By Justin Urquhart Stewart
Seven Investment Management
Much of the rise in share prices that has taken place over the past three years has resulted from companies merging or being bought out.
Justin Urquhart Stewart says not all mergers or buy-outs are good
Private equity firms have been behind much of this wheeler-dealing.
These firms use investor cash to seek out undervalued companies and assets and to improve the effectiveness and success of the targeted companies.
As for the frenzy of private equity, the figures are mind-boggling.
Virtually 80% of the FTSE 100 is being talked about publicly as being involved in mergers, acquisitions and buy-outs.
Borrowing by private equity firms currently stands at £680bn, equivalent to 43% of the total value of all the companies listed on the FTSE 100.
In many cases there have certainly been some very successful turnarounds, where ailing companies who had lost their way had been refocused and returned to the market a far sharper and brighter business than when they left.
According to the British Venture Capital Association companies bought out by private equity firms are returned to profit, often with some jobs being created.
This is the brighter side of the private equity craze.
From some perspectives, there is a less attractive side to the takeover boom.
Of late we have started to see more deals being proposed not simply to "release shareholder value" or "increase balance sheet efficiency" - but rather to buy assets, break them up and sell them off.
Additionally, there are others where it has been proposed to buy the business, load its balance sheet with far larger borrowings (or "gearing up" as it is more politely called) and pay the extra cash back to the new owners.
Does this really increase the effectiveness of the business? Or does it just weigh the company down with the extra cost of more debt and thus reduce its ability to expand in the future?
Such behaviour in the past went by a far less attractive title, which few ever dare repeat today: asset-stripping.
Bond holder woe
Most press and analyst comment about private equity buy-outs tends to ignore the magnitude of the debts being loaded on the companies being acquired.
Loading high levels of debt can have a disastrous effect on the companies' existing bond-holders.
They can find, almost overnight, that the value of their bonds has been seriously reduced.
It tends to be pension and insurance funds which hold large numbers of bonds.
Just as we hear more and more about a pensions crisis, the private equity feeding frenzy has the potential to erode the value of UK pension saving.
No surprise, therefore, that some pension and insurance fund managers are asking for extra safeguards from firms before they buy bonds.
The idea is to protect the value of their bond investment just in case of a private equity firm "raid".
So will the private equity frenzy continue?
Yes, so long as three key elements remain; access to cheaper investment money, confidence from investors and an availability of suitable targets.
Maybe, though, we are seeing some counter-reaction. As markets have risen so there are fewer companies looking quite so appealing with under-valued assets.
The result has been to see a change in the style of certain proposals in becoming more aggressive in their debt loading and cash extraction for the new investors. Perhaps this is the last phase of this fashion.
The latest attack on ITV was repulsed quite possibly as a result of the amount of debt being proposed - and of various bond-holders not being willing simply to passively accept a compulsory reduction in value.
Maybe this reaction may show that such views can go too far - and that the longer term corporate logic may win through.
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