Private equity firms, like hedge funds, took advantage of the flood of cheap money to engage in speculative trading. However, their focus is not financial assets and derivatives, but trade in companies.
Like hedge funds, most private equity firms are not listed on the stock exchange and fall outside the regulatory framework. They specialise in trading in existing companies, taking over private companies or taking stock market companies back into private ownership. Making money through mergers and acquisitions and asset stripping is not new and was condemned in the early 1970s by the British Prime Minister, Ted Heath, as the ‘unacceptable face of capitalism’. Private equity firms claim that they are not asset strippers but make their money by streamlining a firm, making it more ‘efficient’ before selling it on at a profit. Private equity firms borrow extensively to buy companies, with a high ratio of borrowing to money directly invested. The borrowed money is usually placed on the balance sheet of the company purchased, rather than on the balance sheet of the private equity company.
The aim of the private equity investor is to sell the company at a profit, despite the heavy debt the business carries. Private equity has proved to be very profitable with investors anticipating a 20 per cent return on their investment within three to six years and their activity has led to relatively small groups of people controlling company assets worth billions.
In February 2007 the British Prime Minister, Tony Blair, declared Britain to be one of the number one places in the world for private equity. Britain became a haven for private equity because it allowed tax relief on interest payments and also had a favourable tax rate for investment. Private equity is tax efficient in two ways.
First, investment through debt is more tax efficient than equity finance. Second, a policy change in the UK in the late 1990s to
encourage venture capital, that is, capital for new businesses, led to capital gains from investment being taxed at 10 per cent. Although they were not usually supporting new businesses, private equity companies benefited from this change. Also private equity partners were able to count their fee income as capital gain, thus paying 10 per cent tax and not 40 per cent as higher wage earners. One private equity director broke cover on this anomaly by pointing out that he paid less tax than his cleaning lady. Subsequently UK capital gains tax was raised to 18 per cent.
Leveraged private equity companies came to public notice through the takeover of the food and tobacco giant Nabisco in 1979 by the US firm KKR (Kohlberg, Kravis Roberts) (Burrough and Helyar 1990). This was followed by a steady stream of acquisitions by private equity companies in Britain and the US. At its height, one in five private sector workers in Britain, around 2.5 million people, were working directly or indirectly for a private equity company. This included many well-known names: Scottish and Newcastle, Canary Wharf, Anglia Water, Thames Water, Madame Tussauds, Kwikfit, Toys R Us, Little Chef, New Look, Odeon UCI, Travelodge, Matalan, United Biscuits, Associated British Ports, Pizza Express, Phones 4U, NCP, Twyford Bathrooms, Birds Eye and Gate Gourmet. The latter saw a bitter strike over pay and working conditions.
Several of the buyouts were controversial. When the British private equity firm Permira and its partners purchased the previously member-based Automobile Association in 2004, there was considerable disquiet. It was a very profitable purchase that made £300 million profit in three years. The purchase price was £1.75 billion, of which £1.3 billion was borrowed. Savings were made by cutting the 10,000 AA staff by one-third, and de-recognising the GMB trade union. Staff alleged that high pressure management tactics were being used and the morale of staff was at rock bottom. In 2003, a private equity consortium bought the UK department store Debenhams back into private ownership from the stock market. Two years later it was sold back to the stock market with the investors making more than three
times their initial investment. Debenhams was left with debt of nearly £2 billion to face difficult trading conditions.
One of the last major private equity purchases before the crash was Alliance Boots, bought by a consortium led by KKR and an Italian entrepreneur. It was bought in 2007 for £11 billion of which £9.3 billion was debt. An investigative team from the Guardian newspaper reported that the cost of servicing this debt meant that Boots’ debt costs rose from £25 million before the buyout to more than £600 million after. The Guardian team also maintain that much of this debt still lies on the lending banks’
books, having fallen victim to the collapse of the securitisations market. Debt that had been traded was achieving only 60 per cent to 70 per cent of face value. There has also been a loss to the taxpayer. The consortium relocated Boots’ headquarters to Switzerland and, as a result, £131 million of tax revenue has been lost (Guardian 9 February 2009). It is not only high street businesses that have been lumbered with huge debts by private equity speculation. Football clubs have also been prime targets. As a result of a buyout Manchester United is reported to have debts of around £700 million and Liverpool of around £350 million.
Robert Peston calculates that the major banks have lent up to $300 billion to fund private equity buyouts and much of this was securitised and sold on to the money markets (2008:176).
He argues that the interest rates charged for these activities were too low given the level of risk. Also, loading the bought-out firms with huge debts to pay for management fees and high returns to investors could undermine the businesses by reducing their credit ratings. In March 2007, a report from the ratings agency Standard & Poor’s indicated that private equity firms might be undermining the financial strength of Europe’s corporate sector.
The proportion of companies with debt rating as junk had risen from around 1 per cent in the early 1990s to 17 per cent in 2006. (Junk bonds offer high rates of return to take account of high levels of risk.) In the US the level might be as high as 50 per cent. Trades unions have also accused private equity companies of anti-Labour practices, excessive management fees, profiteering, asset stripping and dealing offshore to avoid corporation tax.
As private equity companies do not have to provide the same information as publicly quoted companies, back bench Labour MPs and trades unions called for more financial transparency, social and environmental reporting and the treatment of workers and suppliers to be monitored. In 2007 the British Private Equity and Venture Capital Association agreed a voluntary transparency code for around 200 private equity companies then operating in the UK.
In January 2009, a report on the private equity industry by Ernst and Young (published jointly with British Venture Capital Association), indicated that half the profits had come from using debt; around a third from the stock market rise and only a fifth from increased efficiencies (the main justification private equity companies give for their activities). Average return on investment was 330 per cent for the firms that had been sold on or floated with higher returns linked to higher debt. Levels of debt in ex-private equity companies was more than three times the level of debt in non-private equity companies. However, contrary to union criticisms, the report did not find marked evidence of job losses or asset stripping, but the very high level of debts made the firms involved very vulnerable in a credit crunch. The credit crunch also hit private equity badly as both credit and investment opportunities dried up. Many closed. The private equity firm 3i which is UK stock market quoted (and was itself a privatisation of a government agency) saw its share price fall by over 70 per cent during 2008.