Jeremy Warner's Outlook: Whether Macquarie is suitable or not, LSE shareholders should not be selling

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The Independent Online

Whatever price Macquarie Bank bids for the London Stock Exchange today, if indeed it bids at all, it won't be enough and shareholders should reject it. OK, so this sounds like silly advice without knowing the price. What happens, for instance, if the Australians bid 650p a share? Unlikely, but surely any price north of the 580p already suggested by Macquarie and then rejected by the LSE board as "derisory", is worth considering.

Well no. Actually it is not. Macquarie suffers from a fundamental problem that afflicts all private equity bids. Whatever valuation the Australian investment bank applies to the Stock Exchange, the company must be worth a great deal more for, be under no illusion, like all private equity bidders Macquarie would not be attempting to buy if it didn't expect to generate spectacular returns. Even a little above average would be seen as a failure. To accept any offer from private equity is just to give long-term value away to someone else.

If this simple rule of thumb applies generally, why is it that such bidders make any headway at all in public to private transactions? One investment banking acquaintance of mine reckons that 30 to 40 per cent of his merger and acquisition activity now comes from private equity, and most of it is successful.

The high returns earned by private equity are attracting an ever widening pool of capital. This money has to be invested somehow or other. Private equity's institutional backers frequently find themselves at the receiving end of bids from funds in which they themselves invest.

This is not the only curiosity of the private equity phenomenon. Institutional money is being progressively withdrawn from the quoted stock market and instead reinvested in a combination of bonds, overseas equities, private equity, and hedge funds. The switch has generated a parallel move by money and corporate managers from the goldfish bowl of the publicly quoted sector into the less transparent and usually more lucrative world of private equity and hedge funds.

Both these asset classes justify their existence on the grounds that they are a higher risk form of investment. The higher the risk, the greater the potential for both downside and upside. This is also typically the argument used by private equity bidders to persuade quoted company investors that they should sell. You take the money, and we'll take the risk. Yet for private equity in particular, and to some extent hedge fund management too, this has always seemed a somewhat disingenuous justification.

Typically, private equity targets the most low risk forms of corporate investment, where cash flows are relatively predictable and secure. By its own admission, this is indeed why Macquarie is so interested in the Stock Exchange, which is a monopoly business with the characteristics of a high growth utility. As such it makes perfect fodder for private equity. Where's the risk in that?

The acquisition of such assets only becomes high risk because the private equity bidder generally takes on a great deal of debt to finance the deal, but again the risks to the bidder are less severe than they might seem.

Once the takeover is complete, the debt is secured against the cash flow and assets of the acquired business and then sold on to others. The risk of the business failing to deliver the anticipated returns is thus largely transferred to the debt holders.

Just occasionally, these deals do go wrong, but when they do, it is the debt holders that end up holding the baby. The private equity player's downside is limited only to the amount of equity put into the deal, which tends to be only a small portion of the purchase price. In the case of Macquarie's bid for the LSE, debt is expected to make up around two-thirds of the purchase price. This has understandably led to fears that Macquarie would then set about running the exchange for cash, driving up charges and freezing all new investment, until the debt is paid off.

When Malcolm Glazer bought Manchester United, the fans couldn't understand it, for by using such a high level of debt and quasi debt to finance the deal, he seemed to be buying the club with its own money. To make the deal work, gate prices would need to rise, and there would be less money to spend on players and facilities. Forget the mumbo jumbo of City speak, in their no nonsense way, the fans had it about right. This is how private equity works.

There's a perverse sort of logic to the transfer of wealth from the many to the few that this process involves. Volatile equity markets in combination with new, government-backed, solvency regulation has been driving pension funds and life assurers out of equities and into bonds. This creates a double opportunity for leveraged and overseas investors. Firstly it makes UK equities relatively cheap. Secondly, the demand for bonds drives down the cost of money, making it ever easier and inexpensive to finance the purchase of equity.

The losers are ordinary savers, who find themselves unwittingly stuffed with expensively priced bonds while private equity, the hedge funds, and a growing army of overseas investors, walk off with the spoils of undervalued equity. If it wasn't so sad, it would be almost laughable.

Nobody should blame the financiers for what they are doing. That's the way the system works. If there is a money making opportunity to be taken, then someone, somewhere will take it. The fault lies rather with well intentioned but misguided solvency regulation, the perverse effect of which is to make existing distortions in the capital markets infinitely worse by driving the big savings institutions out of shares and into debt.

The LSE has been forced to deny that it ever described Macquarie as an asset-stripper, or as an unsuitable owner of the exchange. Why are they being so shy? The term "asset stripper" has some unfortunate connotations, yet it accurately describes an awful lot of private equity, the fundamental purpose of which is to extract value as quickly as possible.

Not us, says Macquarie's European head, Jim Craig, who would like us to think of the Australian investment bank as a quite different form of long-term investor and exactly the right sort of owner for the LSE. Not for Macquarie the quick turn, where the company is taken off the market, stripped down to the last lightbulb, and then refloated at double the price a few years later.

Well perhaps, but it would be a bitter irony indeed if the platform by which shares are publicly traded in Britain ended up, like so many of its quoted participants, being taken off the market altogether, leaving others to realise the value that undoubtedly exists in this little gold mine of a business.

GUS catches the internet bug

Dot.con the sequel, or is there more substance to this new wave of internet mania? GUS yesterday became the latest grand old name of the old economy to plunge back into the internet "space" with the $485m acquisition of, a US-based website which enables consumers to compare prices for shopping online. As with the last internet buying frenzy, the valuation is off the scale.

GUS is paying eight times sales for a business making just $25m a year before interest and taxation. The price being paid is also more than the current value of the entire comparison shopping services market in the US, estimated by GUS to be worth $400m.

Yet no internet acquisition would be complete without some long-term forecasting, and, according to GUS, the comparison market is expected to grow at 40 per cent per annum for at least the next five years. Most of us find it difficult enough to forecast into the next week, let alone five years, but luckily the stock market seemed to buy the projections and gave a positive welcome to the deal. There's more reason to believe in the transforming commercial powers of the internet this time round than there was during the bubble of the late 1990s. Yet the valuations again look heroic. Let's hope GUS's John Peace knows what he's doing.