The problem with private equity’s race to buy up the UK
2021 will be a record year for UK private equity deals as corporate raiders target cheap UK companies on the stock market.
Private equity (PE) refers to financial firms that invest in private companies or do business to make public companies private. PE firms usually target underperforming companies in order to turn them inside out and sell them for profit. But the industry has also been linked to asset erosion and job loss.
Low interest rates have created a dream environment for private equity, which typically relies on credit to fund its businesses. The global buyout industry has raised a record $ 1.6 trillion (£ 1.15 trillion), according to data from Preqin. The funds are now under pressure to spend that money.
Great Britain is an attractive place to shop. The legacy of Brexit and the FTSE’s over-reliance on “boring” industrial and heavy industry stocks have largely deterred international investors in recent years. As a result, many UK listed companies look cheap compared to international competitors.
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“The FTSE 100 is the worst performing equity index since the UK Brexit vote in June 2016,” said Russ Mold, Investment Director at AJ Bell. “Unpopular is unloved and unloved is potentially undervalued.”
There were 401 private equity deals valued at more than $ 49.8 billion in the UK this year, according to data from Refinitiv. That is the highest number in the first half of the year since data collection began in 1996. The second highest was in 2018 when 297 companies were privatized.
UK companies that have fallen for private equity include: Asda Supermarket; Mechanics AA; Infrastructure company John Laing; St. Modwen Properties; Fund Manager Sanne Equiniti; Signature Aviation private jet company; Insurer LV; Aerospace Company Senior; and the pan-Asian snack chain Itsu.
The latest UK deal to hit the headlines is the ongoing battle over the Morrisons (MRW.L) grocery chain. A consortium led by Fortress Investment Group led the purchase of the company in advanced talks and increased its offer to GBP 6.7 billion (USD 9.3 billion) on Friday. Apollo, another buyout firm, is considering joining the acquisition. Clayton, Dubilier & Rice (CD&R) – a competing US company – is reportedly considering a counter offer.
If the Morrisons are privatized, 1 million UK workers will be employed by private equity-owned companies. This equates to around 3% of the total workforce in the UK.
The deal frenzy is causing concern in some circles as old questions about the merits and pitfalls of private equity re-emerge. Politicians and unions fear that takeovers could mean the liquidation of important companies and the loss of jobs. Meanwhile, investors complain that private equity barons are choosing British companies too cheaply.
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Darren Jones, chair of the House of Commons’ Business, Energy and Industrial Strategy Committee, is concerned about possible “job losses and pension fund shortages” at Morrisons. In a letter to the Competition and Markets Authority, he expressed concerns about the large amount of debt used to fund these types of acquisitions.
Private equity firms borrow to fund acquisitions, but the way business is structured means the debt ends up on target companies’ balance sheets. Refinitiv data shows that private equity businesses typically involve debt worth about six times company profits. That is much higher than the typical debt level for public companies. Huge mountains of debt make companies more vulnerable to changing economic winds.
“Our main concerns are job security while maintaining and improving the working conditions of our members,” said Joanne McGuinness, National Officer of the Union of Shop, Distributive and Allied Workers.
Morrisons employs 118,000 people in the UK and there are fears that that number could drop after each deal. Downsizing to reduce costs and increase efficiency is a typical private equity strategy. A recent study by the Harvard Business School found that employment in target companies fell by an average of 13% in the two years after taking over private equity.
McGuinness said his union has a “constructive working relationship” with the Morrisons bidders but is seeking “more engagement and reassurance for employees about the future of the company.”
Private equity involvement also raises asset erosion concerns. A company can sometimes be valued less than the sum of its parts known as its book value. Buying a company and then selling the crown jewels – real estate, factories, equipment – can be a quick way to make money for private equity firms.
Andrew Koch, a senior fund manager at Legal & General Investment Management, one of Morrisons’ top 10 shareholders, said the bidders appeared to be interested in Morrisons for “wrong reasons” last month.
“If a buyer is getting strong returns, it should be because the company is getting a better deal,” Koch said last month. “It shouldn’t come from buying your real estate portfolio too cheaply, inflating the company with debt, and possibly lowering taxes paid to the treasury.”
Bernstein analysts said they were “tired of seeing” how Morrisons’ assets would not run down if the deal price were raised. Assets that could be sold include gas stations, factories, warehouses, and stores.
The Morrisons bidders tried to reassure shareholders by saying that the supermarket’s large real estate portfolio – part of what makes it an attractive destination – would not be jeopardized. But this promise is not legally binding.
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The EU has put in place a policy to stop asset stripping after a PE acquisition, and the ECB requires strict internal reviews of “any type of credit or credit exposure where the borrower is owned by one or more financial sponsors”. But there are no similar rules in Great Britain.
A negligent attitude towards acquisitions partly explains why private equity firms like the UK so much. In France, for example, labor laws are stricter and the government is tough on foreign workers.
“With previous purchases of high street, highly leveraged brands that have ultimately resulted in administrative losses, job losses and pension fund bottlenecks, there are concerns that regulators may not have sufficient oversight or authority to intervene when new owners act irresponsibly,” wrote Jones from Labor to the CMA.
Not only the political left is concerned about the private equity deals. Many investors fear that boards are pushing through the deals too cheaply. The data compiled by AJ Bell shows an average bid premium of 36% for these private equity firms.
Morrisons ‘largest investor recently said it was “unwilling to accept Fortress’ s offer,” forcing bidders to sweeten their offer.
Given the uncertain state of the UK economy, many fear that the latest wave of transactions could end badly for millions of workers and investors.
Whatever happens, the money men behind the deals almost always win. Private equity firms charge a management fee of 2% on the money raised by investors and a performance fee of 20% on the money generated from the expiring investments.
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Private equity firms argue that this structure gives them an incentive to ensure that their investments are indeed successful. It has also helped make PE managers the big cats of the corporate world, as many fund managers make millions of pounds annually on their investments.
Notable names who have amassed fortunes in private equity include Stephen Schwarzman, Chairman and CEO of Blackstone, which is reportedly worth a cool $ 15.4 billion. John Grayken, founder and chairman of Lone Star Funds, was last worth $ 7.4 billion. Tom Gores, founder of Platinum Equity, has net worth of $ 5.7 billion, according to Forbes.
“Cheap money is a huge bonus for operators like private equity firms, so the current record-low interest rates are fueling their purchasing power,” said Susannah Streeter, senior investment analyst at Hargreaves Lansdown. “If they can finance acquisitions cheaply, then the potential gains for them are all the higher.”
Disclosure: Apollo Global Management has entered into a deal with current owners Verizon to purchase Yahoo Finance UK as part of a larger transaction. The deal has yet to be finalized.
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