https://youtu.be/hIyl5SI6OL0?si=wWlGveLcKZrS8Hr-
BACKGROUND
In the past the activities of Private Equity were called asset stripping the idea was to borrow a pile of money using the target asset as collateral reaching the finances and upgrade the asset and then extract the improved profits and eventually sell on the asset at a substantial markup.
This often brought big social problems as restructuring would involve redundancies however for those PE activities undertaken at a time of low interest rates the Threat to the economy inflation and employment, now becomes more serious.
THE LBO, HOW IT WORKS
Post brexit and post covid, American private equity recognised that Valuations to Earnings multiples in the UK were significantly lower than in the US and they proceeded to buy up many high street names on cheap debt, using the leveraged buyout LBO tool.
The idea of the leveraged buyout is to borrow a large wedge of money, maybe 80% of the purchase price, to buy an asset - in this case, a chain of High Street shops - often with the acquired company’s assets used as collateral.
And after re-tuning the finances and upgrading the asset, sell it on at a profit. The sale includes the debt, ie selling on the debt, the debt is not repaid by the seller but is included in the sale, the debt is passed on to the buyer together with the asset, it is not repaid by the seller out of the sale proceeds.
Private Equity could buy the asset using low interest debt and pass that debt on to the buyer, who found it manageable because of low interest rates.
THE RESULTS
Burger King, The Body Shop, New Look, Morrisons, Byron Burgers, Wagamama, Café Rouge, Pizza Express, Bella Italia, Madame Tussauds, Zizzi. These are examples of High Street names controlled by Private Equity. Bought by PE at a period when UK valuations were on average 11 times earnings, compared to 20 in America.
DEPENDENCE ON CHEAP DEBT
Brexit and covid caused the pound and stocks to plunge, making these assets appear cheap compared to their valuations of just a few months earlier and compared to valuations for equivalent American assets.
Between 2016 and 2023 Private Equity PE companies spent 200 billion USD dollars buying UK assets compared with 81 billion in Germany and 36 billion dollars in France.
It is a problem because Private Equity backed companies employ 1.9 million people in rhe UK and their suppliers employ another 1.3 million.
If interest rates increase significantly, as they have done, then these deals can go wrong, meaning higher prices for consumers as the company attempts to pass on the higher costs of capital, and loss of jobs if they can't.
THE PROBLEM
PE brings in a lot of money to the UK economy, at a time when Brexit has made the UK a less interesting place to invest, but leveraged buy-outs carry risks to the economy from the rise in interest rates - inflation, price gouging and employment.
What policies might a new incoming UK government develop In order mitigate the risks to the economy and to increase FDI ?
GOVERNMENT INTERVENTION
The government must consider ways to mitigate the immediate threat to the economy as well as policies for long-term management of PE and FDI.
Post brexit and covid, private equity companies looked at the market-cap-to-earnings multiples for quoted and family companies, and comparing America with UK found that the UK was little more than half the American market valuation.
So they piled, in taking out cheap loans, often on the collateral of the target company itself, to buy up, then retune the finances, upgrade the asset in order to extract the enhanced cash flow, with the idea that later they would sell out at a substantial capital markup.
That's how capitalism works so what do we have to complain about?
You might think the sale means that the seller can repay the Debt out of the sale proceeds but that is not how a leverage buyout works the lbo means the buyer acquires not just the asset but the debt as well. This is what the word "leverage" means. It means borrowing a pile of cash to buy not just the asset but buy the target's debt as well. In effect the buyer is restructuring the sellers debt using capital that it has borrowed at a lower interest rate than the seller was paying.
That's all fine and dandy until the interest rate for the buyer on its debt increases what happens then well the buyer the PE company will try to pass the increased interest rate onto the companies customers or if it can't it will go bankrupt. So here are threats to inflation and employment - the twin mandates of the Bank of England.
I don't know if this was anticipated by the b o e and changes made to the regulatory framework because the Bloomberg short video doesn't actually give any negative real world consequences all it does is to highlight the risks of lbo at a time of low interest rates.
So anyway if we were too seriously consider this video then we would look at short and medium term responses from the Boe, from the government.
In the short term there'd be tax-funded government bailouts or subsidies and encouragement to these PE companies to restructure their finance. That's what it means when it says government is lender of last resort.
Hopefully the government has set up a department to monitor cash flow and debt levels and changes in the business processes of the companies in this now vulnerable sector of the economy and offer advice and guidance to avoid employment disasters, disasters for the economy but also for communities.
Then there'd be stuff to discourage these companies from suddenly laying off great numbers of workers and to offer retraining if they do, and to lead the company's down the path of sustainable business processes like green energy initiatives or local sourcing of products... in other words, to lubricate the wheels of capitalism.
But you might wonder whether the government had policies in place at the time because after all what goes down must come up and here we are with the higher interest rates.
I don't have any info on how real the risks in that video are I mean what High Street chains have gone under? Perhaps something in residential property construction and home maintenance...
Surely there must be strict controls on borrowing by these PE companies and regulations to make sure that financing is declared openly and transparently?
Surely the whole tax and innovation regime is set up to encourage long-term sustainable growth rather than short-term profit?
The whole idea of the Boe when it comes to managing interest rates is to tackle inflation without discouraging growth.
And knowing nothing about fdi-dimension that the activities of these assets strippers is discouraged by government policies so that fdi comes in in a more transparent long-term diversified area that's good for the economy.
And finally there'll be all the stuff to do with protecting jobs and enabling retraining as the economy evolves.
MORE QUESTIONS THAN ANSWERS
It will be interesting to know why PE was so much lower in Germany and France was it that the assets were less attractive or was it that the regulatory framework was better?
So it's all about how the economy has been managed since the great financial crisis have the Tories made a good job of this I don't know whether the economy is better or worse under threat or blooming it just depends on which Media outlet you read.
Ordinary people are not satisfied and there is a big chance the Tories will be kicked out but what will the policies of an incoming government be?
Actually I'm not so sure about this threat from the asset strippers I know it sounds bad to rely on low-cost capital and focus on short term profits but actually maybe pe is being maligned as it is actually interested in stable longer-term cash flow and long-term re-evaluation of the target asset. It wants to create robust cash cows that it can sell on at a vast profit.
This is all about creative destruction, the survival of the fittest, the search for the most efficient allocation of capital.
Eg, rhe rise of digital photography replacing film cameras, streaming services disrupting traditional cable TV I had a few shares in ITV.
The only examples I was able to find where an LBO has gone wrong are Toys R Us, Debenhams, Lloyds Pharmacy, The Body Shop and Farfetch.
Toys "R" Us failed to adapt to digital innovations and changing consumer preferences. Netflix and Amazon did so well by embracing new technologies and business process models. Lehman Bro failed, Revolut is far more successful their NatWest.
Striving for enhanced cash flow and capital valuation, these PE firms have brought in a lot of expertise. You could probably make an argument that target companies were undervalued because they were poorly managed with poor returns for shareholders. PE changed that.
PE made financing more efficient, improved business processes (which is a job I was a bit involved in) and they have focused on innovation as a tool for long-term improvement.
For example, B&M and Homebase have thrived under PE ownership, according to this article:
https://www.retailgazette.co.uk/blog/2023/12/private-equity-killing-retail/
To me the real criticism of PE which this video completely missed is how it concentrates capital into fewer and fewer hands afterward you're going from public ownership on the secondary market to private ownership in the hands of a few and also it is making it harder for small businesses to survive as this is top-down injection of expertise and economies of scale whereas what we want is bottom up creativity and innovation.
So what I'd like to hear about is is government fitting PE successfully into its management of the UK economy?
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