Enter your search terms

Submit search form

Finance Navigation

Property Bubble | Private Equity | UK Mortgage Market |

Search

Latest news

Links:

• GRender Silverlight Control

Private Equity

This is a first in an occasional series of reports with a Financial theme. I chose Private Equity as the first theme because although it has had some coverage over the last few years, it is only now becoming clear how this will play an important part in everybody's lives certainly in the Western World, if not globally. Private Equity seems to be rather a shadowy entity run by people who don't enjoy the public eye, who are not liable to shareholders, to any government and yet wield enormous power. It seems that we need to try to understand what is happening, how it affects us from the perspective of shareholder, employee, employer, tax payer, and customer. I don't pretend to be a financial expert and I would certainly not wish any one to make any financial decisions based on this. I will take it as a success if it just makes people think a little bit more about what is going on. All of the information here has been obtained from books (in particular 'The Debt Illusion', the web, newspapers, TV. I have tried to be as objective as possible, and while I have tried to make this as accurate as possible, this can only be true at a certain point in time. By its nature Private Equity is fast moving with ownership and partnerships changing on a daily basis. This is also a perspective from a UK point of view; it is more than possible that Government regulation of Private Equity will vary from country to country. I am also learning that Private Equity is by no means a UK phenomenom - the more I look the more I find worldwide.

Recently it would seem that Private Equity is a little bit in retreat. I would hazard a guess that the first reason is the 'credit crunch' where it is becoming more and more difficult to raise the large sums of money needed to carry out the takeovers. The second reason appears to be that Company directors, shareholders and pension funds are becoming more savvy to the tactics being used and therefore making sure that a bid has to satisfy certain conditions. Certainly there have been the usual parliamentary questions which have led nowhere as usual except to raise the public awareness. There also seems to be a move towards openness on the part of the Private Equity companies but none of them are rushing to declare a balance sheet, details of individuals earnings which would go a long way to easing some of these questions.

What is Private Equity?

Firstly to avoid any confusion this article is not about Venture Capital which is a well established practise for providing funds to 'start up' and newly established businesses. Typically Venture Capital is used when there is a relatively small company in the early stages of development which has an innovative business plan and requires Venture Capital to grow. On the other hand Private Equity finance is used to gain a stake or most often to acquire a well established business with the aim of increasing the growth potential of the company. These are the pat answers to what Private Equity is about, but as we shall see later on there are far more complex reasons for their being, involving governance, tax, debt and above all profit. In my defintion of Private Equity I also include the so called Sovereign Investment Funds which are foreign based government backed funds. If you want an easy to understand interpretation of taking a company Private, then liken it to buying a house with a large mortgage, except here we are not talking hundreds of thousand pounds to buy a house but millions or even billions to buy a company. Unfortunately just as house buyers can find themeselves with negative equity (where the value of the house is worth less than the outstanding mortgage), Private Equity companies can find the value of the Company is worth considerably less than the debt used to fund the purchase.

Private Equity and Regulation

One of the problems in trying to regulate Private Equity funds is how do you create a level playing field? There are large private companies such as Branson's Virgin which is very secretive in terms of their financial dealings, although no one could accuse Branson of being shy of a bit of publicity. Also, there are the Sovereign Investment Funds which would be quite difficult to regulate. However, clearly a situation where £1.55 billion pounds just disappears from a subsidiary balance sheet into thin air after the KKR takeover of Boots, does nothing to reassure the general public that Private Equity companies are as benign as some of their political commentators make out. It is interesting to note that Philip Green, although he is a Private owner of BHS is relatively open with his dealings and does voluntarily publish accounts.

Lack of Transparency

For markets to operate on level terms there has to be some transparency as to who owns what and who is owned by whom and some outline of their intentions in the market place. Private Equity manages to circumvent most of these and also can under certain circumstances greatly reduce their liability for tax. On the other hand others would argue that this makes for more efficient markets, since Private Equity will help to sort out the dinosaurs quicker than would normally happen by more conventional routes. However, there are problems to the consumers because they don't always know who they are dealing with, what the Company ethics are and more importantly whether the model can be sustained during a period of economic downturn.

Returns on Private Equity

Returns on private equity have underperformed the stock market over a decade, confounding boasts about huge gains, a study has found. The research, by Paris business school academic Oliver Gottschlag, studied 6,000 private delas and about 1,000 buyout funds and showed that their average returns, after fees charged, were 3pc behind Wall Street's S&P 500 share index.

The Players

I guess many people don't really care about Private Equity until maybe they are caught up in it as for example when there is a takeover and maybe they feel perhaps their job or pension isn't quite as safe as they thought. In fact I believe that Private Equity affects us all even if we just like to go shopping or maybe like to invest in shares or just have some money tucked away in a savings account.

Private Equity Groups

Some of the Private Equity Groups in the list you may have heard of, others I have just stumbled across in my researches. None of them are household names exactly, yet they dominate large portions of the high street much more than say the W H Smiths and Marks and Spencers. I put this list together based on recent press reports, financial news. I have not been able to track down a formal list such as exists for equities listed on Stock Exchanges, so it is quite difficult to be exhaustive and probably adds weight to the 'Private' in 'Private Equity'.

• Blackstone
• Kolberg Kravis Roberts & Co. (KKR)
• CVC Capital Partners
• Delta Two - Qatari Investment Fund which is a Sovereign Investment Fund
• Permira
• Prestbury
• Cinven
• Terra Firma
• Paribas Affaires Industrielles (PAI)
• Carlyle Group
• Robert Tchenguiz
• Apax Partners
• Barclays Capital
• BC Partners

This is a snapshot of some of the UK businesses in the hands of Private Equity Groups - any inaccuracies or omissions is all down to me. To view the graph you need to have the Silverlight 2.0 plugin installed. If part of the graph is obscured you can pull the objects out of the way - try it and see! I really like the GRender application because all the data is held in a plain text file which is an embedded resource in the compiled dll. Basically what this means is that you don't need a database sitting on the server; just the dll - if you need to make changes just change the text file, recompile the dll and upload.

Investment Banks

These are firms, acting as underwriter or agent, that serves as an intermediary between an issuer of securities and investing institutions, and which advises corporate, institutional and sovereign clients on their acquisitions, disposals, capital raising, structuring and risk management. They specialise in corporate finance activities (rather than banking services for individuals as in a retail bank). Normally the Investment Bank makes considerable profits when acting as agent for Private Equity deals, unless of course they find themselves caught in the middle when the debt cannot be securitised, or in normal speak the debt cannot be packaged and offloaded to other financial institutions.

Ex Private Equity Companies

It might be of interest to look at some of the Companies that have been through the Private Equity Process and see how they stand up :-

QinetiQ - Acquired by Carlyle Group February 2003 and floated on Stock Exchange February 2006.
Debenhams - Acquired by Texas Pacific, CVC Capital Partners and Merrill Lynch Global Private Equity consortium in December 2003 and refloated in April 2006
Jessops - Floated by ABN Amro in 2004

What Happens to the Pension Funds?

Private Equity and Pension Funds do not seem to sit easily together. On the one hand there is deep Trade Union concern about new research where a link has been shown between Private Equity firms and collapsed pension funds which are now having to be bailed out at tax payers expense. Prime Minister Brown's close supporter, Labour donor Sir Ronald Cohen, appears to be at the centre of the concerns. On the other hand there was a Daily Telegraph article in May 2007 guarding caution to Pension Funds against investing in all but the top investment funds. The report quoted Watson Wyatt, who provides investment advice to Pension funds - "Private equity companies are taking on record levels of debt and easy credit has led to leverage structures that are incomprehensible. Any significant hiccup in the economy is likely to cause major problems for a few privately financed and over-leveraged companies. In the short term, returns will probably suffer a correction." So does this mean that Pension Funds could be hit by a 'double whammy' from Private Equity. More recently there has been the case of the done deal between Boots and KKR, leaving the pension fund abandoned to secure the best deal it could. Meanwhile the Delta Two bid for Sainsburys has involved much wrangling about the Pension Fund and it now looks like the fact that the Pension Fund takes precedence over other creditors in the event of Company insolvency may be one of the factors which scupper the deal. Perhaps the Government needs to look more closely at how the taxpayer bailouts work when there is a greater risk associated with the large debts inherent in Private Equity schemes.

Private Equity and the Debt Cycle

The creation of debt in Western Economies, which really started in earnest in the late 1980's, is not unique to Private Equity deals. In fact one could be entitled to say that Private Equity deals are just a logical extension to the liberalization of Money Markets and Financial Services which started at that time. After all the Government funds its overspends by borrowing, consumers fund their lifestyles using personal loans, credit cards and long term house mortgage deals. Many businesses also fund their activity by borrowing from banks - but all need to be careful that their undertaking does not collapse under the weight of the debt repayments.

• Borrow the Capital - So along comes Private Equity with mega bucks borrowed from - you guessed, the Investment Banks. The Investment Bank now has a notional asset which could be risky so they package up the debt into bundles and spread the risk around the Financial markets. Depending on how successful the Investment banks are at passing on the debt will determine how much interest the Private Equity Fund has to pay.
• The Makeover - The next stage is crucial for the Private Equity Company since it now has an asset on which it hopes to make a quick return. This stage is a bit like doing the makeover that we see on TV on a dilapidated house which is bought cheaply with a bit of money spent on paint and decoration, so that all the cracks are painted over. A little bit of asset stripping is often applied here, such as selling off land, buildings etc. and leasing them back. Losing a few staff here and there, which only affects long term survival is also standard practise and can be justified in terms of efficiency savings.
• Pass the Debt On -Of course the Private Equity Fund is still saddled with debt, so what better place to put the debt than on the target's balance sheet. Now the target Company has a real debt to worry about - but as long as the debt can be sustained by profits all is well. So after a few years we now have a lean, mean Company which still has it's name and reputation, trading profitably and really looking quite trendy.
• Refloat the Company - Now is the time to refloat on the market, using the expertise of the Investment banks the original dowdy looking Company can now be sold at a tremendous profit, the loans can be repaid or used to finance another buyout.
• Everyones a Winner - So everyone wins, the initial Shareholders probably got an above average price at the time of sale, the Investment Banks made a profit by arranging the Financing and then refloating the Company. The Company Directors made big gains either in terms of payoffs or retention fees. Private Equity made gains at every stage of the deal. The staff are now part of a dynamic new Company and the customers are now dealing with a shiny new entity.
• Everyones a Loser - Along comes Credit crunch and suddenly the Private Equity Company finds it has negative equity in the asset. The Company goes bust and another household name bites the dust and the Investment banks get burnt, leaving only the original shareholders better off.

Of course this is an over simplification and a generalisation but from what I have read there does seem to be a large element of truth in this. After all there is virtually no regulation of debt in the UK, so anybody can set themselves up to lend money or grant credit. On the other hand if you want to take deposits from the general public you are regulated up to the hilt. This ability of the Investment banks to grant almost unlimited credit is at the heart of massive problem now facing most Western Economies.