Has Anyone Told Reeves That There's Another City Crash Looming?

The Private Equity Model Is Falling Apart As Interest Rates Rise. Does Reeves Even Know?

The City of London evolved as a swashbuckling centre of finance as England and Wales split from Catholic Europe (which until 1707 included Scotland). By pooling assets, sharing risk and collocating financial institutions with a large port, the seat of government and a vibrant capital The City started generating and distributing serious wealth. Its mettle was tested by the 1720 South Sea Bubble, but it survived.

Having learned the lessons from that crash, The City funded the creation of the British Empire and the Napoleonic Wars. Britain won (in part) by being to outspend the French, which is odd as France is twice the size (more food production) and then had about three times the population (more labour and soldiers). The City of London’s greater ability to raise money meant we not only had naval dominance and well equipped solders, we were also able to pay substantial subsidies to other nations to fight France.

Until very recently The City still had a reputation for innovation and the concentration of expertise to deliver finance where it was required. Parts of it, such as the Lloyds insurance market, still thrive. Other parts struggle, one being the London Stock Exchange (LSE). The LSE is where companies raise equity finance. Big ones go on the main list, smaller ones – typically worth £50M or so – list on the Alternative Investments Market (AIM), which is also run by LSE but has lighter reporting requirements.

Both LSE and AIM are in trouble: the number of companies listed is falling, and has been for some time, as the chart below (snipped from Raconteur) shows, that’s been the story for well over a decade.

That has all sorts of bad effects. These include: a smaller cost base to cover operating costs and so rising membership fees; a smaller pool of expert’s advisors to support companies listing and fewer companies for investors to buy shares in. That’s bad for the UK as those investors – which includes pension funds – must invest (cash sitting on their balance sheets doesn’t deliver the growth ). So they invest elsewhere and investments overseas don’t stimulate the UK economy. In 1997 UK Pension Funds allocated 53% of their funds to UK equities, now it’s just 4.4%. There are other reasons for that but it’s not good news for LSE, AIM, the City of London or the UK economy.

One reason is that London valuations are generally rather less sporty than in the United States – similar companies in the US may be valued twice as highly, which tends to grab shareholders attention. (There are downsides to US listings as well, which is why many companies prefer the UK). However a stagnating UK stock market makes it hard for UK companies to raise money. Over recent years this has led to the emergence of private equity as a source of funding for growing companies.

The private equity business model is simple. Borrow big and borrow cheaply. Buy companies with positive cash flows. Either run them better (in this case meaning more profitably) or merge them with others and run the combined entity better. Then sell the company for more than you paid for it, pay of the debts and the surplus becomes the private equity house’s profit. This model relies on two things, cheap money and plenty of buyers.

Unfortunately debt is no longer cheap and buyers are hard to find. This means that the private equity houses are unable to do new deals and refinancing the ones that they have is more expensive and harder to achieve. The latter is because as the private equity companies haven’t sold their acquisitions they can’t recycle their capital to pay off their debts.

The investment managers who have lent them the money thus far have filled their capital allocations to private equity in the UK. As the private equity companies have not repaid their loans the only way that tint investment managers could lend more would be to increase the proportion of their capital (your pension) allocated to UK private equity. Their job is to make the best return for their investors (your pension) and in the current circumstances they may feel disinclined to invest more in one of the riskier parts of the UK economy. They can make as much money with less risk somewhere else.

Worse, when they look at the private equity books they may disagree with the valuations of the investee companies, not least because those companies cash flows are now increasingly dedicated to serving the private equity debt rather than growing the business. As recession approaches wise companies hoard cash. Private equity owned companies haemorrhage it.

Moreover, as they are private companies their valuation is debatable. The private equity companies estimate their price based on similar public companies (whose valuation is not in debt as they have publicly traded share price). In the City’s jargon this is know as “marking to market.” Investors don’t believe the marks anymore. Even if they had money to allocate they don’t agree with the proposed valuations; private equity companies are in trouble.

You can guess what happens next. Desperate for cash the private equity cowboys look for other piles of cash that could help. In the financial crash the investment banks got it from the government or, more accurately, your taxes. This time round, with a rather smaller problem, they are eying up the pile of cash held in ISAs, currently some £300 billion. They are seeking to persuade Rachel from customer service to get that ISA cash put to work by “investing” it in private equity, although they obscure that in jargon.

Rather than showing them the door and pointing them to an insolvency advisor (the inevitable destination for any company that can’t pay its debts when they fall due) she seems to have fallen for their pitch, hence the rumoured tinkering with ISA regulations. What she’s actually considering, although she might not realise it, is another taxpayer bailout of the financial services industry.

Now the UK’s private equity market is not a direct systemic threat. Yet. With annual revenues of £4.6 Billion and total assets under management of some £400 billion, that is some seven times the value of the all the companies on the LSE, or about one tenth of the UK’s £4 trillion bond market. Private equity is now a shadow investment banking system. That’s risky; by definition a shadow banking system doesn’t operate under bank regulation or have access to emergency support from the Bank of England.

Just like the sub-prime loans that caused the Global Financial Crisis in 2008, private equity has got itself into trouble in the era of cheap money and now its world is falling apart as interest rates have risen. The opacity of private equity valuations means other financial players simply can’t assess the risks of default of the private equity houses, nor what they’re underlying assets are really worth. That in turn means that those who have investments in private equity might take a financial hit.

Those dealing with the investor in other transactions can’t know how sound their finances are. That contagion is infectious. If one of them makes a loss others will too, but no-one knows who will suffer, how badly or when. Any bank with investments in or loans to private equity may suddenly find its balance sheet impaired, which would affect all its other counterparties in other transactions. That uncertainty is what exacerbated the problems of 2008.

The optimistic view is that because private equity is a high risk, high reward sector prudent pension fund investors (and they have legal obligations to be prudent) won’t have a large proportion of their funds at risk. They’ll take a haircut but they won’t be eviscerated. The underlying companies should survive, indeed losing the burden of their private equity owners rapacious needs for cash to pay interest could make them healthier. Of course, in all the chaos that comes with collapsing investment models they could equally become collateral damage.

A pessimist would say that the problems of contagion are at least as serious as the plight of the outstanding loans, so the finance sector will grind to a halt. At that point everyone has a problem which will trigger a rerun of 2008 liquidity problems. Once again, financiers got greedy and reckless and, once again, the Treasury either didn’t notice or failed to act.

I’m told that this looming disaster is widely known of in financial circles, including the financial press. However they choose not to report it as they would lose their access to reliable sources. Sorting this mess out is a job for a either a financial titan or a commanding Chancellor.

We’ve got Rachel Reeves.

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