The private equity business is in the spotlight again in the UK, and as usual not in a good way. Care home operator Southern Cross was owned by Stephen Schwarzman's Blackstone Group, one of the oldest and best-regarded private equity firms, for a few years during the Noughties. Now it's struggling for survival. In the usual private equity way, Blackstone loaded the company up with debt by means of a sale-and-leaseback of Southern Cross's entire property estate, then exited via a public flotation in 2006, pocketing a huge profit: Blackstone admits that it put in £500 million and took out £1.5 billion.
The business model, if you can call it that, worked fine as long as revenues held up. However, as local authorities and private insurers look to cut their spending on care for the elderly, Southern Cross's revenues are falling far short of the sums it needs to meet its massive rental obligations. Its survival depends on convincing its landlords to accept a 30% cut in payments. Since the properties were sold to about eighty landlords in order to maximise (Blackstone's) revenues, it's going to take a Herculean effort to stop it all from blowing up. A collapse would inevitably leave the taxpayer to pick up the pieces, since it's inconceivable that the government could allow thousands of seniors to be pitched onto the streets.
The key characteristic of private equity is this: there's almost no equity in it, or at any rate no more than smallest amount, for the shortest time, that the owners can get away with. Private equity makes its money by leaving businesses with a dangerously thin equity cushion and a whole lot of debt, then moving on to the next opportunity. As soon as something goes wrong in the underlying business, the balance sheet proves unequal to the strain. Southern Cross is a good example. In an ageing society, elder care looks like a sure-fire cash cow. However, the business model imposed by Blackstone relied on the company keeping virtually all its beds occupied all the time, and on local authorities and insurers paying fees that rose in line with inflation. Now that those conditions are not being met, the company has been brought to its knees.
It's not just private equity that's loaded everything up with debt, of course. In fact, thanks to the tsunami of cheap money unleashed by central banks, it's been one of the underlying themes of the past two decades. NINJA mortgages in the US*, no-down-payment home loans in the UK, ghost estates in Ireland, overdevelopment on the Costa del Sol -- they're all symptoms of a world in which go-go bank lending replaced the discipline of people actually having to put some of their own money at risk in order to get rich.
This has all sorts of implications for public policy. Consider the banks, now being forced into keeping much larger capital reserves. A key reason for this is that they will, until the balance between debt and equity in the overall economy is restored to more normal levels, be carrying equity risks that would be more appropriately carried by their borrowers.
Or consider the planned health care reforms in the UK. The hope is that private providers will begin to compete more actively with the NHS for taxpayers' funds. This is exactly the kind of business that the private equity sector loves -- quasi-utility business, predictable and growing cash flows. Just like Southern Cross used to be, in fact. If the reforms go ahead -- a big IF, perhaps, but who knows? -- the government is going to have to be very careful who it deals with.
* Here's a useful phrase, picked up from the Elmore Leonard-inspired US series "Justified", to keep in mind as the UK housing market stagnates. A mortgage in excess of the value of the underlying property is "upside-down". Much more expressive than "negative equity" -- thanks, Elmore!
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