Private equity promoters propose layer upon layer of debt, leveraged by non-recourse finance. But the same finance theory also tells us that you do not increase the value of an investment portfolio by increasing gearing.
Sitting on my desk is a prospectus for a fund of private equity funds. It offers me some of the best names – Blackstone, Permira etc. I have just received a large cheque for my holding in Equity Office Properties and, if a similar bidding war for Sainsbury’s takes place, I will have a lot of cash to reinvest.
But wait a moment. Was it not Blackstone that just bought Equity Office and are not the names in the frame at J Sainsbury almost exactly those in my fund of funds? The prospectus invites me to buy Equity Office Properties and Sainsbury from myself, at prices around twice what I recently paid.
The private equity people often claim they will run the businesses better, but surely not here. Sam Zell and his team at Equity Office were among the shrewdest property traders, which is how they created America’s leading property investment trust. There might have been an argument about management at Sainsbury five years ago, when the store found it hard to get goods on the shelves. But everyone seems to agree that Justin King and colleagues now have matters under control and should be kept on as part of any deal.
I have read that Sainsbury has less space devoted to profitable non-food items than rivals Tesco or Asda, and private equity owners could press for change. I am sure Mr King will be grateful for the suggestion – you can see why these guys got distinctions in their MBAs – but this idea is not quite enough to justify 2 per cent of assets and 20 per cent of uplift.
The private equity group will introduce financial engineering. But lecture one in the MBA finance course they took explains that you cannot increase the enterprise value of a business by changing the debt equity ratio, because the greater riskiness of the equity exactly offsets the lower cost of the debt. The argument assumes no taxes and the chancellor of the exchequer does contribute by treating debt more favourably than equity, to the fury of the GMB union: but the effect is small, and, to the delight of the GMB, Ed Balls, Gordon Brown’s chief aide, has made threatening noises.
The idea that property investment trusts such as Equity Office do not have enough gearing for tax efficiency is a bit surprising. Shares in British property companies have soared on the prospect of moving in the opposite direction. But that seems to be the way nowadays: shareholder value increases when you change things and increases further when you change them back. Taking a company private increases its value and taking it public increases its value again.
If management and business operations remain much the same, as does the underlying ownership structure once you drill down through the layers of fee-collecting intermediaries, it is hard to see where value is being added. If financial engineering of the business is not the explanation, can the answer lie in financial engineering among investors?
The private equity promoters propose layer upon layer of debt, leveraged by non-recourse finance. What I get is an option on an option on an option. But the same finance theory also tells us that you do not increase the value of an investment portfolio by increasing gearing: once again the greater risk exactly matches the greater prospect of return.
The last, most convincing, argument for the prospectus – although not contained in it – is that banks are providing debt too cheaply. The new private equity owners are unloading more risk than the holders realise. The banks are in turn passing risk to – well, then the story gets murkier. Credit risk is still in the financial system somewhere, but it is more and more difficult to work out where it has ended up.
Perhaps the sophistication of modern financial structures means that the distribution of risks and the design of governance structures can be finely tuned to the needs of individual investors and the businesses they fund. Or perhaps there is a miasma of complexity and confusion in which everyone persuades themselves that the uncertainties of business have been landed on someone else. Make up your own mind: but I have decided to keep my cheque book in my pocket.