As private equity firms consider bidding for Sainsbury, they are becoming increasingly visible and controversial. Let's look at the issues.
Private equity firms have been attracting considerable attention of late. A record $45bn bid for American energy company TXU
(NYSE: TXU)
has highlighted the fact that few companies are beyond the reach of these giants, while a possible takeover of Sainsbury
(LSE: SBRY)
, capitalised at £9bn, would set a record for this side of the Atlantic.
Meanwhile, unions, politicians and investors have been queuing up to criticise private equity. When German socialist politician Franz Muntefering described them as locusts in 2005, many regarded it as a particularly continental viewpoint, but it's an opinion being increasingly expressed in Britain. So why the criticism?
Labour relations
Takeovers by private equity often lead to job losses, which unions tend to regard as undesirable. Others would argue that if the job can be done more efficiently by fewer people, then there's no justifiable reason to employ more. Apart from the raw numbers employed, there have been allegations of undue pressure on employees -- obviously this is more difficult to measure objectively.
Asset stripping
Unions also oppose selling off the family silver, seeing this as diminishing the value of the business and placing it in danger. Owners would say that capital should not be tied up in assets that aren't needed.
Poorer customer service
As a consequence of these changes, unions argue that customers get poorer service. But bear in mind that private equity often wants to sell the company for a profit after restructuring, so losing business to competitors would not be in their interests either. And even if that were to happen, it would provide an opportunity for competing businesses, rather than degrading the overall economy.
Excessive debt
Financial restructuring of target companies usually involves increasing the gearing, thus amplifying gains and losses. This increases the risks for all concerned, especially if interest rates continue to rise. Even private equity boss John Moulton, of Alchemy Partners, has warned of casualties as a result. But it could also be argued that these businesses were under-geared when publicly traded, especially if there is a reliable cash flow -- utilities have been accused of this in the past. Calculating the 'correct' level of debt is not a science.
Tax treatment
Heavy debts require high interest payments, which reduce profits. Lower profits means less tax to be paid. Some regard this as cheating the exchequer out of its 'fair share' of tax revenue. As interest is a legitimate business expense, I have yet to hear any sensible suggestions as to how this 'fair share' should be defined. There has also been criticism of the rate of capital gains tax.
Buying companies too cheaply
With hindsight we can say that some companies were picked up cheaply when markets were depressed, but that's the nature of a market. Large institutional investors didn't have to sell if they thought the price was insufficient, although the average small investor had no choice but to take the deal once the critical level of acceptances was reached.
My main criticism is not of the private equity firms, but of the companies they take over: If the directors can shake up a business under new ownership, they could have done it when I owned a piece. Admittedly, a proportion of directors' efforts are spent placating the City rather than running the business, and this requirement is removed after a buyout, but this is hardly an excuse.
A sceptic might even suggest that directors leave a certain amount of slack in publicly traded businesses so that it can be got rid of when the time is right. There is also a potential conflict of interest when a bidder offers a rich future to directors who are supposed to be acting in the best interests of existing stakeholders.
The arguments are as complex as they are heated, and I think we'll hear more of them in the months to come.
More: Private Equity For Private Investors
