Two big takeover battles in the UK are a sign of the times: supermarket chain Wm Morrisons and respiratory medicines group Vectura are both the subject of bids in the billions of pounds by private equity firms. In the case of Vectura, Carlyle Group is battling it out with Marlboro cigarettes giant Altria, while different private equity suitors are competing to land Morrisons.
It comes as private-equity buyouts of London-listed companies are their highest in 20 years, contributing to takeover deals worth £156 billion in 2021 to date. Big deals include aerospace firm Meggitt (bought by Parker-Hannifin for £6.3 billion), Signature Aviation (bought by a consortium led by Blackstone for £3.5 billion), and another supermarket chain: Asda (TDR Capital and the English billionaire Issa brothers for £7 billion).
Private equity firms have also bought motoring support group the AA in recent months, marking its second stint in private-equity ownership; and a 10% stake in Liverpool football club (whose majority owner, Fenway Sports Group, is essentially a specialist private equity firm anyway). With the exception of Asda’s private-equity owner, which is based in London, these buyers are all American.
Private equity firms are investment vehicles that are not listed on the stock market. Their objectives are no different to listed investment companies, namely increasing profitability by making businesses more efficient. But private equity has long had a reputation for cost-cutting, job losses, hiking product prices and loading acquisitions with heavy debts, so a big influx of takeovers is always going to raise eyebrows. So why the surge, and what are the implications?
Understanding the model
Private-equity deals are a bit like a corporate version of buy-to-lets. Where a landlord would buy a property and get the tenants to pay the mortgage in the hope that the property goes up in value and can be sold at a profit, private equity does this with companies.
They take control of an “undervalued” publicly listed firm using their own money and substantial borrowings from financial institutions. The aim is for the acquisition to pay back the takeover price and all the interest payments on the loans. The remaining profits then compensate the private-equity owners for their risk, as well as being reinvested in the business. Most private-equity firms expect to sell acquisitions within three to five years, whether by public listing or a resale.
The current popularity of these buyouts has been ascribed to the effects of Brexit fears and COVID-19 on UK share prices (“bargain valuations”, according to The Times). Since the 12-month lows at the end of October 2020, the FTSE 100’s gain of 29% lags behind that of the Dow Jones (33%) and the DAX (38%).
Yet the appreciation of sterling against the US dollar and euro has negated this difference to some extent, particularly for US-based investors. Rather than UK listed companies being undervalued overall, it is more that some businesses look cheap – particularly given the UK economic recovery, which is expected to be the fastest of the major economies.
Private-equity firms and institutional investors, which accumulated substantial cash during the worst of the pandemic because they saw deal-making as riskier than usual, aim to seize on these opportunities by taking advantage of historically low borrowing rates.
Most attractive are businesses with relatively stable income streams. Morrisons fits this profile well. Its pre-tax profits fell 50% in 2020, softening the share price. But grocery revenues are resilient and Morrisons has a £6 billion property portfolio, including most of its supermarkets.
Reasons to be wary
So how worried should we be about private-equity buyouts? Some might argue their reputation for asset-stripping is worse than is deserved. There have certainly been examples of this behaviour but the need to sell on a valuable asset in the three to five-year time-horizon is a strong incentive not to sweat a business too much.
Advocates of efficient markets would add that undervalued assets should be acquired by whoever values them more highly and can improve their efficiency and profitability. But while this may often be true, there is more inherent value in taking companies private than keeping them listed:
- Private-equity buyouts are generally heavily debt-laden. Public companies tend to be more conservative with debt given their duty to stakeholders and their reluctance to disclose commercial information to lenders. Highly indebted firms’ interest repayments are tax deductible as a cost of doing business, which reduces their debt-servicing costs and thus gives them a funding advantage.
- Privately owned firms are not subject to the same financial reporting and accountability checks and balances. They are under no obligation to answer to all their stakeholders or the public. For example, they don’t need to disclose who ultimately owns them, or the remuneration of their directors.
- Because private-equity ventures don’t have to reveal ultimate ownership, potential conflicts of interest can be obscured. For example, two companies in the same sector both owned by private equity could have the same ultimate owner and be quietly colluding without the competition authorities realising.
- The Wates Corporate Governance Principles, introduced in 2018, are a voluntary code of governance for both public and private firms above a certain size. Principles include mitigating business risks and fostering good relationships with stakeholders. But there has been limited uptake to date, and since public listed companies are arguably expected to follow such principles regardless of Wates, private companies again benefit.
With private-equity takeovers so popular, these advantages threaten the idea of shareholder democracy – namely that listed companies are more likely to do the right thing because shareholders can walk away at any time.
Private-equity buyouts may improve the efficiency and profitability of UK companies. But if firm does this by, for example, taking advantage of the reduced scrutiny to flout workers’ conditions or raise product prices, there will be adverse implications for society as a whole. And if, as many are predicting, interest rates soon have to rise to ward off inflation, more heavily indebted companies could mean more corporate collapses.
If adherence to the Wates’ principles is anything to go by, it will take more than voluntary codes of conduct to protect against these dangers. If we need new legislation to ensure private-equity owned firms are transparent about their ultimate ownership, avoid behaving anti-competitively and act in the interests of stakeholders, then so be it.