Qantas Bid Funding Has Plenty Of Built-in Insurance To Ground The Risks

The Age

Friday February 2, 2007

STEPHEN BARTHOLOMEUSZ

THE more that is learned about the funding for the $11 billion private equity bid for Qantas, the more obvious it is that the Airline Partners Australia consortium has taken advantage of a unique capital markets opportunity to take the risks out of a bid that would otherwise have been impossibly risky.

The combination of financial leverage and the operational complexity and volatility inherent in any airline, even one with the consistent record of profitability of Qantas, should have made the carrier the least likely target in this market for private equity.

Among the major participants in the bid, however, there is a lot of knowledge of the airline industry. Whether it is the Allco group or Macquarie, which have a long history of financing aircraft purchases, or Texas Pacific Group, a major investor in several airlines in the US and Europe, there is substantial experience and expertise. APA is unusually qualified to assess the business risks and potential.

TPG is a critical player, given it has turned around major distressed airlines in the US and backed low-cost carriers such as Ryanair in Europe. It was, perhaps uniquely, well positioned to assess the novel Qantas business model of a full-service airline stapled to a low-cost carrier.

As one of the world's biggest private equity firms - it did more than $US100 billion of deals last year - it also has strong relationships with global banks, which were the key to creating a structure that would dampen the combustibility of a highly geared Qantas and ultimately make the bid possible.

Even though Qantas has demonstrated its ability to profitably ride through industry cycles and has shown it can compete with full-service international carriers and an aggressive low-cost domestic carrier Virgin Blue, a conventional private equity funding structure would probably have aborted the bid before it could take flight.

Lenders would have been too wary to fund a highly geared airline, the Qantas board would have been fearful of being held responsible for the loss or gutting of the national flag carrier, and the Federal Government would have had an easy excuse to block the bid. It would have been absurdly reckless.

Global debt markets are, however, awash with capital and capacity. There has probably never been a better moment to raise large slabs of debt at cheap rates, nor one that gives the big private equity funds greater negotiating clout with the global banks. Private equity is delivering balance sheet growth and/or huge fee streams for the participating banks.

APA is bidding $5.60 a share, or about $11 billion for Qantas, which has about $5 billion of net debt in the form of borrowings and off-balance sheet liabilities. The consortium - Allco Equity (27 per cent economic interest) Allco Finance (8 per cent), Macquarie (15 per cent), TPG (25 per cent), Onex of Canada (12.5 per cent) and other foreign investors (11.5 per cent) - is putting up $3.6 billion of equity. That means Qantas would, post-bid, be geared about 75:25, which conventionally would seem a reckless way to fund an airline.

APA has, however, made much of its ability to negotiate "covenant lite" funding with its bankers - Morgan Stanley, Citigroup, Credit Suisse, Deutsche Bank, Royal Bank of Scotland and Goldman Sachs - funding that has none of the normal covenants related to ratios and where the only default trigger is a missed interest payment.

The consortium has said it will keep $2 billion of cash on the Qantas balance sheet as insurance against an "event" that might otherwise threaten the group's ability to meet an interest payment. It has also secured a $1 billion revolving credit facility that it can draw on for that same contingency and has the capacity to meet up to $150 million of its interest costs with "payments in kind" or more borrowings.

That is a lot of insurance against external conditions - the $3 billion of cash and dedicated undrawn borrowing facilities alone would probably cover several years of interest payments without any contribution from Qantas' cash flows.

It would probably take an "event", or several events, of unprecedented magnitude to destabilise the structure, events that would probably swamp Qantas in its present form, along with every other international carrier.

It is those contingency arrangements that render irrelevant conventional analysis of gearing levels and interest coverages. They seem to represent unprecedented concessions from the major banks, which reflects either their desperation to participate in the big private equity deals or a realisation that in Qantas' case the absence of traditional protection perversely creates a more resilient structure.

APA has added further layers of protection by hedging the debt, even though Qantas' international revenue provides some natural hedging, and by taking out swaps to fix the interest rates on the funding, 75 per cent of which is senior debt.

There is, understandably, concern about the impact of leverage on Qantas and cynicism about how APA will generate private-equity type returns from acquiring what is universally regarded as a very well-managed airline.

The Bidder's Statement due soon will, in its statement of intentions, shed more light on the consortium's plans, although TPG's existing involvement in the industry suggests it is likely to be as focused on growth as it is on costs. Without having to concern itself with the market's appetite for short-term profits and dividends, Qantas could be more ambitious in its expansion plans.

Whatever the strategy, however, it appears that the funding structure, while apparently aggressive in terms of the leverage that will be injected into Qantas, is highly conservative and risk-averse in its detail.

-- bartho@theage.com.au

© 2007 The Age

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