Overleverage, short-termism and asset stripping must be countered with progressive policies
Wielding record levels of cash, US private equity (PE) firms are bargain hunting in Britain, buying up more companies in the first six months of 2021 than ever before. The Conservatives champion ‘Global Britain’, however, they allow our assets to be sold to extractive buyers without challenge. The next Labour government must legislate to protect British enterprises. A culture of short-termism in British markets is a driver of decline and progressives must work to build a long-term economic mission for Britain, ensuring the sustainable deployment of public and private capital.
British business is attractive to PE. With valuations depressed by Brexit, a liberal takeover regime, and an emphasis on short-term performance measures across the investment industry, it’s never been a better time to buy British. This hospitable environment encourages the predatory elements of PE. Loading businesses with debt can lead to corporate failure, asset stripping can compromise the long-term prospects of an enterprise, and imbalances between public and private valuations expose the weaknesses of British capital markets. Encouraging long-term thinking by aligning the goals of investors and stakeholders must become a core economic goal of a future progressive administration.
Traditionally, Britain has been a nation of shareholders and public markets have been dominant providers of capital. However, a significant proportion of the economy has now been snapped up by private actors, motivated by depressed valuations and enabled by low barriers to entry. The British stock market has largely missed out on the global boom experienced in the USA and China since 2015. British public markets offer less competitive returns for business. Although the shorter-term volatility associated with Brexit has dissipated, its legacy is one of depressed valuations.
With a backdrop of low interest rates, cheap money provides ample leverage for PE funds. Fund managers prevailing culture of short-termism therefore incentivises executives to seek the quickest financial hit and sale to PE funds yields a quick return on investment. When combining these macroeconomic and cultural factors with an extremely liberal takeover regime, it becomes clear why Britain has become such a happy hunting ground for PE. Just look at preeminent PE firm Clayton, Dubilier & Rice’s acquisition of Morrisons – a company employing 110,000 British workers and holding a 10% share of the UK grocery market. A company of systemic importance that could and should be delivering value to British stakeholders is now controlled by a small group of lightly regulated American investors.
But why is this so bad? To many, ownership by a group experienced investors directly incentivised to grow a business is seen as beneficial to the public. That’s the theory, however, the reality often differs. In short, PE owners can destroy the long-term prospects of a business to deliver returns. The key problems are:
- PE owners often rely on the principle of leverage, sometimes borrowing six times more than the equity they hold in a business. This risk is borne by the target company, not the investor, with such dramatic increases in corporate debt increasing the risk of corporate failures.
- Depressed valuations in public markets incentivise management to sell to PE, as funds commonly offer a premium unlikely to be obtained via public markets. This reinforces a culture of short-termism in public markets.
- It is common for the combined assets of a company acquired by PE to exceed its corporate valuation. Some investors see this as an opportunity to purchase ‘cheap real estate’ that can be sold at market value, with this practice of ‘asset stripping’ intended to fund short term returns.
A pragmatic progressive government cannot simply ban or disincentivise PE investment. However, it must initiate the alignment of shareholder and stakeholder interests in pursuit of sustainable growth. PE, when adequately regulated, is another form of capital deployment that can create jobs and wealth across our country. It simply is a fact that large amounts of private capital have accrued across the global financial system, and a socially productive use must be found for it. A suite of policies is required:
- Progressives must legislate to ensure that PE funds cannot contain risk within portfolio companies; funds must bear substantial responsibility for any borrowing.
- The levels of debt in a portfolio company must not exceed the initial stake taken by a PE investor. Any borrowing must be appraised by corporate lenders to validate financial sustainability, and a principle of risk retention must be implemented to drive up lending standards.
- Parallel reporting requirements should be instituted, with large privately owned enterprise subject to similar reporting standards to public companies. This should be required over a certain threshold, such as annual revenues.
In addition to these policies is shadow chancellor Rachel Reeves’ commitment at Labour Party Conference last year to stop PE executives from taking advantage of the carried interest loophole which sees them pay a lower rate on bonuses.
Pragmatic interventions are required to reorient private equity in a way that works for stakeholders, not just a small group of investors. The UK simply will not remain globally competitive if the deployment of private capital is not encouraged. Bringing together the interests of stakeholders and investors is critical to create a hospitable business environment that works for everyone.