronger international investment. Foreign investors have grown more active in Australia over the past two decades (18% of investors to 49%). International firms are participating in buyout deals in Australia. For example, in September 2021, KKR completed a leveraged buyout of business outsourcing specialist Probe Group for AUD1.1 billion, the third-largest buyout deal in recent years, and in February 2022, gaming and entertainment group Crown Resorts agreed to a AUD6.3 billion all-cash takeover by Blackstone.

Private debt. With commercial banks imposing tighter lending conditions in response to regulatory pressure, and distressed debt creating opportunities, private debt managers are increasingly providing funds to small and mid-sized Australia companies. Private debt was the fastest-growing asset class in Australia, with a 144% increase in assets under management from December 2020 to June 2021 (Preqin and AIC Report).

Venture capital. Following a record breaking 2021 in which AUD10.1 billion was invested by venture capital (VC) firms, activity fell significantly in 2022 to AUD7.4 billion (The State of Australian Startup Funding Report 2022 (Startup Funding Report)). International VC investment activity followed a similar trajectory, as global firms turned their attention to management of existing portfolios. Australia's standing as a world-class hub continued in 2022, with participation from international investors in 21% of transactions in the second half of 2022 (although slightly down on the 27% in the second half of 2021). While overall funding fell, 2022 saw an increase in early-stage funding in Australia. In contrast, the US and Europe saw a fall in funding for pre-seed and seed stages.

Easing off of fundraising levels. While Australia-focused PE funds raised AUD3.4 billion in 2021 (a 23% decrease year-on-year), this figure is still higher than in 2019, when ten funds raised AUD1.6 billion. While fundraising slowed marginally in 2021 compared to 2020, it was higher than the years prior, and the second highest since 2010 (Preqin and AIC Report).

Record growth funds. The aggregate total deal value of private equity-backed buyout deals in Australia reached a record AUD20.1 billion, up 32% year-on-year and 20% higher than 2019's AUD16.8 billion. The number of deals increased by 48% year-on-year from 2020 to 2021. Buyouts represented almost one third of deals during 2021 (BDO Review).

Venture capital. VC fundraising in Australia slowed to AUD492 million with six funds closed, compared with AUD2.6 billion in 2020, when 13 funds closed (Preqin and AIC Report). However, the 2021 figures do not account for more recent VC fund announcements in 2022, which saw Blackbird Ventures close the largest ever Australian venture fund (AUD1 billion), which was itself preceded by Square Peg Capital's announcement that it had raised an AUD861 million fund. AirTree Ventures also announced in February 2022 that it had raised a new AUD 700 million fund. These funds were likely raised in 2021, but took time to complete due to the due diligence requirements of superannuation fund investors.

Drop in dry powder. PE and VC dry powder (that is, funds committed but not allocated) fell 11% to AUD10 billion as of September 2021 from December 2020 (Preqin and AIC Report). Total assets held by Australian PE and VC funds rose to a record AUD42.2 billion, constituting a third of total private capital assets under management and growing at an average rate of 11% in the past five years. Meanwhile, aggregate deal value reached a record AUD20.1 billion, up by 30% year-on-year and 20% higher than 2019's AUD16.8 billion (Preqin and AIC Report).

Appetite for direct investment and co-investment. The significant uptick in public M&A activity in 2021 and 2022 saw a resurgence of superannuation trustees participating in PE-sponsored co-investment opportunities, attracted by competitive performance and fee arrangements (which help lower the costs of their alternative asset portfolios). In part due to the drop in public equity markets in 2022 and the required rebalancing of portfolios between public and private market investments, the percentage of Australian superannuation funds with a preference for private equity co-investments has dropped from 75% in 2020 to just over 60% (Preqin and AIC Report). The authors expect to see a continuation of the trend of moves beyond traditional co-investment vehicles which sit and invest alongside the main fund in a specific portfolio company, to bespoke fund-of-one and separately managed account solutions, including evergreen co-investment structures with a fund life designed to provide ongoing access to investments, often alongside multiple main funds. Given ongoing consolidation within the Australian superannuation industry, resulting in a smaller number of larger funds, the authors expect to see a continuation of an increase in the trend of Australian superannuation trustees making more direct investments and joining consortia, among other steps, rather than simply investing passively via third-party-managed funds.

Continuation funds. The number of continuation funds (vehicles established by a sponsor to acquire one or more assets from an existing vehicle operated by the same sponsor) raised in Australia has increased. Given the benefits these funds can offer both to investors and sponsors (providing liquidity to investors in the existing fund, while also allowing managers and investors to retain high-performing assets beyond the fixed-term life of a fund and benefit from continued upside) the authors expect continued growth in the use of continuation funds, as managers seek to provide liquidity for their investors amid global headwinds, including geopolitical tensions, valuation uncertainty, and public market volatility impacting traditional PE exit strategies of trade sales or IPOs.

VC funds invest at earlier stages of a company's life cycle, when investment is riskier (but with the potential for higher returns).

VC funds tend to take minority stakes, while PE funds are more likely to take majority stakes.

Investors in VC funds are more likely to be high net worth individuals or Australian superannuation funds, and only occasionally offshore institutional investors, while investors in PE funds are more likely to include offshore institutional investors.

Funds-of-funds.

The public sector.

High net worth family offices.

Other private investors.

Foreign investors in a VC limited partnership (VCLP).

Domestic and foreign investors in an early-stage VC limited partnership (ESVCLP).

Foreign investors in an Australian venture capital fund of funds (AFOF).

VCLPs cannot invest in entities with assets of more than AUD250 million.

ESVCLPs are limited to investments of AUD50 million or less.

Under the new CCIV regime (see Question 4), subject to certain conditions, investors should be taxed on an attribution flow-through basis for income derived by a qualifying sub-fund of a CCIV, which, as discussed in Question 4, is generally treated as a unit trust for Australian tax purposes.

Carries on a trading business in the relevant year of income, or controlled the operations of another person who carried on a trading business (certain activities, including deriving rent or holding certain financial instruments, are not taken to be activities of a trading business).

Is a "public unit trust," which is the case if any units were quoted on the ASX or offered to the public, or if certain ownership concentration thresholds are exceeded.

A right contained in a side letter (ancillary to the fund's main documents) to be excused from an investment.

Generally applicable investment restrictions in the fund's constitutional document.

Given the higher level of risk involved in the VC model of investing in early-stage businesses (see Question 2), the expected investment return hurdles tend to be higher.

Minimum equity mandates are structured to allow the manager to complete significantly more investments per fund than a traditional buyout fund.

The fund terms allow managers to take minority positions to back existing and founder shareholders (in these situations, managers often require a liquidation preference (or similar), to protect the underlying economics of their investment as a minority shareholder).

Dealing in financial products.

Providing financial product advice in the course of carrying on a financial services business.

Dealing.

Provision of custodial or depository services.

Financial product advice.

VCLPs can make investments in companies or unit trusts with total assets of not more than AUD250 million and must have committed capital of at least AUD10 million.

ESVCLPs can make investments in entities with total assets of not more than AUD50 million and cannot have committed capital which exceeds AUD200 million.

Those required to reflect the nature of the vehicle (for example, a unit trust as opposed to a limited partnership).

Distribution and other provisions required to ensure favourable tax treatment.

Ordinary shares. These are the most commonly used form of investment. They represent rights to receive dividends and the residual assets of a company on winding up.

Preference shares. These represent a preferential right to receive a pre-determined level of dividends or distributions. They can be used to assist with managing a company's debt levels and related gearing and leverage ratios. The issue terms of preference shares can vary significantly between sponsors and transactions (for example, the shares may be redeemable, non-redeemable, cumulative, or convertible into ordinary shares on an exit event).

Shareholder loans. These are generally unsecured and subordinated to other externally sourced debt of the portfolio company. Similar to preference shares, shareholder loan terms can vary between sponsors and transactions (for example, the applicable interest rate, repayment triggers, and rights to convert into ordinary shares are driven by deal-specific factors). For a portfolio company with significant foreign ownership, Australian thin capitalisation rules in the tax law also generally limit total debt funding to no more than 60% of the assets of the portfolio company. The Australian Government has recently proposed significant changes to the thin capitalisation rules (see Question 33).

No maturity date.

No interest rate.

Automatic conversion on any priced share issue.

A valuation cap (the maximum value to which the SAFE note will convert).

Restrictions on issuing new shares unless first offered to the current shareholders on a proportionate basis to their existing shareholding.

Restrictions on transfer, except with other shareholders' consent, after following a pre-emptive rights process, or after complying with applicable drag-along and tag-along rights.

Payments of dividends from taxed profits of a company (franked dividends) are not subject to final withholding tax.

Payments from untaxed profits are subject to final withholding tax of 30%, unless reduced under an applicable double tax treaty.

Corporation (30%).

Individual (45%).

The foreign investor's ownership interest in the portfolio company is more than 10% (calculated on an associate inclusive basis).

The majority of the portfolio company's value is attributable to Australian real estate or mining assets.

In the first phase, the shareholders usually appoint a financial adviser (often an investment bank or other financial adviser) to solicit as many bids as possible on a non-binding basis from a wide range of potential buyers based on an information memorandum.

After the non-binding bids have been received, a smaller group of potential bidders is given access to the company's confidential information to undertake due diligence and submit binding bids. After this period, it is relatively common to enter into a short period of exclusivity with the most competitive bidder to finalise transaction documents. If a definitive agreement is not signed at the end of the exclusivity period, the company shareholders are free to re-engage with other bidders.

Foreign investment restrictions.

Anti-trust/competition rules.

ASX Listing Rules (if the selling shareholder is listed on the ASX).

Formal takeover bid (where an individual offer is made to every target shareholder).

A shareholder and court approved scheme of arrangement (which is a court-sanctioned process that is largely driven by the target company).

Confidentiality agreement.

Sale and purchase agreement.

Subscription agreement.

Governance documents.

Management equity participation documents.

Financing documents.

Shareholder loan documents.

Confidentiality agreement.

Pre-bid acceptance agreement (for a takeover bid) or option agreement (for a scheme of arrangement).

Subscription agreement.

Implementation agreement.

Bidder's statement and target's statement (for a takeover bid).

Scheme of arrangement and deed poll (for a scheme of arrangement).

Scheme booklet (for a scheme of arrangement).

Financing documents.

A full and comprehensive set of business and operational warranties.

To the extent that it has identified certain issues or risks as part of its due diligence investigations, specific indemnities in relation to those issues/risks.

A covenant or indemnity in relation to pre-completion tax liabilities.

A covenant restricting the sellers from competing with the target's business, employing its staff or otherwise interfering with the business after completion, to the fullest extent permitted by law.

To act with reasonable care and diligence.

To act honestly and in good faith in the company's best interests and for a proper purpose.

To avoid actual and potential conflicts of interest.

Not to use improperly their position as a director, or information obtained in their position as a director, to gain an advantage for themselves or someone else or to cause detriment to the company.

To refrain from misusing confidential information.

To work with care and diligence.

To act honestly and in good faith.

To obey lawful and reasonable directions.

Restraints. Post-employment restraints (applicable for a specified period of time and within a specified geographical area) designed to protect the employer if a manager leaves the business, by prohibiting the ex-manager from competing with the employer or soliciting the employer's customers, suppliers, or employees.

Notice period. Lengthy notice periods intended to ensure managers cannot depart from employment on short notice to join another business. The obligation to give notice is reciprocal, and typically the required period of notice is the same for the manager and the employer.

Intellectual property. An express provision that all intellectual property created during the employment of the employee will be owned by the employer.

Confidentiality. More substantial confidentiality obligations owed by the employee than would otherwise be owed under common law.

Incentives. Short- and long-term incentives aimed at retention as well as performance, which can be forfeited if the employment ends in circumstances where the manager is a bad leaver (typically involving a resignation or misconduct).

Nature of the portfolio business.

Competence and proven track record of the management team.

Investment strategy of the PE fund.

Type of transaction.

Target asset's credit profile.

Target asset's sector.

First lien/second lien structures.

Traditional holdco or structurally subordinated mezzanine debt financings.

Stretched senior debt (which combines senior and subordinated debt in one package), as well as traditional bank debt.

Unitranche financings (which replace the senior and junior debt layers, and possibly a portion of the equity, with a single layer of debt provided at a blended cost).

TLB financings.

Representations and warranties.

Positive and negative undertakings.

Financial undertakings.

Events of default.

Permitted payments of debt obligations.

Priority of debt.

The respective rights and obligations of the different classes of lenders.

The giving of the financial assistance does not materially prejudice the:

The assistance is approved by shareholders of the company, and by shareholders of the company's ultimate Australian holding company, under section 260B of the Corporations Act (the whitewash procedure).

The financial assistance is exempted under section 260C of the Corporations Act.

Secured creditors with super-priority (such as creditors supplying goods on retention of title terms or leasing assets).

Any costs in connection with realising assets.

Secured creditors, except to the extent of the proceeds of secured circulating assets.

Employee entitlements.

Secured creditors of the proceeds of secured circulating assets, to the extent not applied above.

Unsecured creditors.

Shareholders.

Certain payments to third parties whose claims are covered by any contract of insurance or reinsurance held by the company. These claims have absolute priority over all creditors other than secured creditors for non-circulating assets and the liquidator/receiver for the costs of recovery.

Liquidators/administrators' costs where the assets are realised by a receiver. These rank before employee entitlements (except where employees have priority over circulating assets).

Funds advanced to pay employees before the liquidation. These have the same priority as the amounts paid would have had if owed to the employees in the liquidation.

Strip equity (particularly in the case of rollover managers), which contains the same rights as the institutional shareholder securities.

Sweet equity, which is aimed at incentivising the management team, and is subject to good leaver/bad leaver provisions.

The portfolio company's assets must exceed its liabilities before the dividend is declared.

Payment of the dividend must be fair, reasonable, and non-prejudicial to the portfolio company's ability to pay its creditors.

For individuals, imprisonment for up to ten years and/or a fine of AUD2.2 million.

For companies, a fine which is the greatest of one of the following:

Strategic acquisition/trade sale. The portfolio company is sold to a third-party trade buyer. This has been the most popular exit route of late.

IPO. The portfolio company's shares (through the incorporation of a listing company) are listed on the ASX so that it can be sold to the public and institutional investors for the first time.

Secondary sale. The PE fund sells its stake in the business to another PE investor. This can happen for a number of reasons; for example, if the business requires further growth capital which is not within the capacity of the current PE fund, or if the PE investor has made its targeted return on its investment.

Management repurchase. The management of the company buys back the equity stake from the PE fund.

Strategic acquisition/trade sale. The trade buyer usually has a strategic advantage in acquiring the business and, for this reason, often pays a premium to acquire the business. A trade sale offers a clean break for the PE fund. A trade sale may give rise to anti-trust/competition issues, depending on the combined market share of the target and the buyer.

IPO. An IPO can potentially offer PE funds high returns when the IPO market is strong. However, some of the downsides are that:

Secondary sale. Secondary sales can often be transacted more quickly and cost effectively than IPOs and trade sales. Anti-trust and competition issues are also less common. However, with these advantages come unique legal tensions as investors look to sell their fund commitments with relative freedom and GPs/managers seek to minimise their potential liabilities arising from any sale.

Management repurchase. This is an attractive exit option for both investors and management; it is a simple way for existing owners to find a willing and knowledgeable buyer, and gives employees the chance to step up and progress their careers. However, it is rare to find a group of managers with enough financial power to be able to buy a business, and additional finance from a bank or an outside investor is almost always required.

Sell shares at a loss. The PE fund sells its shareholdings to another investor or to the existing shareholders of the company for an amount less than its investment.

Redeem preference shares. The PE fund exercises its redemption rights, which allows the PE fund to return its shares to the company in exchange for cash or some other type of consideration.

Facilitate repayment of shareholder loans. PE funds advance shareholder loans to the companies they invest in which may be repaid on exit.

Sell shares at a loss. Negative returns from selling shares at a loss is an unattractive option. However, this may be preferable to suffering further losses if the PE fund does not believe the company can deliver better returns in the future or if it no longer fits within the risk profile of the PE fund. Selling shares at a loss can crystallise a capital or tax loss that can offset current and future gains or income of the PE fund. However, PE fund investments are often illiquid, especially if the company is unsuccessful/distressed.

Redeem preference shares. This allows the PE fund to exit an unsuccessful/distressed investment with a positive return, as redemption rights are typically priced at a premium. However, these rights are generally exercised in underperforming companies because the price at which the PE fund can redeem its preference shares is usually lower than the returns originally expected by the PE fund. The ability to redeem preference shares depends on the existence of redemption rights which are typically determined at the beginning of the investment. The ability to redeem is also affected by company's ability to pay for redeemed shares and the amount of debt it can borrow to pay for the redeemed shares.

Facilitate repayment of shareholder loans. Deferred interests to be paid to PE funds as lenders are, subject to certain regimes (including the thin capitalisation regime), tax deductible for the company and increases the amount of profits available for distribution. When an investment is unsuccessful, seeking the repayment of these shareholder loans allows the PE funds to exit their investment with interest. As it ranks ahead of shares, it ensures that the interest payable on the shareholder loans serves as a hurdle to be cleared before the other shareholders accruing value on their shares. However, the ability for PE funds to seek repayment of shareholder loans is likely to be restricted if the senior debt remains outstanding.

Tax concessions review. On 27 October 2022, the Government released the Venture Capital Tax Concessions Review Final Report (completed in November 2021). This found that tax concessions and fund vehicles offered under the VCLP and ESVCLP programs (see Question 4) were well-received and supported the growth of the Australian venture capital sector. Investment fund vehicles and concessional tax treatment contributed to funding AUD20.04 billion of capital since the introduction of the first government programmes in 2002. The report acknowledged suggestions by stakeholders that the programmes should be broadened by increasing the funding cap thresholds for the fund vehicles to address inflation over time and the increasing funding needs of investee companies.

Thin capitalisation rules. The Australian Government has recently proposed significant changes to the thin capitalisation rules. The proposed changes are still in the form of exposure draft legislation. Among other things, if passed in their current form, these changes would:

The Australian Government has also proposed the removal of deductions for interest expenses incurred in deriving non-assessable, non-exempt income from foreign corporate distributions under section 768-5 of the Income Tax Assessment Act 1997 (Cth).

The proposed amendments apply to income years commencing on or after 1 July 2023 and do not include any grandfathering for existing arrangements or any transitional relief.

PE funds may no longer be considered to be foreign government investors (FGIs). Fundamental changes to Australia's foreign investment review board (FIRB) regime took effect from 1 January 2021. The changes include a permanent zero-dollar threshold for all foreign investments in sensitive national security businesses, and a new last resort power to allow the Federal Treasurer to impose new/varied conditions or order a divestment even after FIRB approval is granted if national security risks emerge. Importantly, the reform contemplates that certain PE funds will no longer be treated as FGIs under the FIRB regime. This results in some material benefits for qualifying funds:

Funds are not an FGI where they have:

Many funds fall within the above and are therefore no longer considered an FGI following the reform.

Foreign financial service providers. ASIC continues to consider the introduction of a new regulatory framework for foreign financial service providers (FFSPs) that supply financial services to wholesale clients in Australia (for example, offshore PE sponsors looking to market to Australian investors). Following the Federal Government's announcement in the 2021-22 Federal Budget of a consultation on restoring the existing licensing relief for FFSPs (rather than maintain ASIC's proposed new forms of relief), the transitional periods for the sufficient equivalence and limited connection relief were extended by a year to 31 March 2023 and then by another year to 31 March 2024. Following the expiry of this transitional relief, it is unclear what permanent options will be available going forward, but if the existing relief is phased out and replaced with new forms of relief, it is possible that it may become harder for foreign sponsors to market their product in Australia without being licensed.

Foreign pension funds. Although not specific to PE funds, reforms which apply to income derived on or after 1 July 2019 limit the concessions previously applicable to foreign pension funds and sovereign investors, who are significant investors in many Australian PE funds. Certain foreign superannuation funds deriving dividends or interest paid by Australian residents are eligible for an exemption from Australian withholding tax. Under the revised measures, these concessions are no longer available unless the foreign pension fund's ownership interest is less than 10% in a fund vehicle and the investor does not have influence over key decision-making. The Government also took the opportunity to codify the doctrine of sovereign immunity into Australian tax law. The rules now operate to restrict the types of sovereign entities that may qualify for a tax exemption. Similar to the requirements for foreign pension funds, sovereign entities must pass a portfolio interest test and the influence test in relation to their investment.

Crowd-sourcing. The government introduced legislation around crowd-sourced equity funding (CSEF). The Corporations Amendment (Crowd-Sourced Funding) Act 2017 (Cth) allows companies to raise capital from a large number of investors through an online platform run by an intermediary. CSEF is available for Australian public companies to raise up to AUD5 million if certain eligibility criteria are met.

The CSEF regime was extended to proprietary companies by the Corporations Amendment (Crowd-sourced Funding for Proprietary Companies) Act 2018, which took effect from 19 October 2018.

Closer competition attention. In the past year, the authors have seen foreign investors (including PE) come under increased regulatory scrutiny, especially from a merger control standpoint. The Australian Competition & Consumer Commission (ACCC) has more closely examined and applied conditions on bolt-on acquisitions by portfolio companies, especially where there is political sensitivity around deals. The ACCC has the power to wholly block a proposed transaction where it has material competition concerns. For example, where a proposed deal leads to potential vertical or horizontal overlaps with an existing portfolio entity.