June 4, 2014
Interviewed by: Ainslie Chandler
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The Emerging Distressed Debt Market

Local and offshore investors are closely watching Australia’s emerging distressed investing opportunities, says Allegro Funds Management’s Chester Moynihan, a veteran of the market.

Local and offshore investors are closely watching Australia’s emerging distressed investing opportunities, says Allegro Funds Management’s Chester Moynihan, a veteran of the market.

The Emerging Distressed Debt Market

With Chester Moynihan of Allegro Funds Management

What is Allegro and which part of the market is it active in?

Chester Moynihan, Allegro Funds Management:

Allegro is a special situations investment firm. The way we define special situations is turnaround investing. We’re looking to target businesses that have suffered some form of dislocation and where we can get control and use our skills in operational turnaround to drive value for our investors that way.

I and Adrian Loader set the firm up in 2004; it’s 10 years this year. It makes us one of the longer established players in the Australian market. We’ve been very active in the turnaround investing market more recently since 2008. We’ve completed just over 10 transactions of over $1 billion in value in a range of different industries from logistics to healthcare, industrial services, pharmaceuticals, and etcetera.

During the financial crisis, you took over an ABN AMRO fund at the request of investors. Can you describe that process?

Moynihan: We’d been operating for broadly four years in a buoyant economy. From 2004 until 2007, there was certainly no sign of financial distress, but we were beneficiaries from the management era and overleverage that tends to be a common theme with us. In early 2008, we were approached by the investors in the ABN AMRO capital fund. It was a 2006 vintage, $300-million fund focused on growth investing that then became a distress fund.

It was the first time Australian LPs had exercised a divorce from their fault clause, so we made a bit of history. There was a process run to find a replacement manager for ABM AMRO. Other Australian LPs had lost faith in the GP. We were unanimously selected.

The operating environment turned significantly negative. Within a week of us taking over the fund, Lehman collapsed and it soon became clear that the fund had severely distressed investments, a number of them with deep, negative equity value. For us, it was an opportunity to move the business into more of a principle role and to work closely with existing Australian superfund LPs.

We commenced turning those businesses around, predominately through operational means. It has been a successful journey. That enabled us to demonstrate a track record in turning severely distressed businesses around in a negative external environment. To date, that fund is yielding just over a 25% IRR and that stood us in stead for the next phase of our history.

You have recently engaged in more co-investments but have decided to raise a new fund. What is the strategy behind that?

Moynihan: The interesting thing is that the turnaround investing or distressed investing market in Australia is still in its infancy compared to other, more developed markets in the U.S. or the U.K. One challenge we had was convincing LPs that there is a viable opportunity set in a viable investing market in the turnaround space.

We commenced really demonstrating that by doing deal-by-deal investing and following the taking over of the ABN AMRO fund, at end of 2010, the ABN portfolio was reaching stability. We’d had a number of exits and we commenced a program of direct deal by deal investing.

It’s an interesting way to invest because you have to find the opportunity, secure it, get exclusivity, and then, raise the money. We chose to co-invest with Australian super funds, Australian LPs. A number of the ABN AMRO LPs had seen what we delivered as part of the ABN process and portfolio and they became supporters of ours and helped us in the co-investment we managed to do from the end of 2010 to date.

We were able to invest in five opportunities in various sectors of the economy. The common theme has always been businesses suffering some form of dislocation, having taken on too much debt or management mistakes or shareholder disputes. That gives us an opportunity to access businesses that are fundamentally sound and able to grow but have lost their way. The dislocation presents the opportunity for us to access these investments below intrinsic value and that’s at the heart of our investment philosophy. It’s getting into these situations at deep-value discount.

You have been in the U.S. raising your new fund. What were investors’ thoughts about the Australian market?

Moynihan: We had a very positive reception from the U.S. LPs, which is great. The great thing with the U.S. LPs is that they have seen turnaround distress investing for 15 or 20 years, whereas in Australia, this market is still in its infancy. It has only commenced since the global financial crisis, 2009 or 2010. We’re talking about three, four years.

The other interesting thing is that they’ve seen the outsized returns that managers in the segment have been able to demonstrate early on the market’s development.

That struck a chord. We’re not looking to raise a lot of money. We’re looking to raise $200 million. There’s a hard cap on the 200. We’ve got some existing investor support. But the thing that really impressed us was their understanding of the ability to generate outsized returns in the turnaround market.

We’re fortunate in that we have an established presence in the market, having operated here for over 10 years. Our ability to access the market has been demonstrated through not having a committed fund and they recognize that as one of the hardest ways to invest. You really must have a differentiated offering to be able to convince a vendor to have patience with you while you go and raise the money to do the deal.

All those factors have been helpful in our discussions with them. We see the predominance of our fundraising coming out of Asia. There’ll be some coming from Australian LPs and hopefully some coming out of the U.S.

What levels of PE activity are you expecting in Australia this year?

Moynihan: We’ve seen that the equity markets opening up have certainly meant that it’s a good time to exit.

It’s been a great environment for that. The other interesting thing we’ve observed, which we saw when things were quite buoyant between 2004 and 2007, is that the workout areas of banks when things seem to be improving and people have capital and they want to spend money, they tend to open up more and bring more assets to market believing they’re going to get a better value for it. From our perspective, that’s fantastic because it creates an environment for us to do the deals we want to do. We’re fairly positive about the environment we’re in.

The other thing we’ve seen is that the level of impaired loans or non-performing loans sitting on banks’ balance sheets hasn’t changed materially. They’re sitting around $24 billion. This is Reserve Bank of Australia data. With BASEL two and three, that’s created pressure on the banks through having to tie up tier-one capital to exit those positions. As we’ve seen, a lot of activity from hedge funds in credit, buying credit off banks, has paved the way for distressed investing in Australia because it’s created a mindset within the banks to sell their debt. We’ve been the beneficiary on that through almost half the situations we’ve done. We’ve bought debt and used it as the entry point to convert to equity.

That’s a trend that’s just started and will continue. We spoke anecdotally to one of the workout banks, one of the people we deal with, and we asked, “In your bank, alone how many situations do you think fitted with our appetite?” He indicated 300 to 400 opportunities in his bank alone.

Which sectors do you feel will offer the biggest opportunities?

Moynihan: One thing we’ve learned and certainly is clear in our minds in terms of the investments we’re targeting is where you find a business in need of turnaround in a structurally flawed industry, it’s a step too far and cheap is never cheap enough. We’re looking for businesses that are either sitting in stable industries or industries suffering some form of cyclical blip, like mining services. Occasionally, China changes its demand and that has a major impact on Australian resource companies. We’re not targeting resource companies. We’re targeting service providers to resources.

We like those sorts of opportunities. They present an interesting access point for us to get below in terms of getting into these businesses below intrinsic values. We love industries that have a tail wind. Healthcare is a good example. I-MED Radiology—that industry’s growing at 8% per annum. If you find a distressed business in an industry with that sort of profile, it’s very exciting.

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