ISIS Report 06/09/10

Vampire Capitalism

A Scientist Peers Into the Dark Labyrinths of Neo-Liberal Finance

You might think it’s impossible to buy a business using its money rather than your own, but private equity companies are able to do just that

The deals can be highly lucrative for them but at the expense of the employees, the taxpayer and people saving for their pensions Prof. Peter Saunders

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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 about £700 million. In the year ending June 2009, for example, the £67m interest on the debt turned what would otherwise have been a substantial profit into a £55 m loss, only redeemed by the sale of one of their best players for £81 m. 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 [1, 2].

What most of us find hard to understand is why it was the club, 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 out.

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 them on.

RealCo has identified one such company, which we call TargetCo and which it can buy for £500 m. It has £150m available for the purchase, and so you might expect it to simply borrow the other £350m. 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 £500m. There’s nothing novel about this so far; you and I do much the same thing when we buy a house. Suppose you make a down payment of £25k on a £100k house and take out a mortgage for the rest. If house prices then double, you can sell the property, pay off the mortgage, and walk away with a total of £125k, 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 £50m as capital into VirtualCo and lends it a further £100 m. VirtualCo then borrows £400m from other investors to make up the total it needs.

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 £50m 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. 

VirtualCo 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 £500m 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 United’s position.

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 £100m it loaned to VirtualCo.  Thus the buyout is leveraged much more in one direction than in the other.

Other Issues

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 worth [3].  

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 deal.

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 [4].

Conclusion

While the Manchester United buyout has attracted a great deal of media attention because of the club’s high profile, it is not an unusual case.  In 2006, private equity firms bought 654 U.S. companies for $375 billion [5]. As I write, the papers are reporting that the AA and Saga, two well known UK companies that were taken over by private equity and then merged, last year made a substantial operating profit which interest payments turned into a loss of £529 m, despite a squeezing of workers’ pay and pension benefits [6].

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. Perhaps 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.

I thank Rod Dowler for his advice and for suggesting the TargetCo illustration.

Notes and references

1.  “How the Glazer family have milked debt-ridden United for millions”, David Conn, Accessed 16 August 2010, http://www.guardian.co.uk/football/blog/2010/jan/12/manchester-united-glazers-debt 

2. “10 key questions about Manchester United’s debts under the Glazers”, Owen Gibson,  The Guardian, 13 January 2010, http://www.guardian.co.uk/football/2010/jan/13/manchester-united-debt-glazer-family

3. The share price can be a surprisingly poor indicator of the value of a company. In June 2010, shares in Tomkins, a UK engineering company, were trading at about 250p. A private equity company made an indicative (i.e. preliminary) offer for Tomkins equivalent to 325p a share. The head of equities at Standard Life said he would oppose a deal at that price, which he claimed “materially undervalues the group and its prospects.” Thus experts on both sides agreed that the share price was more than 25 per cent below the real value of the company.  You might remember this the next time someone tries to tell you that the market always knows best.  See “Don’t sell Tomkins on the cheap, Standard Life warns”, Terry Macalister, The Guardian, 22 July 2010. http://www.guardian.co.uk/business/2010/jul/22/tomkins-takeover-offer-undervalues-group

4. Debenhams (a department store group) paid £40 m in corporation tax in its last full year as a listed business, but none after it was bought by a private equity consortium. Peston R. Who Runs Britain? Hodder and Stoughton, London, 2008. p54.

5. "The Private Equity Boom", Robert J Samuelson. The Washington Post, March 15, 2007.  http://www.washingtonpost.com/wp-dyn/content/article/2007/03/14/AR2007031402177.html

6. “Anger over losses of £529m at AA and Saga owned by private equity groups”, Simon Bowers, The Guardian, 16 August, 2010. http://www.guardian.co.uk/business/2010/aug/15/aa-saga-private-equity 

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