I am a bit worried about private equity

Private equity is growing – now owning over a quarter of British industry, I believe. While it’s great that sources of capital are available to entrepreneurs, the trend for major buyouts of established public companies is growing. And I’m a bit worried.

Here’s why.

1. Private equity buyers aren’t really using their own money
. They generally finance a big deal by loading their target’s balance sheet with debt so it can buy its own shares back. The imbalance – VCs essentially mortgaging the company’s cashflow and not needing to pay it back themselves – creates an imbalance of risk, risk almost entirely taken on by the company’s staff rather than its new VC owners. New financial instruments are now coming into play to mitigate such risks; I just hope they’ll be well used.

2. Private equity drains cash needed for investment. With an eye on profits, companies owned by private equity firms tend to use over-optimistic assumptions about plant lifetimes and investment cycles; just look at Rover. When new models were needed, their answer was the CityRover – a car that looked good in Excel (cheap to produce, required minimal factory retooling) but in marketing terms a 7-yr old design that drove like a crate and fooled nobody.

3. Private equity doesn’t think long term. With a horizon of 3-5 years max, the objective is to maximise margins and sell out, rather than build a sustained business. When they re-enter the market, VC-sold companies seem to have clapped-out assets and higher staff dissatisfaction than other companies. Their balance sheets will look similar, but all the things that don’t appear on balance sheets but we all know are essential factors in business success – staff happiness, pent-up wage demands, freshness of equipment – give the company a hidden disadvantage.

With giants like Vodafone and British Airways now talked of as takeover targets, perhaps it’s time to look again at takeover rules? (BA for example has a massive pension fund – in fact, it’s basically a pension business with a small sideline flying planes. BA’s staff may have paid into this fund for decades, yet a buyer would have few obligations to maintain it at appropriate risk levels; think of the pressures loading £20bn of debt into the business would put on a major line item like its pension fund.)

Here’s an idea: what if private equity buyers of public companies weren’t allowed to factor in the debt capacity of their targets when making their bids?

It’d mean they at least have to use their own money – which might make them a bit more interested in the actual companies, rather than the cash on their spreadsheets. Food for thought…

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