A Recent CaseThere is not only asset stripping; there is also liability shedding. HIG,

the European arm of a US private equity firm, acquired control of the British bed manufacturer Silentnight by buying, presumably at a very substantial discount, its senior debt. It then offered 65 pence in the pound to the subordinated creditors, with the exception of the pensioners. As represented by the Pension Protection Fund, the latter were offered 6 pence in the pound. When the PPF rejected this offer, HIG put Silentnight into administration which meant that the PPF was required to assume its pension liabilities. HIG then bought Silentnight back from the administrator as a going concern, purged of its debt. A large part of the purchase price must have come back to HIG as senior creditor. The jobs of 1,250 English and Irish employees were thus secured “in the short run.” Losses to the pension fund were of the order of ₤100 million; the pensioners themselves will receive about 75% of their accumulated entitlements. The potential gain to HIG has not been made public. (Financial Times 9th May and 12th May 2011).

Another

Britain’s largest care home provider, Southern Cross, is close to collapse and is seeking a 30% reduction in rents for homes housing 31,000 elderly people. It followed a strategy of selling and leasing back these properties. American PE company, Blackstone at one point owned both Southern Cross, floated in 2006 for a profit of around ₤320 million, and the principal landlord, NHP, also sold in 2006 for ₤1.1 billion, double what it paid. Guardian, 4th June.

Also last week…….

A press release from the Department of Business, Innovation and Skills reports (9th May 2011) that the “Phoenix Four” have been barred from serving as company directors, in one case for as long as six years. (Earlier, the Serious Fraud Office had found no basis for criminal proceedings.) Phoenix Venture Holdings had purchased the distressed motor manufacturer MG Rover in 2000 for a nominal ₤10. It failed in 2005 with debts exceeding ₤1.4 billion. Five executives appointed by Phoenix had taken ₤42 million in “compensation” from the loss-making company.

Restructuring Under the Sign Of the Capital Markets

Prior to dispersed ownership, issue of industrial control coincides with the issue of distribution of industrial capital.

With dispersed shareholders, issues are to some extent separated. In whose interests are the big corporations managed?

Berle and Means

Faustian pact: control sacrificed for liquidity.Role of the corporation under-determined:“It is conceivable, - indeed it seems almost

essential if the corporate system is to survive, - that the “control” of the great corporations should develop into a purely neutral technocracy, balancing a variety of claims by various groups in the community and assigning to each a portion of the income stream on the basis of public policy rather than private cupidity.”

Technocracy?

• Baumol sales maximisation theory of the firm (1959)

• J. K. Galbraith, New Industrial State

• Retained earnings

• Baran & Sweezy, The Soulful Corporation

Destabilisation

• Need for Restructuring: attack on separation of ownership and control as a principal-agent problem.

• Heightened role of the capital markets (very high interest rates; deregulation and liberalisation)

Jensen and Meckling:

Key transactions costs are agency costs among shareholders, bond-holders and managers.

“The development of theories to explain the form which agency costs take in each of these situations (where the contractual relations differ significantly), and how and why they are born will lead to a rich theory of organizations which is now lacking in economics and the social sciences generally.”

Jensen and Fama: Social Darwinism?

“Most goods and services can be produced by any form of organization, and there is competition among organizational forms for survival in any activity. In the absence of fiat, the form of organization that survives is the one that delivers the product demanded by customers at the lowest price while covering costs. This is the telling dimension on which the economic environment chooses among organizational forms.”

Two Views of Market Evaluation (1)

“This overpricing argument makes little sense, however, because there is vast evidence that investors are capable of pricing risks in all sorts of other markets. That they are peculiarly unable to do so in the high-yield bond market is inconceivable.”

Michael Jensen, 1987

Two Views of Market Evaluation (2)

“The market for corporate control solved many of the problems of undervalued equity in the 1970s and 1980s through hostile takeovers, leveraged buyouts, and management buyouts. It could not, however solve the agency problems of overvalued equity. It is difficult, to say the least, to buy up an overvalued company, eliminate its overvaluation and make a profit.” Michael Jensen, 2004

And the European Commission

“The disposal of securities concerns only the holders of these securities”

- Contribution to the discussion of the Takeover Directive from D.-G. Internal Market

LBO – the romantic era

• Corporate raiders

• Junk bonds

• Ban on many forms of defence by incumbent managements

Michael Milken

Milken was indicted on 98 counts of racketeering and securities fraud in 1989 as the result of an insider trading investigation. After a plea bargain, he pled guilty to six securities and reporting violations but was never convicted of racketeering or insider trading. Milken was sentenced to ten years in prison and permanently barred from the securities industry by the Securities and Exchange Commission. After the presiding judge reduced his sentence for cooperating with testimony against his former colleagues and good behavior, he was released after less than two years.[

Fall of Drexel Burnham Lambert

• While only the parent company sought protection under Chapter 11, no one expected the investment firm to rise from the ashes. In an industry that operates on trust and good faith, Drexel had exhausted its reserves. The move meant that Drexel, whose financial wizardry reshaped corporate America and ushered in an age of runaway debt and excess, will swiftly liquidate its business. The 152-year-old titan -- with 5,300 employees and $3.6 billion in assets -- will vanish almost overnight in the biggest failure in Wall Street history.

• Time, 26-02-1990

http://www.time.com/time/magazine/article/0,9171,969468,00.html#ixzz1GqrogZUy

Shareholder Value Model

Principal-Agent problems can be mitigated by governance reforms (functioning of board of directors, structure of executive pay etc).

Key problem, institutional investors completely committed to trading their holdings.

Difficult to argue that shareholder interests are paramount.

LBO Mark 2; the epigones

The 1980s LBO boom came to a fairly rapid halt,killed off by scandals involving junk bond traders and by a

modest turn down caused by risinginterest rates, which led to some well publicised defaults on

businesses where 90 per cent ormore of the purchase consideration had been borrowed.

However, falling rates of interest inthe late 1990s led to the reincarnation of LBOs as private

equity with business journalistsrepeating the same schtick about how private equity could

solve agency problems.Froud and Williams

Value Extraction – part of the models

LBO Mark 1: Greenmail; use of junk bonds;Shareholder Value: Dividend hikes, share

buy-backs; as a second best solution, even acquisitions

LBO Mark 2: asset sales; substitution ofdebt for equity;Rationale: capital market as best allocator of

funds; corporate indebtedness makes financial constraints tight.

Value Extraction – distributional issues

“the legacy effect of private equity is likely to be a cultural shift which normalises value capture insofar as it helps to institutionalise and normalise value extraction for the few as a practice and motivation for investors and managers within and beyond the Anglo Saxon economies.

Froud and Wiliams

Measuring PE

Because of leverage, the value of assets managed is much greater than the value of PE investments.

Edhec cites Strömberg (2007) who estimated that by 2007 PE firms worldwide had acquired almost 14,000 companies worth nearly $3.6 trillion.

A Leverage Cycle (EVCA yearbook)

Funds Raised Divestments at Cost

Billion euro

2001 40.0 24.3

2002 27.5 27.6

2003 27.0 29.1

2004 27.5 36.9

2005 71.8 47.1

2006 112.3 71.2

2007 79.9 72.2

2008 79.9 54.3

2009 17.5 24.0

2010 20.0 42.6

Targets Increasingly Ambitious over the cycle

Leverage Cycle in Britain

More money and bigger targets:

Overall Trends of Buyouts/Buy-ins: UK

Significance of Capital Market Conditions for Private Equity

Performance

“ Contrary to some arguments by fund managers,our results show a close connection between public and private equity: the average stock-market return over the life of an investment has a significant impact on IRR.” (Edhec study)

“Venture” versus “Buyout and Growth”

Employment Relations Concerns relate to Buyout.

EVCA puts total Venture Capital raised in 2010 at €3.31 billion. “Growth” is put at €2.56 billion, “Mezzanine” and “Generalist” together at €2.60 billion.

“Buyout” dominates at €11.52 billion.

Edhec Study

Two principal findings:

1. Significant Diseconomies of scale among PE firms: the more investments a PE firm is investing in, the lower the rate of return from each investment it makes.

2. Rate of return is much higher on the “quick flips” – investments held for less than two years.

Rewards do not reflect Diseconomies

• “If PE is now operating in more difficult times, it is hard to be sorry for the PE general partners. They have run PE funds under the standard fee system with a flat 2 percent on funds managed and a ‘carry’ of 20 percent on all profits once a hurdle rate is reached. As with CEO pay and firms, the connection between these returns and performance is weak while the connection to size of operation is strong.

(Folkman et al.)

Edhec study: duration and returns

Period Held Number of Investments

Median Rate of Return

Median Duration of Investment

(years)

0-2 years 903 85% 1.33

2-3 years 1,557 38% 2.42

3-4 years 1,289 27% 3.42

4-5 years 993 17% 4.35

5-6 years 734 16% 5.42

> 6 years 1,347 8% 7.42

Unknown (often bankrupt)

630 -45%

LBO returns (from Edhec)

Median Rate of Return (%)

0

10

20

30

40

50

60

1986 1988 1990 1992 1994 1996 1998 2000 2002 2004

Cui Bono? (1)

• “Private equity funds are illiquid and are risky because of their high use of debt; furthermore, once investors have turned their money over to the fund, they have no say in how it’s managed. In compensation for these terms, investors should expect a high rate of return. However, though some private equity firms have achieved excellent returns for their investors, over the long term the average net return fund investors have made on U.S. buyouts is about the same as the overall return for the stock market.”

Harvard Business Review

Cui Bono? (2)

• “Private equity fund managers, meanwhile, have earned extremely attractive rewards, with little up-front investment. As compensation for taking the initiative in raising money, managing investments, and marketing their benefits, they have structured agreements so that a large portion of the gross returns – around 30%, after adding management and other fees – flows to them.”

• Harvard Business Review

Labour Movement Critique (1)

• Socialist Group in the European Parliament:“LBOs increasingly tend to recover their

investment not just by its sale after restructuring but by immediate special dividends out of new debt, recapitalisations and very high consulting fees. This has a negative effect on the capital base, the cashflow and the creditworthiness of the company. From this follows he danger of under investing in productive assets, markets and R & D undermining the long-term prospects of the company.”

Labour Movement Critique (2)

Andrew Watt, Some of the criticisms found in the media

or political speeches may be one-sided or exaggerated or ignore countervailing effects elsewhere in the economy. An efficient market economy clearly needs pressures on owners and managers to optimise productive efficiency, and PE can rightly claim to be one vehicle for this.

Watt, concerns (1)

• Cuts in employment and pay, increased intensity of work and worsened working conditions in target companies in order to generate higher returns to owners;

• Related to this, negative impacts on workers’ representation at the workplace, on information and consultation rights and collective bargaining more generally;

• Shortfalls in corporation tax revenues and a distorted playing field both between companies resulting from the tax deductibility of interest payments;

Watt, concerns (2)

• Due to the taxation of carried interest as capital gains income, further tax revenue losses, which in turn promote inequality and is perceived as unfair, reducing citizens’ willingness to pay tax;

• Increased risk of insolvency (at the micro level) and heightened instability of the financial system (macro level) due to the use of leverage;

• The prevalence of a short-term orientation (in PE firms, with knock-on effects to other companies) that depress real longer-term investment in real assets and human resources (training);

Watt, concerns (3)

• Substantial risks to workers’ pension funds in investing in PE, which also run the risk of pitting (retired or elderly ) workers against (employed, younger) workers;

• Conflicts of interest and market abuse, such as collusion between PE firms and incumbent management and efforts to drive down the share price prior to purchasing the target company, etc.; and

• A reduction in the transparency of the corporate sector, leading to a loss of socially valuable data, resulting in particular from the taking private of publicly listed companies.

Conclusion

Corporate Power is not a principal-agent problem: shareholders and institutional investors are not principals.

Capital markets cannot be the arbiters of institutional development because:

• Their criteria are too narrow

• Their valuations are unstable and frequently misleading.

Conclusion

• Inescapable public interest in restructuring

• Need for financial system to reflect and enforce social priorities.