From the Editors
How private equity companies are allowed to buy a business using its money in highly lucrative deals at the expense of the employees, the taxpayer and people’s pensions
Five years ago, an American businessman Malcolm Glazer
bought Manchester United, at the time the most successful football club in the
world. The sale was, to put it mildly, not popular with the supporters. That’s
partly because they would have preferred the club to remain in English hands,
but mostly because the takeover left it with a debt of more than £700 million.
In the year ending June 2010, for example, the club made an operating profit of
£101m but a loss of £84m when interest charges and the cost of restructuring
the debt were added on. Meanwhile, ticket prices have almost doubled since the
takeover. But while the club and its supporters are worse off than before, in
the three and a half years following the takeover, the Glazer family took out a
total of £22.9 m in fees and loans.
Why was it the club, and not the
new owner that took on this massive debt? Can you really buy a company using
its money instead of your own? The answer is yes, if you use a ‘leveraged
buyout’, a device that has become quite common over the past 30 years. Like all
takeovers, leveraged buyouts can work to the advantage of the company, but more
often they do not. They do, however, generally make a lot of money for everyone
involved in the deal, especially the new owners and the accountants and lawyers
who arrange the purchase.
It’s the rest of us that lose.
How the trick works
To see how this can happen, imagine a private equity company
which we call RealCo to indicate that it has real owners and does real
business. The term ‘private equity’ tells us that it does not buy and sell
shares on the stock exchange as most investors do. It either invests directly
in unlisted companies or, if a company is publicly traded, it will aim to buy
it out completely and then delist it. RealCo will probably hold any company it
buys for no longer than three or four years; it is not interested in long term
investment. It is looking for businesses that are essentially sound and from
which it believes it can make a large profit in the short time before it sells
RealCo has identified one such
company, which we call TargetCo and which it can buy for £500 m. It has £150 m
available for the purchase, and so you might expect it to simply borrow the
other £350 m. It would then own TargetCo outright and have a debt of £350 m.
The buyout would be called leveraged because while RealCo invested only £150 m,
any gain it made (or loss if things went badly) would be a proportion of £500 m.
There’s nothing new about this so far; you and I do much the same thing when we
buy a house. Suppose you make a down payment of £25 k on a £100 k house and
take out a mortgage for the rest. If house prices subsequently double, you can
sell the property, pay off the mortgage, and walk away with a total of £125 k,
five times what you started with, not just twice.
In the world of finance, however,
you can do even better than that. Instead of
borrowing money on its own account, RealCo sets up a wholly owned subsidiary,
VirtualCo. It puts £50 m as capital into VirtualCo and lends it a further £100
m. VirtualCo then borrows £400 m from other investors to make up the total it needs.
It is VirtualCo that buys TargetCo.
Naturally these deals are
arranged by staff from RealCo, and because they are doing this not for
themselves but for what is legally a different company, RealCo charges a £50 m
fee. You may think this a bit pricey, but financial consultants and advisers
are typically very well rewarded for their efforts. In any case, the only
people in a position to object are the directors of VirtualCo and they are
hardly likely to say anything as they were put in place by RealCo.
now has no cash at all, but it doesn’t need any because it isn’t actually doing
anything; it is a shell company, only a front for RealCo. It has debts
of £500 m that have to be serviced, and only one way of doing this: drawing on
TargetCo’s assets and income. Because it owns TargetCo outright, there is
nothing to stop it taking out as much as it needs. Thus while the debt
is legally with VirtualCo, for all practical purposes it is TargetCo that has
taken it on. Until the debt is paid off, TargetCo will have less money than
before to carry on and expand its business. And that is exactly Manchester
RealCo, on the other hand, is
debt free, and it should be able to recoup its investment long before VirtualCo
pays off what it owes; it has only to sell or mortgage £100m of TargetCo’s
assets to do this. Even if TargetCo goes to the wall, which is more likely than
before because of the large debt burden it is carrying, the most RealCo could
possibly lose is the £100 m it loaned to VirtualCo. Thus the buyout is
leveraged much more in one direction than in the other.
That is basically how the
trick works, but there are other issues. The outside investors will demand
some sort of guarantee that RealCo will not immediately take so much money out
of TargetCo that it collapses before they have been paid back. What happens
after that is of no concern to them. It does matter to RealCo but only if it
can make more money by selling TargetCo, or what remains of it, as a going
concern than by selling off its assets. It matters much more to TargetCo’s
employees but of course they have no say in this.
When the price is being decided,
the key players on TargetCo’s side will be its CEO and directors and the fund
managers of the institutions, many of them pension funds that are major shareholders.
If the CEO sees the prospect of a large golden handshake when the deal goes
through and the fund managers are looking forward to substantial gains boosting
their next quarterly performance statistics, they may be a lot keener to see
TargetCo sold than if they owned the company themselves. They have little
incentive to hold out for a higher price; on the contrary it may be in their
interests to see the firm valued at well below what experts believe it to be
Of course if there are winners,
there have to be losers, and here it is the people who would have had the
prospect of higher pensions if their fund managers had insisted on a better
Another consideration is the tax
position. As a successful business operating in the UK, TargetCo was paying a
significant amount of corporation tax. After the buyout, it is making little or
no profit because of interest charges. In principle this shouldn’t matter to
the Treasury because the investors will be liable for tax on the payments.
That’s only true, however, if the investors pay tax in the UK, and most of them will either be foreign or will have organised their affairs so as to avoid UK taxes. Thus the taxpayer too is losing out.
What has happened to Manchester United (and also Liverpool) is by no means unusual. It’s just that football is a high profile business, and
when the money that should have been invested is siphoned off, the consequences
are there for all to see. Only people who read the financial pages know that AA and Saga, two well-known UK companies that
were taken over by private equity and then merged, made a substantial profit in
2009 that interest payments turned into a loss of £529 m despite a squeezing of
workers’ pay and pension benefits. You
can get an idea of the scale of the problem from the fact that in 2006 private
equity firms bought 654 US companies for $375 billion. There have been
fewer such takeovers recently because it’s been harder to borrow money, but,
just like bankers’ bonuses, we can expect private equity to bounce back long
before the real economy recovers.
It’s not easy to find a way of
protecting businesses from having their assets diverted into the pockets of
private equity companies – vampire capitalists, we might say. But that’s no
excuse for not addressing the problem. Governments could make a start by
looking at the whole issue of shell companies, which are also used to avoid or
evade tax, to escape regulation, or as parts of complex webs of ownership that
make it effectively impossible to prove or even to find out who is responsible
for anything that happens.
We thank Rod Dowler for his advice and for suggesting the
Fully referenced versions of this editorial and all
articles are available on ISIS members website: http://www.i-sis.org.uk/sismembers.php