The Coming Private Equity Crisis

In Moneyweek this week, I've been writing about the looming crisis in Private Equity. Here's a taster of the piece, but do buy the magazine.

There must be relatively few thoughts that can console the former Royal Bank of Scotland boss Sir Fred Goodwin as he looks back over the tatters of his career. There won’t be many publishers asking for his memoirs, not many universities asking him to take up a chancellorship. Still, there is one. The backlash over his pension will look like nothing more than a mild disagreement between friends compared with the political and economic storm that is about to erupt over the private equity industry.
Fast forward a few months, and it already obvious to anyone who cares to take a look that the next, and potentially the most painful, stage of the credit crunch will be the collapse of a string of companies owned by the buy-out funds.
The signs are already there, just as they were in the banking industry six months ago. And yet, with extraordinary and reckless negligence, the City and the Government are keeping their heads buried resolutely in the sand, taking few steps to stave off the trouble ahead. In time, there will no doubt be a heavy price to pay for that carelessness.
This week, the warning lights of trouble ahead have been flashing bright red.
On Monday, Candover, one of the pioneers of the private equity industry, and among the smartest players within it, reported a truly terrible set of results. The firm cancelled its dividend, scrapped plans to invest in a fresh fund, and said it was looking at job cuts. Its shares have fallen from £22 as recently as last August to only just over £2 now. Elsewhere, the news is just as grim. KKR said this week the value of its publicly quoted funds dropped by a third in the latest quarter. 3i has watched its shares slump all the way from a peak of £11 to less than £2 now. Over in the U.S, shares in Blackstone, the world’s biggest quoted private equity group, have fallen back from $30 to less than $5 now.
No one should be in any doubt about why that is. The buyout business was partly about taking control of tired business run by timid and lazy management and freshening it up with a lot of smart new ideas. But, in truth, it was mostly about clever financial engineering. The funds loaded up company balance sheets with lots of debts, sliced and diced it a dozen different ways, then sold it on to hundreds of different institutions, all the while generating huge fees for the funds themselves and their bankers. If you think sub-prime mortgages are complicated, trying unpicking the average private equity deal.
Inevitably, there are going to be collapses. In a deep recession, the one thing a company needs, just like an individual, is a strong balance sheet. They need plenty of equity, adequate capitalisation, and the ability to ramp up borrowing to get through a couple of lean yeans. Very few of the businesses owned by the buy-out funds are in that kind of shape. True, some will be able to re-structure their balance sheets, swapping debt back into equity. But, in reality, that is a lot easier in theory than in practise. Bond holders won’t want to take the losses it will inevitably involve. Amidst the arguments and recriminations, companies will collapse into insolvency.
When it happens, the anger is going to make the outrage over banking bonuses look mild. If a few derivatives traders lose their jobs, it doesn’t matter very much. Only the lap-dancing clubs of EC1 really suffer. But the private equity firms own huge companies, employing tens of thousands of people: Companies ranging from Iceland, to the AA, to Kwik Fit and Travelodge are all owned by the buyout funds.
Jobs will be lost, houses will be re-possessed, and pensions will be destroyed. On some estimates, as many as one in five private sector workers in the UK are ultimately employed by the buyout funds. The impact on ordinary people’s lives is going to be huge.
Neither the industry or the government will be able to escape the fall-out. The funds have been paying their partners a fortune during the boom years. If you think the board of Royal Bank of Scotland rewards itself generously, then you’ve never taken a look at a private equity firm. Sir Ronald Cohen of Apax has made an estimated £260 million from the industry. Guy Hands of Terra Firma has made an estimated £160 million. Damon Buffini, of Permira, is worth an estimated £150. Lower down, there are dozens of middle-ranking executives who have accumulated fortunes running into millions.
If, as seems likely, it becomes clear those fortunes were made by manipulating balance sheets, and leaving them in such poor shape that that thousands of people lost their jobs, there is going to be a lot of anger out there.
The Government won’t be able to escape the blame – and nor will it deserve to. Gordon Brown has long been the private equity industry’s best friend. Cohen bankrolled his leadership campaign. Buffini has been a key adviser. And whilst it is a myth that the private equity industry gets special tax breaks (it simply manipulates the existing rules better than most people) there is no question that as Chancellor Brown tolerated tax wheezes that allowed the industry to flourish.
He could have done a lot more to regulate its growth. As a result he can hardly complain if his government gets caught up in the backlash once companies start crashing down. If, as he claims, he was trying to ‘save’ the economy, he’d be trying to stave off the looming crisis now. Instead, either through ignorance or carelessness, it is being ignored – at least until the first major insolvency hits the headlines.