CompareShares.com.au - investment news

Shares
Private equity locusts at the gate
Karin Derkley - June 19, 2007

Every week it seems there is some news of a fresh private equity take-over bid, inevitably accompanied by a warning that it will all end in tears – not just for private equity firms, but for the financial system as we know it. Some commentators are talking of a repeat of the “Barbarians at the Gate” of the late 1980s, named for the book that chronicled the $25 billion leveraged buyout of RJR Nabisco by private equity firm KKR.

This time they’re called “locusts”, swooping on some of our best loved – if not always best run – icons such as Qantas and Coles, and gobbling up others such as Rebel Sport, Cleanaway and Flight Centre. Private equity deals in Australia totalled $29 billion last year – up from an average $1 ½ billion a year in the previous ten years, and an eight-fold increase in the value of leveraged buyouts on the global scene in the last five years.

In the UK the Financial Services Authority is keeping a close eye on private equity developments, and here in Australia the RBA is being similarly vigilant saying that, if the process continued, corporate debt levels could be a bigger risk to the economic and financial system than they have been for 20 years. An ABC background briefing late last year quoted Westpac’s David Morgan saying: “we are very, very wary about the private equity segment, have very low exposure to it, and are approaching it very, very cautiously”.

A portfolio manager at global funds manager Lazard Asset Management, Philippe Tison, said recently that we are at the top of a very hot bull market for private equity. “Opportunities for good private equity deals are becoming rarer and managers are taking bigger risks in order to compete for them”, he said. “You have to wonder whether this is as good as it gets. And the question is: Is the firehose of private equity still going to be gushing after the first private equity disaster?”

But are we really at the brink of private equity disaster? Or are the takeover threats just what the doctor ordered to whip Australia’s inefficient listed companies into order? And has the wave of private equity takeovers still got further to run?

A recent report by Russell Investment Group, one of the world’s biggest investment firms, points out that despite the recent boom private equity activity still accounts for only a small proportion of the sharemarket. In Australia for instance the $29 billion of takeover activity last year amounts to less than 2.5% of Australian market capitalisation. Even if the Coles and Qantas deals had succeeded, they respectively comprise about 1.4% and 0.7% of the S&P/ASX 300 and the takeovers, while significant, would not have overwhelmed the market.

The report also puts the debt levels on private equity deals in perspective. Private equity firms are typically highly leveraged, borrowing up to 70% of the value of the deal to make the acquisition (compared to gearing levels of around 30% for listed companies). While credit is cheap this is not such a problem. But the fear is that if interest rates should tighten, there may be defaults by private equity firms on their huge loans, with a flow-on effect to lenders.

But the increase in gearing is against a backdrop where corporate borrowing is arguably too low, the Russell report says. The ratio of debt to equity in listed companies in Australia has been slowly pulling out of the five year slump that followed the tech crash, and is still below the levels of most of the 1990s and well below that of the late 1980s. With private equity deals still a small proportion of the market, the higher leverage involved is not likely to make too large an impact, even in a worse case scenario, the report says.

In fact both Russell, and other commentators, argue that the threat of private equity takeovers is doing the Australian market a favour. The chief economist of AMP Capital Investors, Shane Oliver, for instance, says the current wave of private equity deals are playing an important role of forcing Australian businesses to become more efficient.

“The threat of takeovers keeps companies on their toes to make sure they make the best use of resources for shareholders”, Oliver says. Private equity firms swoop on companies that they believe are worth more than the low valuations they are trading at, so lazy inefficient management are the ones that have most to worry about.

Private equity ownership of a company usually results in a higher level performance because it is freed from the constraints of shareholders reluctant to support changes that may dilute short term returns, says Oliver. “When a firm goes private, management doesn’t have to worry about getting shareholders offside when it is restructuring, or increasing investment. Private equity firms are expert at turning inefficient companies around.”

Which doesn’t necessarily mean that private equity firms strip companies of their assets and sack their workers, leaving a skeleton that they then foist back on the listed market, Oliver says. “Asset stripping would make a profitable exit very difficult. Private equity is usually about empowering existing management teams to get it right, not about slash and burn.” Which is why some management teams, such as Flight Centre, Seven and PBL, have been only too happy to agree to a takeover proposal.

As for the fear that private equity takeovers reduce the depth and quality of listed companies that can be invested in by shareholders, the Russell report points out that takeovers are part of the natural cycle of sharemarkets, “New equity is raised and takeovers occur as a matter of course in equity markets,” it says. And ultimately, the made-over companies are returned to the market, as private equity investors seeks to crystallise their gains.

Far from being at the brink of disaster, all the signs are there that the private equity phenomenon has further to run, according to Oliver. “We have a relatively benign environment of low inflation and reasonable growth, which should ensure that that the cost of capital remains low and the return on capital remains high.”

Then there’s the fact that we’re worried. The sharemarket climbs a wall of worry, Oliver likes to say. The same goes for the private equity market. While there’s angst in the air, things are okay. It’s only when we’re all cheering thinking the party will never end, that it’s really time to worry.

For shareholders the trick is to be invested in the next takeover target. Look for companies with good cash flows (needed to pay the interest bills on those big loans) that are clearly underperforming their potential, and sit tight in the hope that before long it will be unearthed by one of the locusts.

Whatever your views, you can discuss this article - or any of Karin's articles - on our message board Your 2 Cents.

Karin Derkley is the former deputy editor of Personal Investor magazine, and continues to write for The Age and AFR Smart Investor. She is author of “Buying & Selling Your Home for Dummies,” published by Wiley Australia.