Sunday 30 June 2019

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!

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