Business Analysis: The Mayfair Mafia meets its match - Is the reign of private equity coming to an end?

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The Independent Online

Somerfield, New Look, Chorion, HIT Entertainment, Debenhams, British Vita, Travelex, Peacock Group, Center Parcs, Madame Tussauds.

Hertz, Gillette, MBNA, Adelphia Communications, Unocal, Falconbridge, Georgia-Pacific, Scientific-Atlanta. (Pause, draw breath).

These are just some of the legion of British, and American, companies to have been consumed, either whole or in part, by private-equity buyers in recent times. That's not to mention the likes of Woolworths, WH Smith and Marks & Spencer, all household names approached by, but eventually not falling to, buyout houses.

HMV and House of Fraser are in talks to be taken private. And since yesterday, Kesa Electricals, the owner of the Comet retail chain, can be added to that list after a consortium of private-equity companies tabled a £1.7bn bid.

Other prize assets said to have caught the eye of the "Mayfair Mafia" - so called after the concentration of private-equity houses in the ultra-expensive London district - include Vodafone, BT, Kingfisher, Unilever, Royal & Sun Alliance, the three-bed semi-detached house in Laud Street, South Croydon, put up for sale last week...

OK, so the last one isn't actually the subject of private-equity interest (to the best knowledge of several industry insiders), but one could easily be forgiven the mistake. The breadth and scope of private equity's reach, and the depth of its pockets, has grown to such an extent that there appears to be almost nothing at which it won't take a tilt.

There are those, however, who are starting to question whether private equity has seen its high-water mark. Too much money is now looking for too few homes, meaning price tags on targets are inflated by canny owners and managers.

M&S, the London Stock Exchange and (thus far) HMV remain public companies after private-equity suitors balked at prices they were being asked to pay. The M&S share price rise since it staved off the attention of Philip Green's private-equity-backed bid has only served to give added confidence to managers who do not wish to be seen to be selling out too cheaply.

The cost of borrowing is ticking higher, while tax breaks exploited by private equity are under review. Global markets are in better shape, bringing trade buyers (rivals from within a target's own industry) back into the acquisition arena with fewer potential targets to aim for as companies feel less inclined to sell off struggling parts of their businesses to keep shareholders sweet.

While private equity could claim to have been behind more than a quarter of all UK mergers and acquisitions at its peak in 2003, more than a fifth the following year, and 13 per cent in 2005, figures from Dealogic, the investment banking data provider, show that it has accounted for only 5 per cent of the total in the year to date.

Dealogic's figures show a similar story in the US and, to a lesser extent, across continental Europe. Some $264bn was raised globally last year, of which $160bn was set aside for buyouts and the remainder for venture capital (for riskier start-up enterprises). That gives the industry an eye-watering spending power of more than $1 trillion.

The business model by which private equity deploys these enormous funds is essentially a simple one: buy something with borrowed cash, use the income it generates to service interest charges on the loan, hold on to it typically for about three years while it (hopefully) appreciates, then sell it on and pocket a healthy profit.

So take that house in South Croydon. A private-equity buyer may borrow from a bank as much as 90 per cent of the purchase price. It installs tenants and uses their rent to pay its interest charges (usually with a little bit on top for the new owners). Three years later, the house is worth more than it is now. The private-equity group sells up and moves on to the next deal.

The greater the proportion of the purchase price coming from borrowings, the higher the returns on the (relatively small) amount of cash invested.

The cost of debt is, therefore, one key element that drives eventual returns for private-equity investors. And it's on the up. Long-term interest rates are ticking higher after the world's three biggest central banks - the US Federal Reserve, European Central Bank and Bank of Japan - all squeezed the cost of borrowing a touch higher to fight inflation.

In isolation, this poses little significant problems for private equity, experts said. John Cole, private-equity partner at the accountant Ernst & Young, said: "Smallish interest-rate rises will not impact banks' attitude to lending. That would require several major defaults in the corporate markets, which have not happened."

But taken alongside stiffer competitive pressures, higher prices and fewer distressed assets on the block here and in the US, returns from private-equity investments are being crimped.

Industry experts reckon that private-equity groups generally are lowering the bar for expected returns. Andrew Curwen, head of mergers and acquisitions at the accountancy Deloitte, said: "They have had to work harder for returns, which have drifted down. In a lower-growth economy, with the weight of money out there, they are prepared to put significant amounts of money in solid businesses with reasonable growth prospects rather than hold out for a deal promising super-returns."

A few years ago, those returns were often a thumping 35 per cent over three years. Today, they are typically somewhere around 20 per cent over a similar period.

Despite the squeeze, experts remain ebullient about prospects for private equity. Simon Godwin, a corporate financier with the French bank BNP Paribas, said: "Returns from every single asset class has come down in the past few years. Private-equity investments are still delivering a significant premium to other assets."

Whatever private equity's future performance, its extravagantly paid leaders may soon find themselves a touch less well off. At present, managers of companies bought by private equity often take lower basic pay but tuck away a hefty armful of shares in the new operation. A few years later, when the business is sold on, the manager pays capital gains tax of 10 per cent on the stock he offloads.

That's considerably less onerous than the 40 per cent tax he would have been liable to pay were his shares treated as income.

Not for the first time in the run-up to a Budget, the taxman is on the case. Thierry Baudon, managing partner of Mid Europa Partners, which specialises in investments in central Europe, said: "The Treasury is, of course, not happy to lose any money. But I would argue that shares for someone who has tripled the value of a company should be treated as a capital gain, not as employment."

The sheer enormity of investors' cash sitting under private equity's wing means prospects for the industry are far from bleak. Predators are hunting in packs to fell bigger prey, and ever larger, more high-profile firms are sure to be snared.

There will be those among the hunters themselves that fall by the wayside over the next couple of years, with survivors becoming all the stronger. But private equity's salad days, for the time being at least, may be past.