When Your Pension Helps Finance the Buyout
The final question in the leveraged-buyout series is also the most uncomfortable: whose money is actually being used?
In the first article in this series, I asked how a company could become too poor to survive being bought.
Raleigh provided the starting point. Its parent company, Accell, had been acquired in a highly leveraged private-equity deal. When trading conditions deteriorated, the debt created by that acquisition became part of the problem the business had to overcome.
The second article asked when a leveraged buyout should really be considered successful.
Debenhams demonstrated why that question matters. Its private-equity owners made substantial returns, yet the company emerged carrying debt and without property it had previously owned. Hilton provided the opposite example: investors made an enormous return, but the company also emerged larger and stronger.
The third article examined Evri from another direction.
Evri did not collapse. It grew. Its owners invested in it, parcel volumes increased, profits rose and the business became substantially more valuable.
Yet while that was happening, I experienced a deterioration in the economics of delivering its parcels.
Three different stories.
One recurring question.
When an investment produces a financial return, who created that return and who carried the risk required to produce it?
There is one part of that question I have deliberately left until last.
Where did the investors' money come from?
Private equity is not simply rich people's money
The phrase private equity can create a misleading picture.
It sounds like extremely wealthy people using their own money to buy companies.
Some of their own capital may certainly be involved, but private-equity firms also raise enormous investment funds containing money supplied by other investors, which can include pension schemes. So the retirement savings of ordinary workers can ultimately provide some of the equity used in leveraged buyouts.
The rest of the purchase price may then be financed through borrowing.
That combination is what makes the leveraged buyout so powerful and dangerous.
Imagine a private-equity fund has £1 billion to invest.
It could buy £1 billion of businesses using that money alone.
Or it could combine its investors' capital with borrowed money and control businesses worth considerably more.
If those businesses increase in value, the returns on the original equity can be magnified.
But leverage works in both directions.
The debt still has to be serviced, and crucially, in a leveraged buyout, much of that financial burden can ultimately sit with the company that has been acquired.
This is the mechanism at the heart of this series.
Now add pensions to it.
Your retirement savings can sit at the beginning of the chain
Most people paying into a workplace pension never choose individual companies for their pension to invest in.
They contribute money.
Their employer may contribute more.
The pension provider or trustees invest it.
Some of that money may ultimately be allocated to investment managers, including private-equity funds.
The chain can therefore look something like this:
Worker → pension scheme → investment fund → private-equity fund → leveraged buyout → company
At one end is somebody trying to provide for their retirement.
At the other is a company that may now be carrying substantial debt as a consequence of being acquired.
Sometimes there are workers at both ends.
That creates a curious circularity.
The worker can be on both sides of the deal
Consider a simplified example.
A pension scheme invests in a private-equity fund, which then participates in a leveraged acquisition.
The acquired company improves. Revenue grows. Productivity increases. Debt falls.
Eventually the company is sold for substantially more than the investors paid for it.
The private-equity fund makes a strong return.
The pension scheme receives its share, and its members benefit.
There is no contradiction there.
This is essentially what a successful investment is supposed to do.
But now imagine a different outcome.
The company is acquired using substantial borrowing.
Property is sold. Dividends are paid. Debt remains high. Investment becomes more difficult. Trading conditions deteriorate. The business begins to struggle. Jobs disappear. Suppliers lose a customer. A town loses a major employer.
Eventually the company enters administration.
The private-equity investors may still have made money during their period of ownership. A pension scheme invested in that fund may therefore have benefited from the return.
From the investor's perspective, the investment may have succeeded. Yet the company itself may have emerged weaker, with employees, suppliers and communities carrying consequences that never appear in the calculation of that return.
That is the problem with judging a leveraged buyout solely by how much money the investors made.
Debenhams demonstrated why that question matters. Its private-equity owners made substantial returns, yet the company emerged carrying debt and without property it had previously owned.
But once pension money enters the equation, another question appears.
Who actually carries the downside?
One of the attractions of investment funds is diversification.
A pension scheme does not normally put all its members' money into one company. It spreads investments. A private-equity fund does something similar.
If one investment performs badly while others perform strongly, the overall fund may still produce an attractive return.
That is sensible investment management.
But the people working for the unsuccessful company cannot diversify their jobs quite so easily. Nor can a small supplier diversify an unpaid invoice after a major customer collapses, or a community instantly replace hundreds of lost jobs.
This creates an asymmetry.
The financial investor can spread the risk but the people closest to the company often cannot.
The consequences of failure become concentrated even when the financial exposure is dispersed.
In a highly leveraged transaction, debt can magnify those consequences. Leverage does not automatically cause a company to fail, but it can make setbacks considerably harder to survive.
This is not an argument against pension investment
There is an obvious response to all of this.
Pension schemes exist to provide pensions.
Their trustees and managers have responsibilities to the people whose money they invest. If private equity can produce attractive long-term returns, why should pension savers be denied access to them?
They should not necessarily be.
Private equity can provide capital to businesses that need it. It can improve management, finance expansion, introduce expertise, and make companies more productive.
As Hilton demonstrated earlier in this series, a leveraged buyout can produce enormous returns for investors while leaving behind a genuinely stronger company.
The issue is not simply whether pension funds should invest in private equity.
The narrower question is more difficult.
Should pension money finance highly leveraged acquisitions without considering what that leverage does to the company being acquired?
The pension fund is not investing in an abstract financial instrument.
Somewhere underneath the fund is a real business.
And underneath the business are real people.
What should count as a successful pension investment?
Suppose two private-equity investments each return 15 per cent a year to a pension fund.
In the first, the acquired company invests in technology, becomes more productive, expands internationally, increases employment and gradually reduces its acquisition debt.
In the second, property is sold, substantial dividends are extracted, investment declines and the company eventually collapses under financial pressure.
From the pension fund's perspective, both investments produced the same return.
Should they therefore be considered equally successful?
Financially, perhaps.
But that answer becomes uncomfortable when we remember whose money is being invested.
The people receiving the return are not separate from the economy in which the consequences occur.
They work in and buy from companies.
Their children work in companies.
Their communities depend upon companies.
Their taxes support people out of work when companies fail.
Their pensions may even depend upon companies continuing to exist.
A pension saver therefore has interests extending beyond the number appearing on an annual statement.
The Raleigh problem
This brings us back to where this series began.
When KKR-led investors acquired Accell, the company behind Raleigh, they did not do anything inherently illegitimate by using debt. Leverage is a normal part of corporate finance.
The problem appears when the financial structure leaves too little room for reality to differ from the assumptions made when the deal was constructed.
Demand can fall. Interest rates can rise. Consumer behaviour can change. Competitors can improve. Costs can increase.
The future rarely behaves exactly as a spreadsheet predicts.
A highly leveraged company has less tolerance for those surprises because money that could otherwise absorb them must service debt.
That is why the source of the equity matters. If pension capital helps make such acquisitions possible, pension investors are not merely passive beneficiaries of whatever return emerges. Their money helped finance the structure.
That should surely give them an interest in the amount of debt imposed on an acquired company, and whether that company remains capable of surviving it.
A better test
Earlier in this series I suggested that a leveraged buyout should pass more than one test.
Did the investors make money?
Did the company become more productive?
Did investment continue?
Was debt reduced to a sustainable level?
Did employees and contractors share in the value created?
Were suppliers and pension promises protected?
Was the company capable of thriving after the private-equity owners departed?
The involvement of pension money makes those questions more important, not less, because a pension fund represents people whose lives extend far beyond their pension portfolios.
A 10 per cent return does not exist in isolation.
Neither does a lost job.
The same people are everywhere
Modern finance separates us into categories.
Investor.
Employee.
Consumer.
Pension saver.
Taxpayer.
Supplier.
Citizen.
But these are not different groups of people.
They are often the same people wearing different hats.
A worker's pension can help finance the acquisition of another worker's employer.
The resulting investment return can improve the first worker's retirement, but the restructuring required to produce it can weaken the second worker's income.
If the company fails, another worker can lose a job.
A supplier can lose money.
A community can lose economic activity.
And taxpayers can carry some of the consequences.
The financial system can record each transaction separately.
Society ultimately receives the combined result.
So should pension funds finance leveraged buyouts?
There is no sensible argument for a blanket prohibition.
Some leveraged acquisitions create stronger businesses.
Some generate genuine improvements in productivity.
Some produce excellent long-term investments.
Pension schemes have a legitimate responsibility to seek good returns for their members.
But that cannot be the end of the analysis.
If a pension fund invests in a private-equity strategy built around leveraged acquisitions, it should surely care about more than the eventual multiple on its investment.
It should care about how much debt was used.
Where that debt ended up.
Whether the company could realistically service it.
Whether investment continued.
Whether value was created or merely extracted.
And what condition the business was left in when the investors departed.
Otherwise we arrive at an extraordinary definition of success.
Workers can provide the capital.
The capital can finance the buyout.
The buyout can load risk onto a company.
Other workers can carry the consequences of failure.
Yet the transaction can still be called successful because the workers whose pension money helped finance it received a good return.
That may be financially successful.
It is much harder to call it economically or morally successful.
The question is not whether leveraged buyouts can make money. We already know that they can.
The question is whether making money is enough.
If our pension savings help finance an acquisition, then surely as members of society we have an interest not only in the return they produce, but in what happens to the company, its workers and everyone else carrying the consequences.
A successful investment should create value.
Not simply move it from somebody else's column into ours.
If you enjoyed this article...
You may also find What If Your Life Had Quarterly Reports? interesting.
This article asks whether we should apply some of the same thinking we use to judge companies and investments to our own lives. Instead of measuring shareholder returns, what would happen if we stopped every three months and asked a simpler question: am I actually better off than I was three months ago?
About the author
Paul Clark is the author of The GOOD Book: A Behavioural Operating System for Escaping Debt and Rebuilding Control and the creator of The GOOD Method. If you enjoyed this article, explore more of his writing in GOOD Thoughts, listen to The GOOD Conversation podcast, or join the GOOD Community to receive new articles, podcast episodes, resources and forthcoming videos by email.