We’re told investing in private equity will always deliver the dream

What happened when investment banks passed the baton to private equity? Private equity is like central banking in that it created a leveraged bubble: It borrows trillions from banks, and trusts investors will soon…

We're told investing in private equity will always deliver the dream

What happened when investment banks passed the baton to private equity?

Private equity is like central banking in that it created a leveraged bubble: It borrows trillions from banks, and trusts investors will soon pay them back. If those investors get spooked, private equity can often fund the loan off the equity of itself. It sounds simpler than it is, and the idea is, of course, to show results and so shareholders can make money. Private equity firms pay themselves a handsome fee in return, in line with earnings expectations. They also dilute investors’ equity by issuing special shares in return for borrowing.

But let’s ignore the comparison to central bankers for a moment. How did those bonuses actually work out for shareholders in private equity?

Let’s use SABMiller as an example. SABMiller made £9bn of revenues and £3.4bn of profit for three years of ownership by Altria (Billionaire investor John Paulson never invested into the company in his own account), while its diluted shares rose more than fivefold in that period. Altria retained 82% of SABMiller’s equity after the spin-off.

Analysts at Deutsche Bank estimated that over three years, SABMiller’s cashflow increased by 1.7% a year on average, but it took a massive £45bn of debt to fund this. Moreover, the company has had to slash its dividend and, in the most recent quarter, reported a negative free cashflow of nearly £300m. This isn’t an investment that worked for shareholders, and would have required an equity raise.

Private equity people will tell you it’s different. There are better things to do with money than paying dividends to shareholders, and with that cash it can create businesses with profit margins that are far better than those at Altria’s own publicly listed entity. But is this true?

First, it’s unfair to compare the private equity payouts to SABMiller to the current pension fund liabilities of large corporate pension schemes. Other interesting points have been made about valuing the pension liability. Looking at the risks – rather than the value – of pensions and their stock market value doesn’t seem to have factored in to decision-making – or given even a second thought. If pension assets fall into negative territory, then the sum of the funded and unfunded pension liabilities rises.

Secondly, at any point in the private equity lifecycle it can decide to return to form by raising capital through equity. And yet for most of the time it has effectively been sitting on £45bn of cash in the bank. This looks more like passive, passive funds looking to minimise risk than active, investment-driven funds willing to pursue return.

Leave a Comment