THEY are findings that should make all those associated with private equity blanch. Deal- makers should take note. Employees of companies in private equity ownership should be aware of the research. Suppliers and customers of companies held in private equity ownership might also sit up.
Institutional investors piling money into this rapidly overheating sector need to pay special attention. And since the money that the institutions manage is, ultimately, owned by Joe and Joanna Public, this is an issue that should be of interest to almost everyone.
It may strike ordinary folk as entirely unremarkable that private equity ventures taking on too much debt are a danger to them. Anyone with a credit card or overdraft knows the debilitating power of debt.
To private equity investors, however, high levels of debt are to be embraced because the higher the debts the greater the potential rewards. The crucial word here, however, is potential. The returns on highly leveraged buyouts can be better than those from companies that are burdened with less debt. But it ain’t necessarily so.
If architects of private equity deals misjudge the debt requirements, the investment returns could be woeful. Even a minor miscalculation on debt, meanwhile, can have major wealth- destroying ramifications. The realities of leverage mean that equity returns can be enhanced if borrowings are jacked up. But equity returns can also be completely wiped out.
The findings of the Centre for Management Buyout Research, one of the most authoritative sources of information on this sector, are important because they show the price of shouldering too much risk. Indeed, the private/public equity debate may be no more than a zero-sum game. Once adjustments are made for the risks involved, the returns generated from companies that are bought using lots of debt may be no better or worse than those delivered by less aggressively financed companies.
The findings of the research need not set investors against private equity. But it should scotch the theory that private equity companies produce above-average returns because they are financed through private equity schemes. Private equity produces above-average returns because deal-makers take on larger amounts of risk. And in this sense there is not a shred of difference between the private equity model and any other financing scheme.
The personal considerations of deal-makers — that is, the payoffs — mean that the private equity bandwagon is likely to continue rolling. Privacy may also bring tangible benefits by giving management teams greater operating flexibility. Frequent changes in ownership may bring out the best management, too.
The research does not undermine the private equity model. It just shows that there is nothing magical about it.
A high price
JUST as the man who first grumbled about irrational exuberance in stock markets was bowing out of the US Federal Reserve, irrationally exuberant investors in Google were reminded of the risks that Alan Greenspan had in mind. Overblown shares in the dot-com darling fell 12 per cent after it reported an 86 per cent year-on-year rise in turnover and 82 per cent higher profit.
Google does not issue profit forecasts because its business is still moving too fast, but it committed the sin of missing forecasts made by Wall Street analysts. They had underestimated the tax charge, which was boosted by high growth in many foreign markets.
Market reaction was nonsensical because, in the rapidly reinflating high-tech boom, the valuation of Google has no basis in reality. Investors seem to have assumed that everyone wants a part of the action and the shares always go up. In reality, this is a great market leader in the fast-growing business of online advertising, not a repository of infinite possibility.
Private investors are clamouring for a stake in QinetiQ on the same assumptions that underlay Google’s appeal, but with an added twist. The public was cut out of the sale plans and has pushed through the fence thanks to the ingenuity of private client brokers — so shares in QinetiQ have acquired the lure of forbidden gold.
QinetiQ, too, is a fine business, combining defence patents, unrivalled expertise and commercial acumen added by Carlyle. But investors are not consciously being sold a bargain, as in some privatisations of yore. The price is being determined by building up a book of offers from fund managers. Shortage of stock in a £1.3 billion company may deliver the instant gains that many would-be stags are looking for. But, if the price rises artificially high, the ghost of Greenspan past may descend at any time to haunt it.
Pension pals
RESOLVING pensions problems amicably is good for your share price, as well as good for your employees. The stock market value of BAE Systems quickly gained about £500 million when the company disclosed that it had agreed with its employees to inject £800 million into its biggest and most worryingly holed pension fund. That sounds quite a bargain. Investors were doubly pleased.
If BAE can also win approval from fund trustees, it will remove a key risk that rankled in the minds of fund managers. The defence contractor’s fund deficits were not just huge in cash terms — they were also among the biggest in corporate Britain as a percentage of stock market value. At a time when deficits are rising even when share prices are on the up, that is a big enough risk to add significantly to the cost of capital.
The deal also extends the spirit of co-operation between BAE and its employees in a shared aim of preserving final-salary pensions without wrecking the company. In theory, deficits are a matter for employer alone, but the balance of power has changed since the mass closure of final-salary schemes.
Three years ago, BAE and scheme members shared the pain by both raising their contributions. Employees are helping the new deficit-plugging deal by accepting an array of cuts in benefits and agreeing to help to pay for future rises in longevity.
The baton now passes to British Airways. If it can make as fair a deal with its volatile employees, they and the shareholders will be able to move forward together more safely.
GORDON BROWN signed an unexpected new recruit to his staff yesterday: a recently retired 79-year-old former saxophone player with no previous experience of British politics.
But it can do the Chancellor no harm at all to seek the counsel of Alan Greenspan on “global economic change” as his honorary adviser, now that he is free to look for new challenges. The old maestro has often spoken out against the complexity of the US tax code and the need to keep budget deficits under control. If Mr Brown gets the message, so much the better for the rest of us.
