Why is private equity stalking Sainsbury?

What do private-equity groups do?

They specialise in what used to be known as leveraged buyouts'. Essentially, a private-equity deal involves a group of investors buying up a public firm and taking it into private ownership, usually borrowing massively (80%, or even more, of the price) to do so. Sometimes private equity' also refers to takeovers of firms that are already privately held. Private-equity investors launch a bid because they believe a business, or parts of it, is worth more than its current market value, and that they can release that value (see the box below).

In practice, that often involves slashing costs or selling parts of the business to meet interest payments on the debt financing, hence the common view of private-equity types as greedy asset-strippers. The idea is to sell on the restructured business in three to five years' time via private sale, or a stockmarket relisting.

What's the sector worth?

Globally, the value of private-equity buyouts nearly doubled to $450bn in 2006 as investors took advantage of cheap credit. In Europe, the biggest deal was the e8.3bn takeover of four-fifths of Phillips Semiconductors by KKR and two other big players, Apax and Bain Capital. In Britain, the biggest deals were Birds Eye and United Biscuits, each worth just over £1bn.

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Do private-equity buyouts do any good?

The stereotyped image of private equity is that of aggressive capitalists intent on sacking workers and making a fast buck solely for themselves and their cronies. A couple of years ago, a German politician described private-equity investors as "locusts", while at Davos last month the leader of the global UNI union pithily summarised the sector's modus operandi as "buy it, strip it, flip it". However, there is also evidence that the industry can create long-term value. A study by US academics, recently cited by The Economist, found that firms refloated after being taken into private ownership performed better than other new issues. That hardly suggests private-equity groups trash the firms they acquire. Indeed, some argue that a private-equity arrangement where the owners are also the managers and as such take a full and hands-on approach to running the firms they own is a step forward from the traditional public firm, where management and owners are separated.

What's the case against private equity?

The advantages of private ownership, such as less public scrutiny and high gearing, are seen differently by critics. There's a potential conflict of interest in management buyouts where executives with an eye on the potential payout might be tempted to help a private-equity group buy a firm cheaply. The group stalking J Sainsbury a consortium of several big players: CVC, Kohlberg Kravis Roberts, Blackstone and Texas Pacific has reignited the debate as to when a sensible co-operation aimed at spreading risk crosses into anti-competitive collusion. The unions' campaign against the putative Sainsbury takeover has focused on the fact that interest payments on all that private borrowing are paid before tax. Arguably, this loads the dice in favour of private equity; the financial engineering involved slashes their tax bill.

Should I invest in private equity?

If you have enough money (funds often have a minimum investment of £100,000), maybe. Private-equity funds are highly geared plays on the stockmarket, but with much less transparency and higher fees (often 2%, plus 20% of gains). They outperformed in the 1980s and 1990s, when a combination of gradually falling interest rates and rising share prices provided the right climate. But now that rates are rising and a glut of cash is leading to diminishing returns, many believe the private-equity cycle has peaked. There may still be money to be made by buying shares in listed targets, as Sainsbury shareholders found out earlier this month when the stock price jumped 15% in a day. Possible targets currently include Wm Morrison, Unilever, Pearson, BA, Experian, BT and Scottish & Southern.

How private equity works in practice

Say there's a firm worth £1bn. It has no debt and £50m of cash on the balance sheet (earning £2m a year interest). It also owns £200m worth of property. The company currently generates a profit of £100m before tax. Tax is at 30%. So the profit after tax is £70m and the valuation is a p/e of 14 times, or an earnings yield of 7%. It is taken over by private-equity managers who borrow £850m at 6% to finance the deal (at an annual cost of £51,000). They then do a sale and leaseback of its property for £200m at a 5% yield. This means it now costs the firm £10m a year to rent back its property, but it does also give it £250m of cash on the balance sheet, which it uses to retire £250m of the debt raised for the purchase. The debt is then reduced to £600m and the annual interest payments to £36m.

The private-equity firm then goes on a cost-cutting binge and removes £10m worth a year from its operations. The result is that annual profits (after interest payments) come down to £62m or £43.4m after tax (instead of getting £2m in interest, the firm is paying £10m in rent and £36m in interest). But as the private-equity group only put down £150m in the first place, they now have an earnings yield of 29% and the effective p/e of the firm has fallen to 3.5 times. Stockmarket investors would've got their money back in 14 years: the private-equity lot will get it in four.