Lambert here: You say “asset strippers” like that’s a bad thing.
By Laurie Macfarlane, an economics editor at openDemocracy, and a research associate at the UCL Institute for Innovation and Public Purpose. He is the co-author of the critically acclaimed book ‘Rethinking the Economics of Land and Housing.’ Originally posted at Open Democracy.
For much of the past half-century, Morrisons supermarket has been hailed as a bastion of responsible British capitalism. Under the leadership of the late Ken Morrison, the company prided itself on its conservative business model, characterised by low levels of debt and good relations with workers and suppliers. But in recent weeks Britain’s fourth-largest supermarket chain has been the subject of a bidding war between investors that have a rather different business ethos.
In June, private equity firm Clayton, Dubilier & Rice offered to buy Morrisons for £8.7bn, in a move that would take the company off the London Stock Exchange and into private hands. The bid was ultimately rejected, but on 3 July a £9.5bn offer from another private equity firm, Fortress Group, was accepted. The deal, which is still subject to shareholder approval, will result in an estimated £19.6m payoff for the company’s chief executive, David Potts. Another private equity giant, Apollo Global Management, has said it is considering lining up a rival counteroffer.
The scramble to purchase a UK supermarket chain in the middle of a global pandemic raises an obvious question: why are profit-hungry private equity funds so keen to sink their fangs into a sector that is notorious for its cut-throat competition and low profit margins?
The answer provides a glimpse into a dramatic transformation of the UK’s corporate landscape that is underway, which has the potential to fundamentally reshape British capitalism.
A Veil of Secrecy
Although Morrisons has long been run as a profitable business, its financial performance has been far from spectacular. This year the company expects to make about £342m in net profit – half what it made a decade ago and significantly less than its arch-rival Tesco. What the company does have, however, is assets, and lots of them.
The company reportedly owns 85% of its retail stores, more than any other supermarket. With a book value of £5.8bn, Morrisons real estate portfolio is worth nearly as much as the market value of the entire company, based on its current share price. Unlike other supermarkets, Morrisons also owns significant parts of its supply chain. The company deals directly with the 2,700 British farmers rather than wholesalers, who deliver livestock and fresh produce directly to its 17 processing facilities. As a result, the National Farmers’ Union calls Morrisons “British farming’s biggest direct customer”. The company, which employs about 121,000 people, also has a healthy surplus in its defined benefit pension schemes.
To most people, these characteristics mean that Morrisons is a prudently run business that strives to treat its suppliers and workers well. But to profit-hungry private equity firms, it means the company is a prime target for the kind of smash-and-grab asset stripping that the sector has become notorious for.
The typical model is as follows: a private equity firm buys a company by borrowing significant sums of money, typically only putting a small amount of its own funds at risk. Once acquired, these debts are loaded on to the company and a process of cost-cutting begins – old management is replaced, workers are laid off, and pay and conditions are attacked. Assets such as land and buildings are sold, often to an entity registered in an offshore tax haven. The company then rents the buildings back on long-term leases, and pays a management fee to its new private equity owners. The extensive use of leverage not only multiplies returns on investment, interest paid on debts can also be deducted from tax liabilities.
This process of asset sales, corporate restructuring and financial engineering delivers spectacular short-term returns for the new owners. Uniquely, these returns, which are referred to as ‘carried interest’, are taxed as capital gains rather than income. This means that private equity executives often pay lower tax rates on their multi-million-pound bonuses than many salaried workers.
But this short-term profiteering often comes at a price of undermining the long-term viability of the company, which is left paying interest on the debt taken out to purchase it; rent on the properties it previously owned; and management fees to its new owners. This, combined with aggressive cost cutting, often undermines quality and standards, leading to eventual decline and – in some cases – bankruptcy.
Unlike publicly listed companies, private equity owned firms do not need to publish regular accounts. Without a plurality of shareholders to hold the company to account they face far lower levels of scrutiny, and often make extensive use of secretive offshore tax havens. As a result they operate largely behind closed doors.
Morrisons isn’t the first UK supermarket to be targeted by private equity. Last month the Competition and Markets Authority cleared a £6.8bn debt-fuelled acquisition of Asda by the billionaire Issa brothers and private equity firm TDR Capital. The latter is renowned for using complex financial engineering to deliver spectacular returns. In 2013 the firm bought the gym chain David Lloyd using £190m of its own money and £529m in debt. Since then, TDR has extracted more than £550m in dividends and other repayments – almost three times its initial investment. That has been achieved in part by loading new debts onto the company, which now owes more than £1bn.
With Asda already in the hands of private equity, many fear that a takeover of Morrisons would not only pose a risk to the company’s staff and suppliers – it could also trigger further buyouts in the sector, leaving a vital part of the economy operating largely behind a veil of secrecy.
As one retail analyst recently told The Guardian: “The whole industry is now in play. It’s not unrealistic to say that there could not be a single quoted British supermarket left in the foreseeable future.”
A Trail of Destruction
Private equity buyouts are not new; since first emerging in the 1980s they have become an increasingly important part of the corporate landscape. The supermarket industry is just the latest in a long line of sectors to be targeted.
Among the hardest hit has been Britain’s care home sector. Lured by the prospect of steady income streams and large property portfolios, over time private equity firms have become a major player in the UK’s care system. But in recent years their impact has been widely criticised. Since 2011, two private equity-owned care home chains, Southern Cross and Four Seasons, have entered into administration. Cash extraction, unsustainable debt and rent obligations and a complex corporate structure have been blamed for the collapse of the chains, who between them provided care for 45,000 residents. In the case of Four Seasons, the company’s sprawling structure consisted of 200 companies arranged in 12 layers in at least five jurisdictions, including several offshore territories. A 2019 report by the Centre for Health and Public Interest, an independent think tank, concluded that the financial crisis in the care sector is in part due to significant levels of “leakage” – excessive spending on rent, dividends, interest payments and management fees rather than care provision.
Britain’s high streets have also fallen victim to private equity. The collapse of high profile retailers such as Debenhams, Cath Kidston, Toys ‘R’ Us, Poundworld and Maplin has been linked to their periods of private equity ownership, when the owners sold and leased back properties, saddled the companies with debt and extracted large dividends. A recent investigation by Channel 4 found that almost 29,000 jobs were lost when these companies entered administration or liquidation, after their private equity owners had extracted billions in dividends.
Since the 2008 financial crisis, the low interest rate environment has triggered a renewed wave of debt-fueled private equity takeovers in sectors as diverse as North Sea oil and gas and veterinary practices to foster care firms and restaurants chains. This surge has led to a dramatic transformation in Britain’s corporate landscape. According to a recent review commissioned by the UK government, the number of listed public companies in the UK has fallen by about 40% compared with 2008, with a growing portion of the economy shifting into private and often unaccountable ownership structures.
Now the economic fallout of the COVID-19 pandemic means that this is likely to accelerate even further.
For the private equity industry, the COVID-19 pandemic represents a potential gold mine. Fund managers are reportedly sitting on a record $1.7trn of so-called ‘dry powder’ – money that has been raised but not yet spent – and are scouring the globe for vulnerable targets to prey on.
The UK, with its relaxed approach to corporate takeovers, is providing a lucrative hunting ground. Elsewhere in Europe, tighter scrutiny of foreign takeovers and stricter labour laws makes the private equity model less practical. Moreover, the UK’s departure from the European Union has created favourable conditions to pick up a bargain. Investors have pulled more than £29bn from UK equity income funds since the Brexit vote in 2016, which many believe has left the UK stock market undervalued compared to its US and European equivalents – and British companies looking like “easy prey”.
Many British firms have struggled throughout the pandemic, and have been forced to take on significant amounts of debt to survive. High street firms have been hit by the rise of online retail and home working, while city-centre commercial property values have plummeted – creating opportunities to pick up real estate on the cheap.
“Basically any predominantly British-listed company, with one or two exceptions . . . is vulnerable to a takeover offer in a way that doesn’t apply elsewhere in the world.” Lord Paul Myners, the former City minister, recently told the Financial Times.
So far in 2021, private equity firms have announced 124 deals for UK companies with a combined value of £41.5bn – the highest on record. Compared with the same period in 2019, the number of UK buyouts is up almost 60%. Leading private equity firms such as KKR, Blackstone and Carylse are reportedly beefing up their UK operations to capitalise on the lucrative opportunities.
On current trends, it is likely that many more British companies will soon be hoovered up by cash-rich private equity firms. What can policymakers do to prevent this?
At a national level, competition authorities can take a more robust stance against takeovers that aren’t in the national interest, as already happens elsewhere. Sectors that provide quasi-public services, such as care homes, can be brought into public ownership to protect them from falling into the hands of predatory capital. Private equity owned companies should also be required to publish more information about their finances and corporate structures.
Tax reform can also help: removing the tax deductibility of interest payments and taxing ‘carried interest’ as income rather than a capital gain would significantly undermine the viability of the private equity model.
At a local level, policymakers can take proactive steps to transform local economies for the post-pandemic age, rather than let asset strippers reshape towns and cities in their own image. For example: local authorities could capitalise on falling commercial property prices to acquire assets for the public good, transforming empty shops and offices into shared co-working spaces and new local amenities.
The COVID-19 pandemic marks a crucial turning point for the UK economy. The question we must ask is: whose interest should the COVID-19 recovery serve? The answer can either be the general public, or it can be predatory capital. But one thing is clear: it can’t be both.