The private equity rollercoaster

Analysis By Toby Poston BBC News business reporter

The private equity industry has seen its share of highs and lows

Even some of the people who work for them have never heard of these immensely powerful companies, with names such as Apax, Blackstone, CVC Capital, Candover and Permira.

Yet these private equity companies are gradually becoming a dominant force in the UK economy.

Already, they have acquired a slew of UK household names such as Kwik-Fit, Debenhams, Somerfield, Halfords and The AA.

And with billions more to spend in 2006, their shopping list is reported to include banking group Lloyds TSB, betting firm Ladbrokes, music company EMI and broadcaster ITV.

Gloom ahead

The private equity industry's rapacious hunger for bigger and more audacious deals led to a huge swathe of corporate mergers and acquisitions in 2005.

This helped propel the London markets, pushing the FTSE 100 index of leading shares up 16% and boosting the value of share portfolios and pension funds.

The private equity firms also earned millions in fees for advisors, bankers and accountants.

But many people are now whispering that this secretive and increasingly important driver of the equity and debt markets could be heading for a major dip.

Bargain hunters

To understand why, it is important to understand how private equity groups work.

In many ways, they operate just like house buyers.

They are looking for bargains: businesses that are undervalued on the stock market or by their owners, companies that are in need of a little "TLC", and firms in up-and-coming areas with real potential.

They usually stump up a bit of money, a deposit, up front, then rely on the bank to lend them the rest.

But unlike most homeowners, private equity firms do not settle in.

They are looking for a quick, profitable sale, usually within three to seven years.

And they do things in relative privacy, often de-listing their acquisitions if they were quoted on any stock market.

This means they can make tough or controversial decisions without having to run the gauntlet of angry shareholders, and without releasing sensitive information because of stock market disclosure rules.

Hence they are accountable only to small groups of private investors and lenders, rather than to stock market investors and company employees, and they do not have to release information to journalists making enquiries into their affairs.

Such apparent lack of accountability has, perhaps unsurprisingly, stirred up considerable resentment from some politicians and business leaders - not just in the UK, but internationally too.

Raiders or saviours?

Private equity groups have been around in one form or another for decades, with groups like Slater-Walker in the 1960s and Hanson Trust in the 1980s.

Such firms became some of the first "conglomerates", hunting down complacent companies and then transforming them with a ruthless devotion to cost-cutting and cash-generation.

Some saw them as corporate saviours, reviving firms and delivering big returns to shareholders.

Others denounced them as corporate raiders and asset-strippers, only interested in quick profits.

Today's private equity firms are after even bigger prey, and tend to buy from each other or via the stock market, rather than by funding management buy-outs.

But the same arguments are still around.

"They get flak for being rape and pillage merchants," observes Geoff Cullinan, senior private equity adviser at consultants Bain and Company, before launching a staunch defence of the private equity firms.

" But if they do get rich, they only do it by making better companies."

Pension fund gamblers

Today's private equity conglomerates can also produce big rewards for their backers, which sometimes include pension fund managers or other large, institutional investors.

Investment fund managers tend to see such deals as high-risk gambles, though high risk can bring about high returns.

Consequently, they often direct a proportion of their portfolios towards such investment in order to outperform stock and bond markets.

A private equity group took over Somerfield for �1.1bn in December

Fund managers typically invest about 3-4% of their capital in private equity funds.

But this money is spread thinly around the private equity industry when compared with the amount of money borrowed from banks.

Research by investment bank Merrill Lynch says that banks will lend around �100bn for European deals over the next three years.

Private equity groups rely on profits from the companies they have bought to pay off such debts.

Traditionally, they borrow an average of five times the underlying profits of the company they want to buy.

Some industry watchers say the level has now risen to an all-time high average of eight times profits.

Walking the tightrope

The more money a private equity group borrows, the bigger the target it can bid for, and the greater the potential profits if it can improve its performance.

Again, it's like buying a house.

The people who make money in a property boom are those who push themselves by taking out a bigger mortgage.

If they sell when the market is rising, they make a profit. If the downturn hits before they have offloaded, the debt repayments can overpower them.

Private equity-owned Debenhams doubled its profits last year

The last time the debt-to-equity ratio was so high was in the late 1980s, when many private equity investments were hit by the eventual economic downturn and rising interest rates.

"It was a tightrope that many people fell off," says Mr Cullinan.

He thinks history could be about to repeat itself.

Many feel that there are now too many private equity groups chasing potential deals and competing with other companies on the acquisition trail.

"When people have too much money to spend, they start overpaying," agrees Richard Sachar, chief executive of private equity advisers Almeida Capital.

Inevitable slowdown

There are some indications that it has already started to happen.

In the space of a week last December, two private equity-owned retail chains - off-licence Unwins and CD and DVD retailer MVC - called in the administrators.

Such stories might suggest that the golden days of private equity will soon be over, but the facts don't yet support this view.

Interest rates are low, stock markets are rising and the total number of private equity receiverships fell in 2005.

But according to Mr Cullinan, a readjustment is inevitable.

You can't have a period of rapid growth without a slowdown at the end of it, and history repeats itself, he argues.

"The history of private equity is one of exponential growth, followed by a crash, then growth again."

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