Less than two years ago, private equity was the new black. Directors trembled as they walked down Collins Street or Martin Place, petrified over whether their company would too fall prey to the scourge of firms like KKR, Texas Pacific or Blackstone. At one stage, private equity looked set to acquire Australia’s largest employer (Coles) and national airline (Qantas). While those transactions never eventuated, private equity firms acquired several Australian companies, including Myer and National Hire, and took significant stakes in Consolidated Media and Seven.
How times have changed. Yesterday, it was revealed that Australian Discount Retail, owner of Crazy Clark’s, Go-Lo, Sam’s Warehouse and Chickenfeed, was placed in receivership by its bankers. ADR was created in 2005 by private equity firms CHAMP and Catalyst Investment Management with funding from banks including NAB, Bank of Scotland and ANZ. The business reportedly owes its bankers $96 million and other creditors $105 million.
The ADR adventure is a percipient example of the negative effects that private equity can have on stakeholders when things go awry. In fact, it appears that everyone involved in the ADR fiasco has come out a loser — that is, except for the culprit private equity firms who ran the operations (and of course, their well paid financial advisers). As Ingrid Mansell noted today in The Financial Review, “ADR’s private equity owners … took $100 million out of the business in 2007 [and injected $20 million last year].”
The private equity strategy is not a complicated one. Purchase a business with reasonably high cash flows using as little equity and as much debt as possible. Usually, cash flows will barely cover interest costs. This capital structure is preferred by PE for two reasons: first, it means PE firms are able to use less equity to fund the acquisition (increasing returns and allaying the risk of loss on any individual buy-out) and second, interest payments on debt (as opposed to dividend payments on equity) are tax deductible. This means the buyout vehicle pays little or no tax during its first three to five years of existence.
Ironically, not only will private equity firms use only a sliver of equity, the firms will seek repayment of that equity from the vehicle as soon as possible, often within a couple of years (as Catalyst and CHAMP did with ADR) — with only a cursory consideration of the underlying health of the company.
Critics argue that the private equity acquisitions are detrimental to the community, as they involve a transfers of wealth which would have otherwise been paid into consolidated government revenue (and theoretically spent on items like schools or hospitals) and into the hands of wealthy private equity firms and their investors. Further, the high use of debt and low interest cover places the business (and importantly, its employees and suppliers) under serious threat should economic conditions worsen. ADR, for example, employs more then 2500 staff, many of whom find their positions under grave threat.
Private equity proponents deny this, claiming that the preponderance of debt compels management discipline, reducing inefficiency and waste. PE firms compare the use of debt to mounting a dagger on a car steering wheel, causing a driver to exhibit far more care than they otherwise would. While the dagger-theory may work in fine conditions, it is not necessarily correct, as Warren Buffett noted in 1990:
Huge debt, we were told, would cause operating managers to focus their efforts as never before, much as a dagger mounted on the steering wheel of a car could be expected to make its driver proceed with intensified care.
We’ll acknowledge that such an attention-getter would produce a very alert driver. But another certain consequence would be a deadly — and unnecessary — accident if the car hit even the tiniest pothole or sliver of ice. The roads of business are riddled with potholes; a plan that requires dodging them all is a plan for disaster.
Private equity is not devoid of merit. In many instances, private equity does improve operational efficiencies of an otherwise bloated and poorly managed business. PE remuneration structures are generally far more aligned with company performance (as opposed to public companies which pay executives generously for non-performance as well as performance). However, the risk of ownership for a privately owned firm in may ways, is transferred from equity holders to debt providers, while the risk to employees and suppliers is significantly increased.
As often appears to be the case, while Main Street appears to be the victim of the private equity boom, Wall Street has, once again, managed to come out on top. In 2006 alone, leveraged buyouts generated US$11 billion in investment bank fees. Investment banks earn fees for providing financial advice as well as arranging debt funding for leveraged buy-outs.
As the collapse of Australian Discount Retail has proved, the global financial crisis has left a lot of black ice on the private equity highway — taxpayers can only hope that the daggers aren’t too sharp.