The private equity sector and cash-rich firms that comprise it split opinion. Some view private equity firms as scavengers who prey on sick and vulnerable companies, denying them the chance to stage an internal regeneration and recovery.
Instead, assets are stripped and debt piled on. Eventually, fat profits banked by the new owners and the balance sheet propped up by a combination of unsustainable value maximisation in successful parts of the business and the sale of anything else there’s a willing buyer for, the company is sold on again.
A favourite example in the UK of the dark side of private equity ownership is Debenhams, the historical British department store. The high street favourite’s ultimate decline into liquidation earlier this year is, rightly or wrongly, often traced back to the three years the company spent under private equity ownership between 2003 and 2006.
Debenhams was taken over by a consortium of three private equity funds, Merrill Lynch, CVC Capital and TPG, who invested £600 million between them. Over the, not quite, 3 years the consortium owned the retailer, its members took out £1.2 billion in dividends. The company’s debt stood at over £1 billion by the time it was returned to the stock market in 2006, ballooning from around £100 million at the time private equity took it private.
There is an argument Debenhams was still in a position to adapt to the changing retail environment that has unfolded over the past decade or so with the rise of online shopping and changing consumer tastes and habits. That its management badly failed to do so, and little attempt was seemingly made to reinvigorate a brand cheapened by years of extensive discounting that maximised short term revenues, cannot be entirely placed on the level of debt accumulated during private equity ownership.
But it certainly didn’t help. There were limited funds available to reinvest in the company with most excess cash flow put towards servicing and trying to pay down the massive debt pile. That’s not to say the right management couldn’t have pulled off a turnaround. But it greatly reduced the chances.
Imagine if Apple had been picked off by private equity in the period before Steve Jobs’s messianic return and the first iPod released. What would have happened to the company? It’s, of course, impossible to tell but it’s also very unlikely it would now be the most valuable public company in the world.
But the world is full of sliding doors moments. And for every example of a period of private equity ownership proving disastrous for the long term prospects of a company, there are seemingly, if you look, as many examples of struggling companies being brought back to health and flourishing.
Another example of a UK-based retailer under private equity ownership acts as the perfect counter-weight to Debenhams’s tale of woe. In 2005, discounter B&M was acquired by the Arora brother, Simon and Bobby, who got the business moving in the right direction again before bringing in private equity investment in 2012. The private equity firm that bought into B&M was Clayton, Dubilier & Rice (CD&R), who are currently in the process of trying to acquire the supermarket chain Morrisons.
With input from CD&R, and the former Tesco boss Sir Terry Leahy, who became chairman at the private equity giant’s behest, B&M went from strength to strength. They found a market sweet spot selling everything from £1 Aero bars to discounted cleaning products, pet food and toys and generates revenues of around £4.4 billion.
CD&R, who reputedly paid £500 million for a 60% stake in the business, exited after B&M listed on the stock market in 2014. The private equity company is believed to have made around £1.5 billion from the little over 2 years it held the controlling interest in the discounter. But the company’s input also left B&M in a stronger position from which it has since built on to reach a £5.5 billion valuation.
The conclusion has to be that private equity ownership is probably just as likely to work out well, or badly, for a company as any other form of ownership. For every argument against private equity ownership; it can result in asset stripping and unsustainable debt being piled up for short term gains, there are arguments for it; private companies can better plan longer term and work towards longer term goals without the pressure to deliver constant quarter-on-quarter growth as a public company.
The private equity sector is also credited, like nature’s predators, of keeping public markets healthy and the gene pool dynamic. By picking off weak companies that might otherwise stumble on for years or even decades as growth-sucking zombies only surviving due to their economies of scale, private equity creates space for younger, leaner, more innovative companies to take their place.
The benefit or cost of individual examples of private equity ownership is a debate that doesn’t change the fact private equity is in a boom period. 2021 is almost guaranteed to be the first year during which the value of global private equity deals will, says data published by consultancy Bain & Co., exceed $1 trillion.
And money continues to flow into private equity funds. Billions are flowing from institutional investors like public sector retirement funds and university endowments sovereign as well as from sovereign wealth funds and the world’s richest families and individuals.
Big investors are chasing inflation-beating returns in an environment of rising prices and historically low interest rates. Private equity is now reaping the rewards of having proven itself to be able to consistently deliver those returns. The private equity sector is reported to be sitting on $3.3 trillion of capital ready to be deployed as soon as the right deal comes up.
A good chunk of the ‘dry powder’ private equity firms have at their disposal is likely to be used to acquire companies listed on the London Stock Exchange. Their valuations are depressed in contrast to comparable peers on other international exchanges, deflated by first Brexit uncertainty and then the economic disruption of Covid. We don’t have the same number of the kind of digital economy companies to have profited while traditional sectors like travel & tourism, finance, energy, construction, real estate and traditional retail have suffered, as Wall Street.
The Nasdaq and S&P 500 indices have both seen major gains since the start of the pandemic, the former up over 55% and the latter almost 32%. Even the Dow Jones industrial average, more exposed to traditional sectors, is up almost 18%. By contrast, the LSE’s FTSE 100 is still down by more than 5% over the same period. Even the gain of just under 9% returned by the FTSE 250, more exposed to the local UK economy than the mainly globally-facing companies of the FTSE 100, is almost half that of the Dow Jones.
Private equity firms are looking hungrily at the current valuations of UK companies, with attractive discounts seemingly available for little reason other than the fact the pandemic has slowed down the process of the market moving on from Brexit. The feeding frenzy is likely to significantly reshape the UK’s major indices over the next couple of years as a wave of established public companies are taken private.
According to the data provider Preqin, deals involving 517 UK-based companies worth £51.6 billion means there have already been more private equity deals in the UK this year than in the whole of last year.
Stock market investors may be concerned, with some justification, that this process, which looks like it has some distance yet to run, will result in a London Stock Exchange poorer in choice and, potentially, returns. It could also free up space for agile new companies to benefit from capital markets cash looking for a new home.
And investors can also gain direct exposure to the private equity sector by investing in listed private equity vehicles like investment trusts. Private equity trusts are generally regarded as higher risk than funds that invest in listed companies. But potentially offering better returns on the upside. Many listed private equity trusts are also funds-of-funds, meaning they spread their capital across investments in other private equity investment trusts.
Younger investors with time on their side might, for example, consider allocating up to 20% of an investment portfolio to private equity investment trusts.
Quoted in The Times newspaper, Rebecca O’Connor, who is head of pensions and savings at the Interactive Investor platform, outlines the case for limited exposure to private equity through investment trusts:
“There are genuine causes to feel concerned that returns from a standard mix of equities and bonds will not deliver big enough returns over the long term for today’s young workers.”
“If forecasts of lower for longer growth bear out, workers will have to contribute more to generate a big enough pot for a decent income in retirement. Alternatively, a higher proportion of pension investments can be allocated to riskier, potentially higher-growth options, such as private equity.”
It also looks like a very good time to buy into private equity investment trusts. Currently, nine of the ten largest private equity trusts are trading on a discount, meaning their share price is lower than the value of the assets they hold. For five of them, those discounts are over 20%.
Some private equity investment trusts to consider:
- HarbourVest Global Private Equity
- ICG Enterprise Trust
- Standard Life Private Equity
- Pantheon International
- NB Private Equity Partners