Private equity: a debt to society?

AuthorHodge, Neil
PositionStatistical table

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For an industry that has typically operated well below the radar, the unprecedented level of scrutiny that private equity is facing must be an unwelcome intrusion into its day-to-day business: making pots of cash

The UK's buy-out houses have always been clear that their main concern is simply to acquire businesses, make money from them and sell them on once their investment goals are realised, But they have been widely vilified as robber barons whose chief aim is to delist companies, strip their assets, load them with debt and flog them to the highest bidder with no thought for the human cost, Is this a valid criticism or an unrepresentative view based on a few isolated incidents?

Neil Hodge (pages 22 to 23) considers the cases for and against the buy-out houses, while Nick Collett analyses the private equity boom for signs of an impending bust,

Alliance Boots is the latest household name in a series of quoted companies to have been acquired by private equity in the past few years--and the urge to buy shows no sign of abating. At the end of May the pharmaceuticals giant agreed to a takeover by Kohlberg Kravis Roberts (KKR) in a deal worth 10.6bn [pounds sterling]. A few weeks earlier Sainsbury's rejected an 11.4bn [pounds sterling] bid from a consortium led by CVC Capital Partners. Private equity has probably been the biggest single factor driving the stock market boom on both sides of the Atlantic. No one doubts that the likes of KKR, CVC, Blackstone, Cinven and Permira have set their sights on other big plcs, but will this unprecedented level of takeover activity continue?

Before answering that question, let's first consider the factors behind the rise and rise of private equity. There are three main reasons, which are related. First, interest rates have been low since 2001. With the UK base rate at 5.75 per cent and inflation near to three per cent, the real rate of interest is only 2.75 per cent, which means that companies can gear up considerably. In the Alliance Boots deal, for example, there is 7.2bn [pounds sterling] of debt from a consortium of seven banks and 3.4bn [pounds sterling] of equity, 40 per cent of which has been supplied by members of the lending consortium.

The ease with which private equity houses have obtained debt has persuaded a number of quoted UK companies to try similar moves in an attempt to avoid possible private equity takeovers. For example, nine months ago the board of Stagecoach Group stated that it would be borrowing funds to return 400m [pounds sterling] to shareholders. When the transport company actually announced the share buy-back about two months ago, that figure had risen to 700m [pounds sterling]. In effect, a third of shareholder wealth (measured by market capitalisation) was returned to Stagecoach's shareholders, with debt substituted for equity.

The second reason is that the banks have been offering substantial levels of credit. And the third, which is particularly relevant to Alliance Boots, Sainsbury's and other realistic targets (eg, Mitchells & Butlers and Whitbread), is the booming market for real estate. Property values have climbed inexorably even as interest rates have risen. Investors are prepared to buy property at a yield as low as four per cent, which is irrational exuberance at a time when a risk-free investment will yield 5.75 per cent.

The claim that private equity involvement can improve a business's performance has yet to be proved. Sometimes costs will be taken out to create a more efficient company that's better able to compete in the future. Sometimes there will be a strong investment to capture market share. Travelodge, for example, recently announced plans for an unprecedented growth drive. The budget hotel chain was acquired by Permira in 2003, which then sold it to Dubai International Capital last year. It has since pledged to triple the size of its estate by the end of the next decade. From 2008 it plans to add an average of 4,000 rooms to its portfolio annually, bringing it up to 70,000 rooms before 2021. The total investment is expected to be 3.5bn [pounds sterling] (see "The defence case", bottom right).

Whatever the operational strategy behind its takeovers, private equity has certainly delivered to investors. Recent research by the British Private Equity and Venture Capital Association suggests that annual returns from private equity have averaged 31.3 per cent over three years, compared with a FTSE All-Share return of 17.2 per cent. They have also comfortably outperformed the index over both five and ten years.

Richard Lambert, director-general of the Confederation of British Industry, believes that private equity has been a positive influence on the UK economy, creating jobs faster than the largest listed companies have over the past five years. But other findings are less favourable--in particular, research has indicated the greater risk (volatility) associated with private equity.

One of the oldest principles of corporate finance suggests that changing the debt/equity mix in a...

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