It used to be that when you looked for an investment, you sought out a company you thought had more value in it than the share price reflected. Then you bought the shares and sat back and waited, sometimes for years, for the rest of market to see what you saw. Not any more.
These days, if the internet discussion boards and investment magazines are anything to go by, you look for companies that you think a private-equity company might think has more value in it than the share price reflects.
How well have private equity targets performed?
Then you buy it, but not for so long. The investors that have poured into Diageo (DGE), Wm Morrison (MRW), Unilever (ULVR), Pearson (PSON), British Airways (BAY), Experian (EXPN), BT (BT.A), Scottish & Southern (SSE), Ladbrokes (LAD)and all the others that have been touted as possible private-equity targets this week, are expecting their hopes to be realised not in a matter of years but weeks. They aren’t buying for the long term.
I wonder if this isn’t to look at things in slightly the wrong way. For starters, selling out to private equity is rarely much of a route to riches. The price of shares in Sainsbury did jump 15 per cent in just one day this month when news of an impending bid got out, but a study just published by a US law firm that analysed 50 recent private-equity takeovers found that the buyers paid, on average, only 6 per cent more than the stock’s highest value over the previous 12 months.
That’s a pretty modest premium, particularly given that you know how much the buyers intend to make. Most private equity groups target returns of 15 per cent to 20 per cent a year over anything from three to seven years (which is why the most popular place to work in Goldman Sachs is their in-house buyout funds).
How private equity restructures companies
If I were holding a stock of the kind that private-equity investors are known to like, I think I’d prefer to forgo the 6 per cent and wait for the company to fulfil its own potential. The fact is there is very little that private-equity managers can do to restructure companies that the managers of a public company can’t do for themselves, and one day they may well get around to doing it.
The next part is a bit heavy on numbers but bear with me. Consider the case of a typical listed company with a market capitalisation of about £1 billion and shares trading on a price/earn-ings (p/e) ratio of about 14 times. It has no debt and £50m of cash on the balance sheet. The cash is earning £2m a year interest (4 per cent). It also owns £200m of property that it uses in its business. It generates £100m in profit and pays tax at 30 per cent. After-tax profit is therefore £70m (giving the p/e of 14 times: £1 billion divided by £70m) and the earnings yield 7 per cent.
Say the company decides to gear things up a little to improve its return on equity. It sells its property for £200m and leases it back at a 5 per cent yield (this seems low but is entirely reasonable these days — much London commercial property yields less than 4 per cent). This means it ends up paying £10m a year to rent what was its own property, but on the plus side it gives the company £250m of cash on the balance sheet. The company uses that to buy back £250m worth of shares, cutting its market capitalisation to about £750m.
The company then decides to borrow again and issues £600m of corporate bonds at 6 per cent (in other words, it will pay out £36m in interest on them every year). It uses that to cut its market capitalisation further, to about £150m. We then have a business with equity worth £150m and debt of £600m. Instead of receiving £2m in interest it pays £36m in interest and £10m in rental payments so its profit before tax is reduced by £48m to £52m, or £36.4m after tax. However, since the equity value is now only £150m, this has the effect of slashing the valuation to a p/e of 4 (£150m divided by £36.4m) and raising the earnings yield to 25 per cent. In other words, the equity investors will make their money back in four years rather than 14.
That is exactly what a private-equity investor would have done. Apart from being able to pay themselves more (there are fewer people watching) there is nothing a private-equity manager can do that a public-company boss cannot. There is much muttering about the private sector having an advantage because interest costs are paid before tax, but this situation is no different for a listed company.
Where to find plays on private equity tricks
The key to unlocking value is finding management willing to gear up their companies while the cost of debt is still low, something they mostly haven’t been prepared to do — yet. If you are holding potential targets you should perhaps hope not that they are taken over, but that they start to look to restructure their finances themselves.
One unexpected place where listed companies have begun to use private-equity tricks is Sweden. Barry Norris, manager of the Argonaut European Alpha fund (which has returned more than 20 per cent in each of the past two years), tells me that he sees increasing numbers of Swedish firms taking advantage of low interest rates and strong profits to gear up and pay big one-off dividends to shareholders.
The only simple way for retail investors to take advantage of this (other than getting a diluted exposure via the Argonaut fund) is to buy shares in Investor, a Swedish investment company set up in 1916 and controlled by its founders, the Wallenburgs.
The shares are listed in Stock-holm and trade at a 20% discount to their net asset value (it has been as much as 35 per cent). However, not only has the firm recently sold a variety of assets at a premium to asset value, but, as Barry points out, the managements of the many established listed companies in which it invests have never been this active before.
Merryn Somerset Webb is a former stockbroker and now editor of Money Week. Her views are personal and investors should always seek professional advice.
First published in The Sunday Times 18/2/07