Private Equity Scuppered by Subprime Fallout

As we go to press, the stock market has just recorded its greatest fall since 9/11. It is timely, therefore, that we had already prepared the following article explaining how the crisis has come about. The devaluation of capital is inevitable, and the collapse of prices on world stock markets on August 9th 2007 has only wiped off the equivalent of 5% of world GDP. It certainly won’t be enough to start a new cycle of accumulation and it certainly won’t be the last.

For a short spell this year headlines announcing the sale of big-name companies to private equity consortiums were matched by outrage at these “predatory” capitalists making quick-kill fortunes from their lucrative deals. Recent and impending buy-outs range from Allied Boots (Kohlberg Kravis Robert, KKR: bought for £11.1bn); Sainsbury, (fought over by CVC, KKR, and lately Delta Two, a Qatar-based group); Cadbury Schweppes (under offer from a consortium of Blackstone, KKR and Lion Capital), Hilton Hotels (sold to Blackstone for £13bn); the AA (bought by CVC and Permira who in turn are negotiating a merger with Saga - the company aiming to profit from the over-Fifties - in a deal involving Barclays Capital and a prospective £2bn profit); EMI (bought by Terra Firma for £2.4bn); Bird’s Eye (sold off to Permira); National Car Parks (bought out by 3i, a fund run by Philip Yea. He’s regarded as a good guy by the press and described by the Independent as the “acceptable face of private equity”. This one-time director of Manchester United was also chairman of Welcome Break when it became bankrupt under the ownership of Bahrain-registered Investcorp in which Yea held a stake.) There are many more examples. In the first six months of this year the volume of private equity deals increased worldwide and their nominal value reached a record high of £284.35bn.

Company takeovers, however, are by no means the sole preserve of the private equity dealers. The growth of private equity buy-outs is only part of a fifty per cent surge in the volume of overall mergers and acquisitions to the tune of £1,390bn over the first half of 2007. (1) The key to it all is easy credit. Fuelled by low interest rates and the innumerable financial “instruments” to hedge, parcel up and spread out the risk for the banks and myriad other sources of the voluminous borrowing involved, so-called M&A (Mergers and Acquisitions) activity has become one of the biggest and easiest ways of making a profit within capitalism.

In themselves, neither the exponential expansion of debt nor all the financial instruments associated with it are the cause of company takeovers and mergers. Rather, the acceleration of such activity in its current form - i.e. predominantly as a means of financial speculation - is symptomatic of capitalism’s long-running crisis of accumulation. This is not the place to go over the distinction between money capital and real capital, between the generation of financial profit and the generation of surplus value from workers’ unpaid labour which is the only means of accumulating real - as opposed to fictitious - capital . Here we can only repeat our contention that the real rate of capital accumulation is declining, despite increased capital growth in China and India and despite the massive expansion of loan capital, the bulk of which is entirely fictitious. At the heart of it all is the tendency for the average rate of profit to decline due to the increased productivity of labour brought about by what Marx calls the rise in the organic composition of capital, or the growing proportion of value tied up in machinery, plant and raw materials in relation to the new value created by a relatively diminishing workforce. For the capitalists themselves a declining rate of profit is inconsequential so long as accumulation proceeds and the annual amount of profit continues to grow. Over time, however, there are repercussions in the immediate world of capitalist enterprise where the capitalists find themselves with little impetus to invest in new capital equipment because the small gain in the amount of profit generated would not be “cost effective”. This is the bare bones of the classical theory which explains why the accumulation of capital brings with it increasing centralisation on the one hand and crises leading to the devaluation of capital on the other. Even in today’s distorted world of global monopolies and financial leverage this is borne out by events. Thus, even though companies have experienced what the Financial Times calls a “profits explosion” in recent years (since 2003) a declining portion of those profits is being invested in new capital equipment, at any rate in Europe and the US.

In June a revealing article by the Financial Times reported:

The amount of capital that European and US companies are willing to spend on factories and equipment, the traditional engine of profit and economic growth, is set to plunge this year...
Capital expenditure as a percentage of profit before tax in Europe will fall from 64 per cent in 2006 to 55 per cent this year...
In the US, the decline in the ratio is worse: spending is expected to fall from 51 per cent last year to 45 per cent in 2007. (2)

A similar investigation by Goldman Sachs, reported in the same article, concluded that an even smaller share of US company profits are destined for capital expenditure:

... of the $1,600bn of funds companies have to spend this year, about 36 per cent will go on share buy backs; 33 per cent towards capex; 16 per cent on dividends; and 15 per cent for M&A.

If these figures are anywhere near accurate, they reveal a picture not only of value-producing capital reducing the portion of surplus value/profits it re-invests in capital equipment but of companies trying to augment their mass of profit by buying up their own shares and thus reducing the amount they have to pay out to shareholders. (And possibly a prelude to a private equity buyout.) It is a picture of capitalists increasingly hamstrung from significant investment in new value-producing capital by the low rate of profit. In this context a merger or takeover of another company or conglomerate, using some of the “home-generated” profits plus a wedge of borrowed financial capital, allows the first entity to increase it mass of profit by acquiring the surplus value-producing potential of another followed by little, if any, outlay on new capital equipment. Indeed, as everyone knows, the most likely outcome of a takeover or merger is plant closures, job cuts and an increased rate of exploitation for the pared down workforce. This scenario holds whether or not the takeover is by private equity, hedge fund or stock market capital. To this extent “mergers and acquisitions” can be viewed as intrinsic to the “law of the market”, part of the natural course of capital accumulation and not a problem for the bodies who act as guardians of capitalism’s economic order. Except that monopoly capitalism has long subverted the “law of the market”. The “mergers and acquisitions” of 21st century capitalism’s well-established cartels and monopolies have little in common with the centralisation of capital due to “free competition”. On the contrary, capital today is so highly centralised that it has to devise its own rules to maintain an artificial game of competition in order to prevent complete centralisation and sclerosis.

Private Equity: Pushing the Boundaries of Monopoly Capitalism

The recent hullabaloo over the private “equiteers” is really about their not keeping to the rules of the game. For the most part, however, they haven’t broken any rules. Rather the game has moved on to another level. So what is private equity? One thing it is not is only the private savings of rich individuals. (Although some of the richest people in the world are investors in private equity.) The “private” in private equity simply means that funds for investment are raised outside the “public” stock market. The bulk of the money in these funds comes from institutional investors: banks, public and private pension funds, insurance companies and a range of other financial money-spinning bodies. The managers of private equity funds tend also to invest in their own ventures, typically providing between 1-5% of the overall capital. However, by far the most part of the capital laid out for any venture is borrowed capital, mainly from banks. Typically private equity groups target what they describe as “underperforming companies” which they buy up, usually remove from the stock exchange and aim to re-sell at a profit within a few years, having loaded the company with debt, broken it up and stripped off as many assets as they can. The “exit” or “sell out” is often achieved by coming full circle: i.e. by making what’s called an initial public offering, IPO, and floating the company back onto the stock exchange. Sometimes the pared-down, “financially restructured” company is sold on to another private equity firm. Yet, as the tedious but instructive example in the box here shows, “financial restructuring” with its share buy-backs, mortgaging and selling of assets is by no means confined to private equity. This is the latest way the capitalists have found of increasing their return on capital. By reducing the capital value of a company its rate of return can remarkably increase, even when the actual amount of profit is less than before. For more and more companies “financial restructuring” leading to an effective devaluation of the market value of the firm is an increasingly attractive option. And in the short term it works.

Since all these calculations are financial ones and by no means based on the real rate of surplus value or the actual organic composition of capital - for example the market value of a company is calculated on the basis of its share price multiplied by the amount of shares issued - and since this is monopoly capital taken to a new level of parasitism far beyond the simple acquisition of extra profits, where every iota of money profit based on the creation of new surplus value is dwarfed by the amount of money made from highly profitable transactions which produce not a jot of new value - they have little impact on the real rate of profit. A real devaluation of constant capital would mean more than a few pence knocked off a company’s shares. (No matter the losses during the bursting of the last dotcom bubble, the financial commentators still admit that world stock markets are still vastly overpriced.) In other words, immensely over-valued company assets are being used as the basis for the “release of equity” and short-term financial speculation overshadows investment that produces new value. Even measures which do help to offset the falling rate of profit, such as lowering wages and increasing the rate of exploitation, are not enough to diminish the attraction of financial jiggery pokery.

For the guardians and regulators of the system this is an uncomfortable state of affairs. Although they are not sure why, they are concerned about the threat to an ill-defined “real economy” by financial speculation. From the IMF’s Financial Stability Forum to the UK’s Financial Services Authority (FSA), Treasury Select Committees, a European Trade Union Confederation (ETUC) conference in Seville and the TUC, the spotlight is focussed on private equity. All are agreed that greater regulation is required. One of their prime concerns is the extent of debt involved in private equity buyouts. The TUC, for example showed its concern for the wellbeing of capitalism by echoing the FSA in its presentation to the Treasury Committee in June:

The TUC urges the Treasury Committee to investigate the rise of corporate debt and its implications for economic stability. ... The Financial Services Authority found that in the five largest leveraged buyouts involving bank lending in the 12 months up to June 2006, the average share of equity was just 21 per cent. This is in contrast to a typical takeover by a quoted company, which might be funded with roughly 70 per cent equity and 30 per cent debt. (3)

Linked to the regulators’ worry about the amount of debt left on the books of the average private equity buy out is the blatant short-termism and disregard for the long term existence of the firms whose assets are being milked. Since private equity groups are partnerships usually operating outside the stock exchange and therefore not subject to the same rules of “disclosure” for shareholders, the fund managers have felt no need to limit their personal gain. The press had a field day during the Treasury Committee enquiry over the fact that these people’s personal windfalls come under capital gains and are taxed at a lower rate than wage workers’ income tax. Yet, as the editor of Moneyweek plainly puts it,

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. (4)

In any case, private equity has nothing to fear in the UK where the Labour government is promoting London as the financial services capital of the world. The Treasury’s committee of enquiry was left up in the air. Instead, the government is settling for “self-regulation” under the auspices of a body created by the speculators themselves: no less than the British Private Equity and Venture Capital Association, headed by Sir David Walker, one-time chairman of Morgan Stanley. He’s eventually going to draw up a code of conduct, after he’s finished the “feedback process”. Meanwhile in his first interview with the press the new Chancellor of the Exchequer, Alistair Darling declared that “... we should be very, very wary indeed of a knee jerk reaction” (to calls for tax changes regarding private equity) and that,

We can’t allow ourselves to get into the situation of somehow saying all incorporated bodies under the Companies Act are good and all private equity is bad - that’s just nonsense - the world is just not like that. (5)

Exactly! But we don’t suppose this Labour Chancellor is working on the premise that all capitalism is bad.

The Trick of Financial Restructuring is Not Limited to Private Equity

Consider the case of a typical listed company with a market capitalisation of about £1 billion and shares trading on a price/earnings (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.

Source: London Stock Exchange website on private equity - Merryn Somerset Webb 20/02/2007 - editor Moneyweek Magazine

Financial Meltdown Halts Private Equity in its Tracks

As it turns out, it is events in the financial world itself that have already curbed the exuberance of the private equity investors and much else in the world of financial capital. As we go to press the knock-on effects of the so-called subprime mortgage crisis in the USA which appeared earlier this year are still reverberating through the world of global finance and debt. “Subprime” mortgages are basically mortgages lent out by dodgy finance companies at higher than average interest rates to people who can’t afford a more conventional deal. The “subprime” refers to the status of the loan according to the financial market’s own classification systems. For example Standard and Poor grades loans according to the estimated level of risk that the borrower will default. That grade can then be used as the basis for setting the price of the loan when it is sold from one financial “vehicle” to another, usually as part of a new package of bits of debts from different sources. “Subprime” just means that the loan carries with it a higher than average level of risk and therefore it won’t get a triple A credit rating with the likes of Standard and Poor. It is worth less to the loan merchants but that didn’t stop them targeting people who would find it difficult to keep up payments. In the US thousands of working class people have lost their homes and new house building has plummeted. But this is not what has hit the international headlines.

It has taken several months, but the bankruptcies which began in a relatively small section of the global financial markets have proved to be the trigger for the bursting of what one FT writer termed the “alchemy bubble in the credit markets”.

Wall Street’s alchemists discovered how to convert junk mortgages, bonds and loans into AAA credits by packaging them as CDOs for the bonds and CLOs for the loans. These credit pools are divided into frontline tranches of pawns that defended the kings and queens. The pawns are getting killed by rising foreclosures in the subprime mortgage market, leaving the better credits exposed. Suddenly, private equity firms and their bankers can’t refinance their bridge loans using these pools ...
This is really the first big stress test of the global boom. We are about to find out how much of it has been driven by financial alchemy. (6)

This was written on 1st August. Already the losses involved more than pawns. The biggest single loss fell on Bear Stearns Asset Management (US) which had to close two of its hedge funds at a loss of $20bn. But the “splicing and dicing” of credit risk had also spread the losses beyond the USA and way beyond the sphere of mortgages to more significant financial institutions. One of the first victims was an Australian hedge fund, Basis Capital, which lost $1bn. However, the pundits began to show signs of real worry when the news broke that a German bank, IKB, was being bailed out by a government-organised rescue via Deutsche Bank and others. At that point, Barings Asset Management estimated that worldwide banks were now sitting with $400bn of incomplete cash-financed leveraged buy-outs and management buy-outs on their balance sheets of banks. The private equity business had been put on hold.

By the next week, several thousand billion dollars had been wiped off the value of financial assets - equivalent to 5% of global GDP. Yet this is a drop in the ocean. The amount of fictitious financial capital is so enormous that, according to a markets analyst writing in the FT it is equivalent to ten years’ worth of global GDP. (7) Since we know that all of the various ways the capitalists have of measuring GDP involve an over-estimation of what Marxists would understand as the “real economy” - i.e., the amount of new and already existing surplus value - even this gargantuan disproportion between real and fictitious capital is an under-estimation of the extent of the overvaluation of capital values. The potential scale of the financial collapse is unthinkable for capital and has already provoked intervention by the US Federal Reserve. Its $48bn injection has, however, been outstripped by the European Central Bank’s €94.8bn injection of “liquidity” to 49 EU banks following the French bank, BNP Paribas’ freezing of three investment funds bound up in the subprime losses. The scale of this intervention has not had a completely calming effect. Some of the pundits are now wondering whether the European Central Bank knows something they don’t yet.

No matter how this particular crisis ends, the problem of the massive under-accumulation of real value will remain for capitalism. And although it is diverting to see some of the most self-seeking, bloodsucking examples of the capitalist class go under we can also predict that the working class will be made to pay one way or another: from wage cuts to price rises, from higher interest rates to stripped down pension funds, never mind the wider conflicts imperialist competition has in store.

There is Only One Alternative

In the face of the impasse monopoly capitalism has reached, the absolute irrelevance to wage workers of demands to reform or regulate capital is glaring. The TUC complains of “casino capitalism” that needs controlling, but all capitalism is a rip off of the wealth we create which ends up in the hands of those who do not labour. The TUC’s answer to the domination of speculative capital is corporatism: a greater say for the unions in the running of companies and a call for workers not to be treated like “pawns whose fate will be decided by others” (8); Socialist Worker recommends that

When huge companies are faced with predatory buy-outs, threatening job losses and economic blight for whole areas, the workers’ organisations should fight for them to be taken into public ownership. (9)

“Public ownership” under democratic control of course, and as a step towards “socialism”. But socialism can only come about by overthrowing capital, not by lining up to help in the management of this or that part of it. The retrieval of the means of production by society as a whole in order to directly satisfy human needs cannot come about without the overthrow of capitalism and the pillars it rests on: money and wage labour. The era when the centralisation of capital played a progressive role in the development of the forces of production is long gone. Today, the technical means exist to provide for the needs of humanity as a whole while the communications technology employed by the financial wheelers and dealers alone could easily be adapted to serve society in the global planning and distribution of goods unencumbered by wage bills and profit and loss accounts. Unfortunately the replacement of capitalism with a more rational mode of production is not simply a technical issue. Nor is capitalism’s accumulation crisis going to disappear of its own accord. Without a conscious political fight to overthrow capitalism the prospect can only be one of increasing barbarism. It is imperative that during the economic crises, social conflicts and heightened imperialist conflict that lie ahead a revolutionary party of the world’s proletariat is formed: a party that will lead the struggle for wresting the means for maintaining human existence from the clutches of an increasingly parasitic and decadent ruling class.


(1) Financial Times, “M&A Activity Surges In Spite Of Credit Concerns”, 29th June 2007 .

(2) FT, “Capital Spending Faces the Big Squeeze”, 25th June 2007.

(3) From the TUC’s submission to the Treasury Select Committee, June 2007. Available on the TUC website.

(4) From an article by Merryn Somerset Webb, editor of Moneyweek Magazine, 20th February 2007 Published on the London Stock Exchange website: .

(5) Quoted on front page of the Financial Times, 4th July 2007.

(6) Edward Yardeni, in the Financial Times, 1st August 2007. CDO and CLO = collateralised debt and collateralised loan obligations respectively.

(7) David Roche, writing in the FT’s Insight column, 7th August 2007:

We are accustomed to view the financial economy as dependent on the real economy. However, the financial economy-the stock of all assets and their funding-is now so great in relation to the real economy our measure puts it at about 10 years’ worth of global GDP. Whatever happens to the financial economy now may affect the real economy as much as the other way around.

(8) TUC submission, ibid.

(9) Socialist Worker editorial, 22rd March 2007. Available on line: .

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