28/11/2006 - 21:00

No 'magic' in private equity

28/11/2006 - 21:00


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Extreme capitalists argue that private equity is the bee’s knees because it proves that markets can sometimes be wrong in valuing assets, such as Qantas. Briefcase, having considered this view, disagrees. It argues that private equity is increasingly becoming ‘unfit for purpose’.

In the case of Qantas, as with all other private equity deals, the formula is astonishingly simple, as shown in this step-by-step guide:

1) an investment bank, or venture capitalist, argues that an asset is undervalued;

2) it pays too much (because it’s not the bank’s money);

3) the bankers reap a fat fee (or fees);

4) the target is stuffed with debt;

5) costs are cut (code for sacking people); and

6) the bankers exit for the next deal, hoping (but not caring) whether there are enough staff left to run the business.

Older readers will yawn, and then smile, when they understand the ‘magic’ behind private equity because it really is so old hat.

As far back as the 1960s and 1970s, this business philosophy was known as asset stripping, and applied most diligently by clever share market raiders such as Slater Walker, Ron Brierley and the late Robert Holmes a Court.

The key then, as now, is debt…mountains of it.

All that has changed is that the system has deepened to allow mums and dads to play the game by handing their savings to the nice young man at the investment bank who has promised to ‘have a bright idea’ and earn them double bank interest, at least.

But, two recent events in the private equity world stunned Briefcase. First was a study into just how much debt these privateers actually dump on a victim, and secondly a prediction that the end of the game is not far away.

According to Jon Moulton from London-based venture capital firm, Alchemy Partners, the death of private equity could be caused by the number of “headless chickens” left wandering the streets after receiving private equity treatment.

He said, in comments reported by the Financial Times newspaper, that private equity raiders are quick (very quick) to repay themselves (handsomely) after a purchase. Some of the spare cash is created by stuffing the target with up to 11 layers of debt (yes, 11), and once stuffed, the privateers walk away, leaving it to flounder.

Mr Moulton told the Financial Times that: “High leverage levels can be appropriate but there is irresponsible leverage going on. A lack of clarity in the ownership of the risk could create confusion in the events of a default.”

Mr Moulton, who maintains a delightful “devil’s dictionary” of venture capital terms at his website (www.alchemypartners.com – go to articles), told a conference in Paris that 200 of 2,500 private equity backed companies had undergone “leveraged recapitalisations”, which allowed the new owners to “cream off large dividends while simultaneously loading the companies with extra debt”.

“More than half of that [debt] has been issued in the last two years and normally these businesses hit trouble in year three,” Mr Moulton told the Financial Times.

“I think there will be a large number of defaults next year.”

Briefcase, always quick to predict, suggests that the collapse of the private equity phenomena has the potential to do as much damage as any previous stock market crash, because it will represent a significant transfer of wealth, and will make the participants poorer; especially those who are late to the party.

Is there nothing new in life?


Before looking at the other things possibly being ‘unfit for purpose’, Briefcase thought a couple of entries from Mr Moulton’s dictionary might lighten the day.

To the letter D is assigned DCF, which some readers know as discounted cash flow. In Mr Moulton’s dictionary it stands for: deceit by computer fraud – “A highly scientific and extremely unreliable method of valuing companies.”

D is also for: due diligence, “the sometimes optional process of finding out what you’re buying, ideally before you buy it”.

E: is the envy ratio. “The ratio between how much money a management team makes and how many workers they make unemployed. E is also for exit: “The only door a venture capitalist can see”.

O: opportunist. “An oft-quoted criticism of venture capitalists. What the critics don’t realise is that this is the nicest thing said about venture capitalists.”

S: is for stock exchange. “Where large numbers of old economy companies have historically been put out to pasture. A slow lingering death awaits. A happy hunting ground for venture capitalists.”


Now for something much more delicate and a thought that links the worlds of business, politics and health.

Patricia Dunn, the former chairman of the US-based Hewlett Packard computer business, has been charged with (and pleads not guilty to) allegations of boardroom spying, and illegally accessing employee telephone records.

Her actions are said to be out of character, and perhaps they are – when she is healthy.

But, what makes Patricia Dunn so interesting (and her story so sad) is that she has not been healthy. In recent years she has been fighting three types of cancer; breast, melanoma (skin), and ovarian. She is so obviously not well that it is quite possible that her health led to errors of judgment.

The curious aspect of the case is that the owners of Hewlett Packard (the shareholders) were apparently never told of their chairman’s ill health, and that leads Briefcase to ask; when does the ill health of a leader become public property?

No corporate examples spring immediately to mind, but there is a nagging worry that the repeated verbal blunders of Kim Beazley, a man once known for his dexterity with language, might (just might) have something to do with the illness which sidelined him a few years back.

Strenuous denials will be made in defence of Kim, but the Patricia Dunn case is a stark reminder of how health can play a vital role in success.


“G: greedy bastards. That’s management. And us.”  Jon Moulton’s alternative guide to venture capital.


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