A Shrinking Balance Sheet for Bonds in Mature PE Funds

In another few more days, the Class A-1 bonds of Astrea III, the first wholesale Private Equity (PE) bond listed in Singapore, will be redeemed as scheduled. What could we learn from the 3-year existence of this bond, which could provide some useful insights on the behaviour of Astrea IV and V bonds?

Astrea III publishes annual reports, which document the cashflows received, performance of its underlying PE investments, outlook for PE investments as well as the usual income statements and balance sheets. In the 3 years of its existence, the cashflows of Astrea III from its investments in PE funds are shown in Fig. 1 below.

Fig. 1: 3-Year Cashflows of Astrea III

Over the 3 years, Astrea III has received total distributions of USD952M, capital calls of USD176M, resulting in net distributions of USD776M. At inception, the weighted average age of the PE funds which Astrea III invested into is 6 years. The cashflows are typical of investments in mature PE funds, as shown in Fig. 2 below.

Fig. 2: Typical Cashflows of PE Investments

Moving forward, Astrea III will likely see less distributions, as indicated in Fig. 2. Already, the investments made by the underlying PE funds into companies are showing signs of ageing, as shown in Fig. 3.

Fig. 3: Holding Period of Underlying PE Investments

The average holding period of the underlying PE funds' investments into companies has increased from 4.0 years in 2016, to 4.5 years in 2017 and 5.2 years in 2018. There are 2 opposing reasons why PE funds hold onto their investments for longer than usual -- it could be to extract more value from a good company, or it could be the company could not deliver as promised and the PE fund has difficulty selling it for a good price. If it is the first reason, it is a good thing for PE bond investors. But if it is the second reason, PE bond investors will have reasons to be worried.

What happened to the distributions received by Astrea III over the 3 years? Fig. 4 below shows the balance sheet for the Financial Years ending in Mar 2017, 2018 and 2019.

Fig. 4: Astrea III's Balance Sheets

The first thing to notice is the investments in PE funds (yellow bar) have been shrinking, from USD1,070M in 2017 to USD904M in 2018 and finally to USD739M in 2019. This is due to the net distributions of USD568M from the PE funds from 2017 till 2019, offset by fair value gains (i.e. capital gains) in the PE funds of USD236M over the same period.

A portion of the net distributions went to increase the cash account (grey bar), which increased from $203M in 2017 to around USD340M in both 2018 and 2019. Another portion went to pay interest of USD21M to bondholders in 2018 and 2019. The remaining distributions were used to pay the sponsor in the form of repayment of shareholder loans and dividends to shareholder. From 2017 till 2019, a total of USD385M was paid to the sponsor/ shareholder. As a result, the sponsor equity (orange bar) has been shrinking.

Because of the distributions and payments to sponsor, the asset base has been shrinking. On the other hand, there is relatively little cashflow used to pay down the bonds (blue bar), as they have not matured. If the trend continues, bond holders might end up holding onto a shrinking asset base of ageing PE funds with declining distributions while the sponsor gets all its capital back (see Where Do Astrea Bonds Stand Along PE Fund Lifecycle? for more info on PE lifecycle and its impact on cashflows). By the time the bonds mature, there might be little cashflows left to redeem the bonds. Remember, once the cash leaves Astrea III by way of repayment of shareholder loans and/or dividend to shareholder, bond holders have no recourse to the sponsor, Azalea, or Temasek.

Thus, one key risk for bond investors in mature PE funds is when the fund is in the midst of the harvesting period, the sponsor gets most of the money while bond investors get only the interest payment. When the harvesting dries up, bond investors do not get sufficient cashflows to redeem the bonds while the sponsor already gets all its capital back.

Fortunately for Class A (A-1 and A-2) bond holders of Astrea III, there are safeguards in place to ensure that the above scenario does not happen. Every 6 months, Astrea III has to set aside some cash in reserves accounts which can only be used to redeem the Class A bonds. The reserves accounts totalled USD161M, USD224M and USD258M in 2017, 2018 and 2019 respectively. These reserves accounts are sufficient to redeem the Class A-1 bonds which will mature in the next few days. The total amount of Class A-1 bonds is SGD228M (approximately USD170M).

Another safeguard that Astrea III put in place is the Loan-to-Value (LTV) ratio should not exceed certain thresholds ranging from 20% to 45%. If these thresholds were exceeded, Astrea III has to divert more cashflows to the reserves accounts. Based on Fig. 4, the LTV ratio of Astrea III is 27%, 18% and 24% in 2017, 2018 and 2019 respectively.

Had there been no such safeguards to set aside cash during the harvesting period, the balance sheet would have been worse for bondholders. Fig. 5 below shows the balance sheet had the reserves accounts been paid out to sponsor.

Fig. 5: Balance Sheet of Astrea III Excluding Reserves Accounts

The LTV ratios would have been 42%, 43% and 58% in 2017, 2018 and 2019 respectively. In particular, bond holders would end up being a larger supplier of capital than the sponsor while still not getting the bulk of the distributions from the PE investments!

In conclusion, if you are a bond investor in mature PE funds, be prepared to see a shrinking asset base while most of the distributions go to the sponsor. Make sure you have safeguards in place to ensure that a portion of the distributions are set aside for the sole purpose of redeeming the bonds!

See related blog posts:

• Where Do Astrea Bonds Stand Along PE Fund Lifecycle?
• Astrea V 3.85% Bonds – Understanding What You Are Buying Into 
• Understanding the Safeguards of Astrea IV 4.35% Bonds

Where Do Astrea Bonds Stand Along PE Fund Lifecycle?

Now that the allocation for Astrea V 3.85% bonds is released, everyone can go back to their regular activities and forget about it. However, if you, like myself, hope to get a piece of the equity portion of Private Equity (PE) investments one day, then we should continue to learn and understand more about PE. Today's discussion is on the typical lifecycle of a PE fund and where do the 3 Astrea bonds stand along the lifecycle. This has major implications on the risks of the bonds, as we shall discuss later.

A PE fund usually has a lifecycle of around 10 years and comprises 4 phases. These 4 phases usually overlap. See Fig. 1 below (source: The Ultimate Guide to Private Equity).

Fig. 1: Lifecycle of PE Fund

In the first phase, the General Partner (GP) who runs the PE fund, will source for new investors and get their commitment to provide capital as and when needed to invest into promising companies. When capital commitments reach the target fund size, the fund will close. 

In the second phase, the GP will source for promising companies to invest into. This is usually called the Investment Period, as the fund is busy investing into companies. During this phase, the fund can invest in any new companies so long as they satisfy the criteria in the investment mandate.

After buying into the companies, the fund will work with the companies' management to enhance their operations such that they can achieve a higher valuation than what the fund paid for. The typical duration that a fund holds onto a company is about 5 years, but could exceed 10 years for an under-performing company.

When the time is ripe, the fund will seek to exit the company, either by IPO, sale to another company, or even sale to another PE fund. This is known as the Harvesting phase. During this period, the PE fund is not allowed to invest in new companies, but is allowed to invest additional money into existing companies, known as follow-on investments.

Finally, before the stated lifespan of the fund is up, the GP has to exit all remaining companies, return all proceeds to investors and dissolve the fund. The 10-year lifespan is not a fixed timeline, as GPs can request for extensions of 1-2 years so that they do not need to carry out a fire sale of the remaining companies.

Based on the above lifecycle of a PE fund, investors of the PE fund (known as Limited Partners) will contribute capital in the early years of the fund before receiving distributions in the later years when the PE fund exits its investments. The cumulative cash inflow over the lifecycle of the PE fund resembles a J-Curve. See Fig. 2 below.

Fig. 2: PE J-Curve

For an investor in a PE fund, where the fund is along its lifespan matters. In the early years, there is significant capital outlay as the PE fund invests into new companies. There are also significant risks in streamlining the company for greater efficiency. In addition, the company might struggle under the usually significant debt load placed upon it by the PE fund. Not all of the companies will prosper and make money for the PE fund. 

In the closing years of the PE fund, although there is no further capital outlay, the cash distribution from the PE fund is declining as it exits more and more companies. Also, whatever companies remaining in the PE fund might be under-performing and might not be worth much. If a company is attractive to other buyers, it probably would have been sold before the 10-year lifespan of the PE fund is up and not get left behind in the fund.

Thus, if the PE J-Curve shown in Fig. 2 is accurate, the sweet spot is around the 5th year of the PE fund. In addition, exits should be timed before the 10-year lifespan is up.

In Jun 2016, Azalea first introduced PE bonds to the market with Astrea III bonds. 2 years later, it launched Astrea IV bonds and just last week, it launched Astrea V bonds. The weighted average age of funds at the time of launch and scheduled call date of the 3 Astrea Class A-1 bonds are as follow.

Bond	Wt Age of Fund	Scheduled Call (Yrs)
Astrea III	6	3
Astrea IV	7	5
Astrea V	5.4	5

Their lifespans superimposed onto the PE J-Curve are shown in Fig. 3 below.

Fig. 3: Lifespan of Astrea Bonds Relative to PE Fund Lifecycle

Astrea III bonds (blue line) will last from the 6th to 9th year of the underlying PE funds that Astrea III invested into. This is the sweet spot that we discussed earlier -- enter around the 5th year and exit before the 10th year. It is probably the safest of the 3 Astrea bonds. In fact, it has just been announced that this bond would be redeemed as scheduled in 2 weeks' time.

Astrea IV bonds (purple line) will last from the 7th to 12th year of the underlying PE funds. The PE funds are generating a lot of cash currently, with total net distributions (after deducting capital calls) of USD243M in Astrea IV's first year of existence. This is equivalent to 22% of its portfolio value at the time of IPO. However, as shown in Fig. 3, the amount of distributions is expected to decline moving forward.

Astrea V bonds (brown line) will last from the 5th to 10th year of the underlying PE funds. Compared to Astrea IV bonds, there is a little more risks initially, as the companies in the PE funds are less mature and less ready to be exited. Furthermore, there are higher capital calls expected. But if these risks in the initial years can be overcome, Astrea V bonds will have less risks towards the end compared to Astrea IV bonds, as cashflows towards the tail-end would not have declined as much.

When you look at the risks of Astrea IV and Astrea V bonds, some of the safeguards that Azalea put in place for the bonds start to make a lot of sense. Let's talk about Astrea V bonds first, as it is simpler. As mentioned, one of the key risks for it is higher capital calls. This is mitigated by the capital call facility that allows Astrea V to borrow money from the banks to meet the capital calls.

For Astrea IV bonds, the key risk is not receiving sufficient distributions towards the tail-end to redeem the bonds in full. Although there is liquidity facility to meet interest payments in the event of shortfalls in distributions, there is no equivalent liquidity facility that Astrea IV can borrow from to redeem the bonds. Money to redeem the bonds can only come from the distributions from the underlying PE funds. However, towards the tail-end, such distributions are declining and might not be sufficient to redeem the SGD242M bonds in full.

In fact, it would be unfair to bondholders if it were to happen, considering that in the initial years of the bond, the underlying PE funds are generating a lot of cash, most of which are passed through to the sponsor. For the first year of Astrea IV, out of total net distributions of USD243M, all classes of bondholders (Class A-1, A-2 and B) were paid only USD26M in interest. Other expenses during the same period totalled USD7M. If there were no safeguards in place, the remaining USD210M (equivalent to 86% of net distribution of USD243M) and another USD15M in existing cash would flow to the sponsor. This money can leave Astrea IV as dividends to shareholder and repayment of shareholder loans instead of being retained within Astrea IV. Once the money leaves Astrea IV, bondholders have no recourse to Azalea as the shareholder/ sponsor to redeem the bonds in full. Recall that the bond is not guaranteed by either Azalea, or its parent, Temasek?

To prevent this scenario from happening, Azalea has put in place a safeguard that part of the distributions have to be set aside in reserves accounts for the sole purpose of redeeming the bonds. For the first year of Astrea IV, a total of USD80M has been set aside. Hence, the distributions flowing to the sponsor is reduced from USD225M to USD145M. This ensures that there will be sufficient cash to redeem the bonds when they mature, even though distributions from the underlying PE funds are declining.

In conclusion, PE bonds are not a simple matter of buy-and-forget. Investors need to understand where they stand along the lifecycle of PE funds and also what investor protection they have. Azalea has done a good job protecting investors from losses, but investors still need to protect themselves by learning more about PE investments.


See related blog posts:

• A Shrinking Balance Sheet for Bonds in Mature PE Funds
• Astrea V 3.85% Bonds – Understanding What You Are Buying Into 
• Understanding the Safeguards of Astrea IV 4.35% Bonds

Astrea V 3.85% Bonds – Understanding What You Are Buying Into

It has been exactly a year since I last blogged. My last blog post was on Astrea IV 4.35% bonds. Coincidentally, Astrea's management, Azalea, has recently launched the IPO for Astrea V 3.85% bonds. One year has passed. What do I think about Astrea bonds?

If you read last year's blog post on Would I Invest in Astrea IV 4.35% Bonds?, you would know that I was not too keen on Astrea IV 4.35% bonds. A large part of the reasons had to do with Private Equity (PE) bonds being a new asset class and there was too little time to properly analyse whether it would be a good investment. Given the time constraint, I relied on whatever understanding I had about fund of funds and leveraged buyout funds and concluded that I would not be applying for the IPO.

A week later, after the IPO had closed, I had more time to look at the structure of the Astrea IV bond and acknowledged that it could be a safe one, but only because of all the credit enhancement safeguards put in place. See Understanding the Safeguards of Astrea IV 4.35% Bonds for more info.

Thus, when the IPO for Astrea V 3.85% bonds was launched this week, the first thing I checked was whether it has similar safeguards as Astrea IV 4.35% bonds. It has. Still, it is necessary to re-iterate that being PE bonds, Astrea bonds are not traditional bonds and it is important to understand the risks of the underlying assets. Below is a summary of the risks that I am aware of.

Understated Loan-to-Value Ratio in Fund of Funds

Astrea V bonds invest in 38 PE funds run by independent PE fund managers. Its stated Loan-to-Value (LTV) ratio for the Class A bonds (comprising Class A-1 and Class A-2 bonds which have equal seniority) is 34.8%. This means that for Class A bonds to start losing money, the value of the underlying investments has to drop by 65.2%. However, the underlying PE funds have their own debts and these debts are not considered when computing the LTV ratio of 34.8% for Astrea V bonds. The true LTV ratio after considering the debts in the underlying PE funds (i.e. look-though basis) is likely to be much higher. This ratio matters. See Would I Invest in Astrea IV 4.35% Bonds? for an example.

High Leverage Used by Buyout Funds

80% of the Astrea V investments are in buyout funds. As discussed in Would I Invest in Astrea IV 4.35% Bonds?, buyout funds use a lot of debts when acquiring companies. Typical debts is in the region of 6-7 times Earnings Before Interest, Tax, Depreciation and Amortisation (EBITDA). High debts at the underlying PE funds, couple with a Fund of Fund structure, underestimates the true, look-through LTV ratio of the Astrea bonds.

Assurance of Net Asset Value

Astrea V has a portfolio value of USD1,342M. This is an important figure that is used to compute the LTV ratio. After the debacle of the Hyflux preference shares and perpetual securities, it became clear that asset values should not be taken at face value. Hyflux's main asset, Tuaspring Integrated Water and Power Project, which has a stated Net Asset Value (NAV) of $902M as at end of Financial Year 2017, could not be sold at close to book value. Given that PE investments are illiquid assets, what is the assurance that the portfolio value of Astrea V is really as stated?

This question was posted during the Astrea Investor Day in Jan 2019 and during the public roadshow on Astrea V bonds conducted with SGX Academy on Saturday. Azalea's management replied that the NAV of PE funds is checked by reputable auditors. In addition, there are secondary markets where PE funds are traded. The value at which they are traded is close to the NAV reported by the PE fund managers. Furthermore, when the PE investments are disposed of, Azalea cross-checks the sale value against the reported NAV. In most cases, the sale value exceeds the reported NAV.

PE in a Potential Bubble

PE investments have generated better returns than public equities in the last 20 years. This has resulted in a lot of funds flowing into PE investments, and increased competition between PE fund managers to find good deals. This has led to assets being purchased at higher prices. At the same time, the debts used by buyout funds to acquire companies has been on the rise. At some point in time, the PE boom will probably end, potentially leading to falls in NAV. See Bain & Company's report on Private Equity: Still Booming, but Is the Cycle Near Its End? for more info.

At Saturday's roadshow, Azalea replied that this is also a good time for selling assets in the PE funds that Astrea V has already invested in, which will result in cashflows coming back to the Astrea bonds. Furthermore, as most of the PE fund managers have a lot of experience running PE funds, they believe that the PE fund managers will be able to navigate the environment.

While I agree that this is a good time for selling assets in PE funds, this also means that the high asset prices are reflected in the portfolio value of Astrea's investments. In the event that asset prices correct, Astrea's portfolio value will also decline. This will lead to a rise in the LTV ratio, but there is a safeguard in place if the LTV ratio exceeds 50%.

Conclusion

Although I believe Astrea IV and V bonds to be fairly safe for retail investors, I cannot emphasize enough that the reason this is so is because of the credit enhancement safeguards that Azalea painstakingly put in place. Also, for investors interested to buy Astrea bonds, please understand what you are buying into.


See related blog posts:

• Would I Invest in Astrea IV 4.35% Bonds?
• Understanding the Safeguards of Astrea IV 4.35% Bonds
• A Shrinking Balance Sheet for Bonds in Mature PE Funds