Forgive the Financial-Times-heavy series of posts today, but it seems to work out once a week or so that the FT has a lot of good material that isn’t replicated in the US press.
John Kay’s comment on private equity funds in Tuesday’s FT is skeptical without being doctrinaire. His big question is whether the activities of private equity funds are worth the money. Changing the capital structure doesn’t change the value of the enterprise, so financial engineering seems of questionable value. The claim that they improve operations also seems overdone.
Kay is at least partly right. His claim that financial engineering doesn’t work may not hold water. The concept he cites about capital structure is based on something called the capital asset pricing model, and as we have discussed, it may not be all it’s cracked up to be. But a company’s investment banker has the same deal structuring skills a private equity firm has (actually, in most cases, better), so why go to all the trouble of taking a company private just to change its structure? Ditto with selling divisions. Companies can and do do that all the time.
His doubts about private equity firm’s management skills are warranted too. Some firms pride themselves on having a good operational team, but if you look at the bios of most PE principals, they are heavy on investment bankers with perhaps a few men (this is a very male industry) with consulting experience thrown in.
The interesting problem that the industry has created for itself is that in the middle market, where the funds can help management (the companies may have a weak or inconsistent management team), the competition for deals is so fierce that most are sold for way too high a price for the funds to have a good chance of making money. That’s why the brand name firms have launched mega funds and are acquiring very large enterprises. They can buy them at a more favorable price. But they we get to Kay’s problem. The quality of management at these firms is much higher, thus the PE firm’s opportunity to add useful strategic or operational input much lower (weirdly, TXU may be an exception. The incumbent management was wedded to the idea of building 11 coal-fired electricity plants, even though the scale of expansion was too aggressive to be attractive on a financial basis. The announced deal with KKR and Texas Pacific scuttles 8 of the plants, improving returns).
The big plus of private equity may be governance arbitrage. Personally, I find the attacks on Sarbox to be overdone. The bigger problem with being public is that companies feel compelled to cater to the analysts’ and financial press’ fixation on short-term results. You can’t run a business on a short term basis. Too many companies are cutting costs, even when spending more would increase revenues, because cost reduction goes immediately to the bottom line, while investing in growth takes time and entails risk. But the current cost fixation goes well beyond what is healthy and has pushed a lot of companies into de facto disinvestment.
Sitting on my desk is a prospectus for a fund of private equity funds. It offers me some of the best names – Blackstone, Permira etc. I have just received a large cheque for my holding in Equity Office Properties and, if a similar bidding war for Sainsbury’s takes place, I will have a lot of cash to reinvest.
But wait a moment. Was it not Blackstone that just bought Equity Office and are not the names in the frame at J Sainsbury almost exactly those in my fund of funds? The prospectus invites me to buy Equity Office Properties and Sainsbury from myself, at prices around twice what I recently paid.
The private equity people often claim they will run the businesses better, but surely not here. Sam Zell and his team at Equity Office were among the shrewdest property traders, which is how they created America’s leading property investment trust. There might have been an argument about management at Sainsbury five years ago, when the store found it hard to get goods on the shelves. But everyone seems to agree that Justin King and colleagues now have matters under control and should be kept on as part of any deal.
I have read that Sainsbury has less space devoted to profitable non-food items than rivals Tesco or Asda, and private equity owners could press for change. I am sure Mr King will be grateful for the suggestion – you can see why these guys got distinctions in their MBAs – but this idea is not quite enough to justify 2 per cent of assets and 20 per cent of uplift.
The private equity group will introduce financial engineering. But lecture one in the MBA finance course they took explains that you cannot increase the enterprise value of a business by changing the debt equity ratio, because the greater riskiness of the equity exactly offsets the lower cost of the debt. The argument assumes no taxes and the chancellor of the exchequer does contribute by treating debt more favourably than equity, to the fury of the GMB union: but the effect is small…
If management and business operations remain much the same, as does the underlying ownership structure once you drill down through the layers of fee-collecting intermediaries, it is hard to see where value is being added. If financial engineering of the business is not the explanation, can the answer lie in financial engineering among investors?
The private equity promoters propose layer upon layer of debt, leveraged by non-recourse finance. What I get is an option on an option on an option. But the same finance theory also tells us that you do not increase the value of an investment portfolio by increasing gearing: once again the greater risk exactly matches the greater prospect of return.
The last, most convincing, argument for the prospectus – although not contained in it – is that banks are providing debt too cheaply. The new private equity owners are unloading more risk than the holders realise. The banks are in turn passing risk to – well, then the story gets murkier. Credit risk is still in the financial system somewhere, but it is more and more difficult to work out where it has ended up.
Perhaps the sophistication of modern financial structures means that the distribution of risks and the design of governance structures can be finely tuned to the needs of individual investors and the businesses they fund. Or perhaps there is a miasma of complexity and confusion in which everyone persuades themselves that the uncertainties of business have been landed on someone else. Make up your own mind: but I have decided to keep my cheque book in my pocket.