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If you want a good illustration of what’s going wrong with this stage of the private equity cycle, take a look at National Grid. The energy and telecoms network operator hasn’t yet received an unwelcome bid, but it fears it might. So it’s taking steps to forestall one – steps that show up everything that’s short-sighted and value-destroying about the current buy-out mania.
We’ve been fans of National Grid for quite a while, since it seems to be the outstanding firm in the generally overpriced UK utilities sector. It has a substantial, adequately-covered dividend. It’s highly defensive, since it operates gas and electricity transmission networks. But it also has a decent growth business, in the shape of its mobile phone masts business. And its debt load is far from oppressive.
Overall, it presents a very attractive investment case. Or rather it did until today. Because very soon, the last two plus points will no longer apply…
The firm is to sell or spin off ‘non-core’ operations, including the masts business and Basslink, an underwater power connector between Australia and Tasmania. The proceeds – or at least £1bn of it – will be returned to shareholders through share buybacks.
From our perspective, there are two problems with this. It may make sense to divest Basslink – given that NG is focused on the UK and the US, the business is arguably a distraction. Analysts estimate that it’s worth a handy £300m; it seems a reasonable idea to extract this cash and put it to work elsewhere. However, spinning-off the fast-growing wireless sector should be a no-no. It’s this combination of defensive and growth businesses that make NG stand out.
But even if you think that paring down to gas and electricity makes sense, the cash should not be returned to shareholders. At present, NG has little debt; but its upcoming acquisition of Keyspan in the US will change that. To us, it makes much more sense to use any disposal proceeds to reduce the debt burden it needs to take on.
That’s not to knock what the NG board are doing. They know that the market, trapped in a spiral of merger-mania, doesn’t see it this way. Unless NG flogs assets and takes on debt to make major payouts, some private-equity outfit will buy it and do the same – in fact, a buyer would probably look at breaking the whole group up. By squeezing out any easy gains, NG improves its chances of keeping out of their clutches.
We wish we could say we’re surprised by these nonsensical developments, but we’re not. In theory, private equity is about buying private firms or struggling public ones, putting them on a sound footing and floating them. But at this stage of the cycle, these principles are being trampled underfoot by a rush of money demanding to be invested.
Of course, there simply aren’t that many good investment opportunities around. But almost no firms are prepared to admit this, hand back cash and forgo their fees. Instead, they look for any home for the money; the game becomes about buying sound firms, breaking them up, loading them with debt and hang the consequences.
Many established members of the industry don’t like the ways things are going either. Earlier this week, the always-outspoken Jon Moulton of Alchemy Partners told a conference in Paris that he was concerned about the amount of debt many buyouts are carrying.
Moulton reckons that about 200 companies in Europe have undergone leveraged recapitalisations, in which the backers pile on more debt to extract their dividends as quickly as possible. At this stage of the business cycle, that’s not presenting many problems. But when things get tougher, these companies could struggle to service their debt load – and their owners, having already got their money back, may bail out on them.
“These companies could be left for dead,” says Moulton. Not only will it be bad for the companies involved, but it will present a “terrible political picture” for the private equity industry to have these “headless chickens” flapping about.
It’ll take some time for these excesses to unravel completely, although probably not that much longer before the process gets underway – Moulton reckons we’ll start seeing the first defaults next year. But when it does, expect it to get very nasty.
Turning to the stock markets…
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In London, the FTSE 100 was given an afternoon boost from weak US inflation figures and closed 25 points higher, at 6,254. National Grid was the biggest riser of the day on its anouncement of plans to invest heavily over the next few years and to sell off non-core operations. For a full market report, see: London market close
Elsewhere in Europe,the Paris CAC-40 closed 5 points lower, at 5,505, whilst the German DAX-30 was 12 points higher, at 6,443.
On Wall Street, the Dow Jones ended the day 54 points higher, at 12,305, with aerospace company Boeing the day’s best performer. The Nasdaq recovered from a weak start to close 6 points higher, at 2,449. And the S&P 500 ended the day 3 points higher, at 1,399.
In Asia, the Nikkei closed at 16,091 today, a 72-point fall.
The price of crude oil fell by over 4% yesterday on reports that OPEC is to exceed its production targets. Crude was trading slightly higher again this morning, at $56.40, whilst Brent spot was at $56.86 in London.
Spot gold fell by as much as $6 yesterday to $616.10, but was back up to $618 an ounce today.
And in London this morning, nuclear power producer British Energy posted lower-than-expected first-half earnings of £481m. The company has been forced to close some of its plants for inspection and repairs, cutting output. It was also announced that chief nuclear officer Roy Anderson is to leave the company. Shares in British Energy fell by as much as 6.5% in early trading today.
And our two recommended articles for today…
Are there really no risks left in the financial system?
– What was notable about the market reaction to both the recent coup in Thailand and North Korea’s nuclear tests? The risk premiums on both Thai and South Korean bonds fell. So is there really no substantial risk left, or is something wrong with the pricing structure? To find out more, see:
Are there really no risks left in the financial system?
Who will profit from the new internet revolution?
– Rupert Murdoch’s controversial $580m acquisition of social networking website MySpace last summer now looks like a very canny move indeed, following a lucrative advertising tie-up with Google. But it faces tough competition from competitors such as Facebook and Bebo. So what exactly is social networking? And – more importantly – how can these sites be used to make money? To find out, see our investment briefing – just available to non-subscribers:
Myspace: herald of an internet revolution?