The mysteries of private equity

By Michael Robinson
BBC Radio 4

Mr Moulton said the private equity business has been transformed in the last seven years

Private equity is the business of dealing in companies: buying them, shaking them up and later selling them on at a profit.

In recent years, private equity profits have boomed and money from institutions like pension funds has poured into the sector.

Jon Moulton, Britain's best known private equity operator, first hit the headlines in 2000 when his company Alchemy Partners tried to take over the then ailing car manufacturer Rover.

Since then, he says, the private equity business has been transformed.

"The institutions have provided the industry with funds of £10bn ($20bn) and if you've got a £10bn fund you do need to go 'elephant hunting'," he says.

"So the guys are out 'elephant hunting' and ever larger targets are being done."

Personal gain

The biggest "elephant hunter" of all in private equity is Kohlberg Kravis Roberts, better known as KKR.

This summer the giant American firm came hunting in Nottingham. Its target: Alliance Boots, the city's most famous business and Britain's biggest pharmacy.

Alliance Boots is the UK's biggest private equity buyout

KKR bought Boots for £12bn after a fierce bidding battle, and a tussle with Boots' pension trustees over a deficit in the fund.

Existing shareholders were delighted - they got a healthy windfall profit.

KKR is happy to point to the above-average returns they have already produced for its current pension fund investors, but is reluctant to talk about how much the firm's elite - the so-called "general partners" - could gain personally if the takeover proves a long-term success.

Given the political storm this year over the how much private equity chiefs earn and how much - or little - tax they pay, this raises two key questions:

What return do KKR's partners stand to make from the Alliance Boots takeover, and how does it compare with what their pension fund investors might get?

This depends on how much KKR's partners have invested in the takeover and what share of their investors' profits they are entitled to when Alliance Boots is eventually sold.

It's a very competitive environment and I need to persuade them to take my money rather than the money of another pension fund round the corner Chris Hitchen, pension fund manager

KKR declines to answer either question, though using the best information available, the BBC has made its own rough estimate of the potential returns.

The estimate is based on a few assumptions.

One, that KKR's partners have invested £80m - a number suggested at a hearing of the Treasury Select Committee.

Two, that they are entitled to a 20% share of the profits - a share common in private equity.

And three, that KKR's investment in Alliance Boots would grow at 23% a year - less than the average returns KKR claims to have produced over many years.

Calm investors, concerned workers

The results are startling.

If Boots were sold after five years, KKR's investors would get back two and a half times as much as they had put in.

We've seen levels of gearing increase to a level where in some cases we find it irresponsible Peter Taylor, Duke Street Capital

But because of the effect of a 20% profit share, KKR's general partners' £80m would have multiplied 11 times.

After 10 years, the gap would be wider still. The investors' initial stake would have multiplied six and a half times, whilst the general partners' £80m stake would have grown to £3.2bn - 40 times the investment we assumed they started out with.

Having seen the estimates and calculations, KKR declined to comment.

Pension fund managers have been criticised for allowing private equity operators to take such large shares of the profits from their deals.

But Chris Hitchin, who runs the massive Railways pension fund, says asking private equity managers to take less has not been an option.

"It's a very competitive environment," he says, "and I need to persuade them to take my money rather than the money of another pension fund round the corner."

So long as private equity firms make money for his pension fund's members, Mr Hitchin says he is "less concerned if some people are getting very rich".

But the general secretary of the trade unions' body TUC, Brendan Barber, is concerned about the potential level of personal rewards from a deal like Alliance Boots, which he says bear no relation to the money originally staked by the general partners.

It is, Mr Barber says, "part of this sense of ever-increasing inequality of a super-rich elite floating free from the rest of society, somehow divorced from the problems that all the rest of us face in the real world".

Highly geared

Some private equity bosses are forthcoming about their business, and about some of the key pieces of financial engineering which underpin its operation.

One such concept is gearing - so-called, according to Duke Street Capital chief Peter Taylor, because it gears up the returns private equity investors would otherwise get.

Provided they [most banks] don't hang on to the loan, they just can keep on: originate, originate, originate, take a fee, take a fee, take a fee Hugo Dixon, editor of BreakingViews.com

For instance, explains Mr Taylor, suppose he invested £30m buying a company and the value of the company doubled to £60m. That would be a £30m profit to investors - doubling their money.

Suppose instead, however, that he had borrowed £70m to add to the £30m from his investors, thus buying a £100m company instead.

If that company doubled in value to £200m he would be able to repay the £70m loan and have £130m profit for his investors - more than four times their original stake.

"The higher the borrowing," Mr Taylor explains, "the higher the gearing effect on our returns."

Not prudent

Since the personal rewards for private equity bosses depend on the returns they produce for their investors, it is not surprising that the amount of borrowed money in private equity deals has been increasing sharply.

Mr Taylor believes it is risky to borrow more than five times a company's basic cash flow.

The amount of money raised gets bigger, therefore you can go for bigger targets and the whole thing snowballs upwards David Matson, IKB Fund Management, London

"We've seen levels of gearing increase to a level where, in some cases, we find it irresponsible," he says.

"There are now a lot of deals being done in the markets with borrowings at seven, eight, even nine times cash flow.

"We think that's too high. We think there are risks being taken there."

Mr Taylor says he is now being offered more debt than he thinks it is prudent to take on.

Transaction fees

But where is the money coming from to fund the huge debts private equity is taking on?

Private equity profits have boomed

Banks used to worry about how much companies borrowed.

That has changed, and according to Hugo Dixon, editor of financial analysis website BreakingViews.com, there has been a sea-change in the way most banks now do business.

"In the old days, what would happen was that banks would make loans to companies and then they would keep those loans on their balance sheets," explains Mr Dixon.

"If something went wrong with the company, the bank would face a loss on its loan."

Nowadays, he adds, most banks make money from fees for arranging or originating private equity loans, which they then sell on to get the loan off their books.

"Provided they don't hang on to the loan, they just can keep on: originate, originate, originate, take a fee, take a fee, take a fee."

Risk level

Dig deep in the undergrowth of modern financial engineering, and it soon becomes clear where the risk ends up.

There is a channel for the money private equity borrows that is now more important than the banks: the impenetrably named Collateralised Loan Obligation, or CLO.

CLOs hoover up bank loans to private equity companies. Because the loans are mostly to highly-borrowed companies, they are rated as risky.

By a fiendishly-complex computerised process, CLO managers reapportion the risk into a series of slices.

Each slice offers a different level of risk and reward: from minimal risk with a small return above the base rate to high-risk slices offering extra interest of 15% or more.

The slices are then sold to investors around the world - pension funds among them - in turn funnelling yet more cash into private equity.

David Matson, a top CLO manager with IKB Fund Management in London, says the CLO market has been growing almost exponentially in the past three or four years.

"The more people that entered the market," he says, "the more money that was raised and therefore you had more money to invest."

From the point of view of private equity operators, cheap, abundant loans make ever-larger deals possible, Mr Matson says.

"The amount of money raised gets bigger, therefore you can go for bigger targets and the whole thing snowballs."

Funds collapse

But trouble across the Atlantic means that the powerful loan-pump provided by CLOs for private equity operators may now have started to dry up.

Last month, two large hedge funds operated by the major New York bank Bear Stearns collapsed.

The funds had invested in complex financial structures similar to CLOs, which processed so-called sub-prime mortgages made to Americans with poor credit records, rather than risky loans to private equity companies.

Some of these mortgages were even being marketed to what came to be known as "ninja" customers - standing for "no income, no job and (no) assets".

After the Bear Stearns funds got into trouble, investors began to realise there could be more risk in complex financial structures like CLO than they had realised, explains Mr Ross, a craggy billionaire veteran of Wall Street.

"When the sub-prime problem first started to show, almost every major financial institution very proudly said 'well, its not going to affect us. We don't have any.'

"And then it turns out they all have some and in many cases it was very big. Now, I don't feel that the executives were lying when they said what they said. I think the really scary thing is they did not know that they had it."

Lending crisis

As nervousness among lenders rapidly spread, credit for private equity companies has started to dry up.

Boots' bankers found themselves unable to sell off their loans as they had planned and, across the world, massive private equity deals have begun to run into trouble.

Some deals have already been pulled.

In others, private equity operators will have to pay more for their money, squeezing the profits in their already highly-borrowed companies.

As the jitters of the present lending crisis have spread to world stock markets, it looks likely that the golden days of private equity - with huge rewards for relatively low risk - are over.

At least until the next time a cheap borrowing cycle eventually sets in.

You can learn more about the world of private equity by listening to Risk, Rigour and Reward - uncovering the financial mysteries of private equity, on BBC Radio 4 at 2000 BST, Tuesday 7 August 2007 and repeated Sunday 5 August 1700 BST.