Private equity – boom or bust?

The reason there’s been a backlash to a private equity take-over of insurance company LV= is because they have a bad reputation.

Debenhams went bust after private equity investment
Debenhams never recovered from private equity ownership. It closed its final stores earlier this year. Photo by Martin Pettitt on Flickr (CC BY 2.0)

Some years ago I interviewed a man charged with turning around the fortunes of a well-known, household-name sports goods company fallen on hard times. This business had spent some time in the hands of private equity, a form of financing whereby rich individuals club together, buy into a business and either try to improve it by supplying those extras funds to expand the company or, sometimes, extract as much cash as they can from it.

This is an important issue at the moment for a number of reasons which I will explain. It is fair to say our sports goods company had not flourished in the hands of private equity investors.

East Anglia companies seek private equity investors

A recent survey by an accountancy firm with, it should be admitted, a vested interest, suggested that the appetite among small but growing firms for private equity investment is very strong at the moment. BDO’s Rethinking the Economy, which takes stock of business trends regionally, has found that almost a third of companies in East Anglia are looking for private equity investors to help them grow after the pandemic

Meanwhile there is a ferocious battle going on over the future of LV=, the snappily titled mutual insurance company that started life in 1843 as the Liverpool Legal Independent Victorian Burial Society, collecting small sums on doorsteps for policies that would often pay for funeral costs. The latest incarnation has attracted a takeover bid from Bain Capital, one of the big private equity players.

The board are backing the move. The opposition has come from financial pundits and politicians such as Ed Miliband and Lord Heseltine who say this is yet another attempt by private equity to buy assets on the cheap. As one of those pundits, I am inclined to agree.

Much of the protests have been orchestrated by the Daily Mail, which has been running a hard-hitting campaign against private equity “vultures”.

Brexit causing uncertainty

Private equity has been on a spending spree during the pandemic, with household names such as Asda and Morrisons and various strategic manufacturers snapped up.

The reasons are obvious enough. Those big deals buying companies quoted on the UK stock market probably reflect the fact that UK shares have lagged behind even the other poor performers on world markets.

Again, the reasons are obvious enough. Recovery from the pandemic has been strong elsewhere, but in the UK has been affected by investors’ concerns over the future direction of Brexit and the damage this could do to the UK economy. The respected Office for Budget Responsibility has said that damage could be twice that of Covid-19.

The key to successful investment is looking beyond current trends and seeing the long-term picture. Those private equity investors buying into UK stocks are betting that the stock market is taking too gloomy a view.

Meanwhile, small firms such as that 30 percent in East Anglia looking for private equity funding have suffered during lockdown and are seeking fresh cash to put themselves back on their feet and grow again. Rich private individuals, who might have shunned quoted companies because of that underperformance, are seeking places to invest their money. What could go wrong?

Theoretically, nothing. Yet critics of that private equity spending spree can point to examples where companies have suffered in private equity hands. The good model is that funds are made available to invest in companies and allow them to grow, to everyone’s benefit – the employees, existing investors and the tax man.

Bad model

The bad model, and there are plenty of examples, is that the new investors load the company with debt backed by its assets, extract the money borrowed in the form of dividends, and then hatchet back on all spending, needful or otherwise, in the name of tight, “efficient” management. This improves profits, short term.

The private equity model is that the investment is often sold on, or “flipped”, to the next investor for a higher sum based on those higher profits. It may take some years for the effect of this short-termism to soak through, in the form of a worsening performance. By that time, the first private equity investor has banked the cheque.

Have a look at this particularly egregious example, involving the AA. This got into trouble because of the high level of debt when it was last floated. Have a look at the numbers. The previous private equity owners made £1.2 billion from the 2014 float.

The company has now had to be rescued, at a price a fraction of what those initial investors made – by two private equity firms, which have also agreed to take on that debt. And around it goes. Guess what happens next?

Debenhams, a salutary lesson

There is a reason why Debenhams stores are no longer on our high streets. It was bought by private equity in 2003, loaded with debt and floated on the stock market. In my view, and I knew the individual whose lugubrious task, ultimately unsuccessful, it was to turn the retailer around, that debt deprived Debenhams of the funds to react to the changes in the high street taking place after it was floated on the stock market in 2006. Others seem to agree.

That is the downside to private equity that companies considering bringing in such investment might consider.

To go back to our sports goods maker, the company had developed a clever promotional method. Promising professionals within the sport were offered the goods for free. The tens of thousands of amateur players saw their idols supposedly endorsing the products and so bought them. It was an inexpensive form of promotion, but it fell foul of the cost-cutters employed by the private equity owners. Cut the costs now, watch the profits grow. For now.

Within a few years the brand had lost visibility and sales were falling. My man was charged with rescuing the business. The private equity investors had sold out by then and moved on to the next victim.

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