PRIVATE EQUITY FUNDS
The Swirling Billions Of The 1% Reach NZ
- Linda Hill
One urgent measure taken by Government to protect us all from Covid 19 was to fast-track an already planned amendment to the Overseas Investment Act "to protect NZ's long-term national interests". A temporary notification power now allows the Minister of Finance to screen all overseas investments during Covid, including those below the normal threshold of $100m (or $200m for buyers based in Comprehensive and Progressive Agreement for Trans-Pacific Partnership [CPTTP countries, or $500m if you're a lucky Australian).
At the same time, the Government brought forward its plan for an ongoing "national interest" test, allowing the Minister discretion to block overseas acquisition of a controlling interest in land or companies in a list of strategically important industries (including security) and in high-risk national infrastructure. Treasury's May 2020 Guidance Note on this is worth a look. The Ministerial power can also apply to acquisitions by overseas governments or in cases of - and I like this one - "potential inconsistency with Government objectives, e.g. environmental or economic objectives".
No Good Crisis Should Go To Waste
Why the sudden urgency on this Ministerial power? Because global capitalism's initial reaction to the Covid 19 crisis was a boom in financial market trading. For financiers schooled on Milton Friedman*, no good crisis should go to waste. One company's Covid disaster is another company's opportunity. Bargains are to be had everywhere - including wide-open New Zealand. *Milton Friedman, 1912-2006, the US economist who was the father of neo-liberalism. Ed.
The Government's recovery plan seeks to support jobs and small-to-medium companies, and to protect our strategic assets from the vultures. Treasury's list of strategic assets includes ports and airports, electricity, water, telecoms, media, payment systems and financial infrastructure, military technology and supplies - and more can be added via Regulations. "Too late", I hear CAFCA members laugh. But it could get worse. And part of that worse may be because of changes in type of investment being made in NZ, and in global financial markets.
In Watchdogs 148 (August 2018) and 149 (December 2018)* I wrote about how the Overseas Investment Act works, and the anonymity of "ultimate owners" of transnational, multi-layers corporations and of private equity funds targeting our land and business assets. There has been a noticeable increase in acquisitions by private equity funds in the last five years and, in the wider world, an increase in the number and size of these financial vehicles since the Global Financial Crash of 2008.
In "Other People's Money" (2016), John Kay, who chaired the UK government's 2012 review of equity markets, attributes the series of financial market collapses since the 1980s to the abandonment of (i) the post-Depression rules separating payments and deposits banking from investment banking, (ii) of the traditional distinction between financial adviser and financial agent (broker), and (iii) of the post-WW2 Bretton Woods controls on international money flows (the 1944 conference in Bretton Woods, US, of all the Allied countries. It established the modern global economic system, with the US dollar as the global currency, and established the World Bank and the International Monetary Fund. Ed.).
He explains the new financial instruments that developed, the increasing complexity yet interconnectedness, and the inherent instability whereby financiers bet against each other and themselves. The financial trades in derivatives of sliced-up equity or debt bore no relationship to what was happening in the underlying industry. Profits were made out of gambling, preferably with other people's money, and out of high fees for this "active management" of funds.
As John Lanchester ("Whoops", 2010) explains, a new development in the lead-up to 2008 was that financiers and bankers began insuring against risk so they could ignore it, so drawing the insurance industry into the financial maelstrom and the global crash. Kay provides a set of practical policies to fix these systemic problems - as have past books on past financial crashes. Yeah, well. He also describes the industry's lobbying power and the revolving door of the financial/political complex that blocks meaningful reform.
The financial sector no longer serves the productive sector but is parasitic on it, says financial centre and tax haven expert Nicholas Shaxson. It doesn't create wealth; it is designed to extract it. In "The Finance Curse" (see Greg Waite's review, Watchdog 150, April 2019) Shaxson describes how finance leeches brains and investment out of other sectors and sucks both profits and tax revenue out of Organisation for Economic Cooperation and Development (OECD) countries. The title reflects a similarity to the "resource curse" in Africa, where countries with oil, diamonds or rare minerals remain otherwise underdeveloped, particular in regard to health, education and social services.
In "The FIRE Economy"* (2015), Jane Kelsey documents the financialisation of our own New Zealand economy, midwifed by neo-liberal ideology and embedded in legislation which, among other things, prised open our economy to the global financial markets. She mentions private equity firms and their often-undesirable behaviour, as has Rod Oram (RNZ, 11/12/18), but the most detailed account I've found is Shaxson's chapter on the subject. It's a scathing critique. *Reviewed by Jeremy Agar in Watchdog 140, December 2015. Ed.
Given the global speed and instability of public financial and stock markets, it's not surprising that big money is turning to more private investment opportunities. Kay notes that serious research-based investment advice on companies and industries can only be afforded by the very rich. That is what private equity and asset management firms offer ultra-High Net Worth Individuals (HNWIs) and their trusts. As well as the chapter on private equity summarised here, he devotes another to how the rich use financial trusts, mentioning the "outrageous" asset protection laws of the Cook Islands.
Shaxson says this group, defined as people worth more than $US50 million, has been growing by 10% a year, helped by financialisation, tax havens, mergers, technology and the rise of supra-national criminal organisations. Between 2013 and 2017, private equity firms raised over $US3 trillion from outside investors (despite under-performing in the S&P 500 US stock market index in those five years).
Private equity firms invite outside investors to contribute to a pool of capital. This private equity fund is intended to operate over a number of years, but there's now a secondary market in fund shares. The private equity firm then creates a Bidco to search for and buy up companies that haven't yet been "financialised", explains Shaxson.
Whereas hedge funds bet on rapid short-term price differences in shares, bonds, derivatives and other debt instruments, a private equity fund buys a particular company, borrows more money, shakes the company up, empties its pockets and sells it on at a profit over a period of years - called "unlocking value" and "a successful exit strategy". An average investment horizon of four years may look like relative stability to HNWIs post-2008 - but not to the employees of the acquired subsidiary or the community in which it operates.
The money that HNWIs or other entities invest in private equity funds may include borrowed capital. Interest rates are currently very low, and near-zero in some countries. In Shaxson's words, there are now "oceans of global hot money out there, trillions of it, the product of immense changes in the global economy". In earlier days, financiers providing money for such loans, repackaging the debt ("securitisation") and selling it in "alternative" financial markets, made the terms "leveraged buyouts" and "junk bonds" notorious in the late 1980s' crash.
So, this financial sub-sector was rebranded as "private equity". And the term is apt enough. The private nature of these finance firms and the funds they establish means they do not suffer the quarterly shareholder pressures, regulatory constraints and reporting requirements of publicly listed corporations. Regulation is encouragingly light-handed. What they do is their own business. And their anonymous investors or holding companies can live in tax havens if they want to.
For both hedge funds and private equity funds, the financiers setting them up benefit from hefty annual fees; typically, 2% of the sum invested, plus a cut, say 20%, of the profits and resale price (capital gain) that goes to their outside investors. The larger the fund, the bigger the fees. Some private equity firms concentrate on particular industries, gaining expertise in that area. Some do pick up distressed companies, introduce specialist expertise or new trading opportunities and turn them. Kay says, when they're good, they can be very good, but when they're bad, they're horrid. Shaxon says, in either case it's pretty much about "good old wealth extraction", though the term these days is "shareholder value".
The usual pattern is to buy up a strong company with a healthy cash flow, have it borrow up to 90% of its own purchase price and channel that back to the new owner. Borrowing (debt) within the corporate group, at amazing rates of interest, can magnify returns and reduce tax liabilities. Managers of the new subsidiary ("portfolio company") are "disciplined by debt" but kept sweet with incentive structures, while wages, jobs, costs and creditors are squeezed. Shaxson cites a 2014 in-depth study "Private Equity At Work", whose researchers found it striking how little of the earnings of private equity funds depended on business strategy or operational improvements.
A portfolio company's capital value may also be leveraged with further borrowing to acquire more companies. Again, that debt is not taken on by the private equity firm itself, but loaded onto the shoulders of the companies it buys. Profits, debt repayments, interest and special dividends are shifted up to the owning private equity fund, while high debt levels, losses and risk of bankruptcy remain with the subsidiary, which is of course a "limited liability" company.
The owning fund and the private equity firm itself will have "limited partnership" structures. Liability is limited to what the investors put in - and they've already taken that out, mainly in forms that don't look taxable. Portfolio companies may then be dropped like empty shells. "Collectively," Shaxson concludes, "private equity firms add little of value, extract a great deal and have persuaded everyone that, because they're so rich, they must be wealth-creating geniuses. They aren't; they are wealth-extracting geniuses".
In the process, their impact on employment is negative 'beyond doubt', concluded a 2008 Davos/World Economic Forum/Harvard study of all US takeovers by private equity since 1980. It showed these companies had high rates of closure, opening, acquisition and disposal of workplaces two years later, and 10% fewer employees five years later, compared to other matched companies. The private equity firms were twice as likely to go bankrupt as the average publicly owned company (see three papers by David Hall, Public Services International Research Unit, as World Economic Forum no longer makes the relevant reports available).
Finance industry site Pitchbook (5/6/20) notes recent high profile bankruptcies of US companies owned by private equity, and reports that private equity-backed businesses are being especially hard hit by the coronavirus epidemic, particularly those in retail, hospitality and travel. Sixteen filed for bankruptcy in May 2020 and the count for this half year is expected to eclipse 2019's total.
Pitchbook's analyst, describing private equity as "a levered bet on future economic growth", says: "Portfolio companies are especially vulnerable to economic contractions due to the highly levered nature of the industry. Even when a private equity firm hasn't owned a company in several years, debt that was piled on during a buyout can still be detrimental".
The global top six private equity firms - Carlyle Group, Kohlberg Kravis Roberts, Blackstone, Apollo Global Management, TPG, and CVC Capital Partners - have made frequent appearances in the OIO consent listings, along with others. They are headquartered in the US. All the OIO tells us about the fund investors that private equity firms have brought together to buy New Zealand assets is their "nationality", mostly in tax haven countries.
As the firms, funds and portfolio companies are privately owned, we are not privy to the financials but we may see finance-driven changes in local business structure and organisation. On the ground, actual work continues to be done by the acquired company, on land perhaps now cashed in and leased back. Or perhaps the overseas fund or its NZ-registered owning company subcontracts the work to an operating company.
Or the work may be further divided and put out to tender, or sub-sub-contracted to seasonal work gangs. And so on, ad infinitum, like that poem about dogs and fleas. Like our sucked-out oil and gas industry; like our forestry with its now appalling accident rates. Like our contract-based tax-funded healthcare and eldercare, also being targeted by offshore investors.
I'm not stating that any particular firm buying up any particular company or forest in New Zealand will necessarily behave like this - who knows? Maybe privately-owned global Bauer Media really has got a case of Covid-19, or we all stopped reading magazines during lockdown (Gordon Campbell, Scoop 3/4/20). Now Bauer's NZ and Australian magazines are being bought up by private equity group Mercury Capital (Stuff, 17/6/20).
Nor am I refuting the OIO's view that individuals who control these investments have the relevant business experience and acumen and are of good character - because all this is unfortunately legal enough. Perhaps High Net Worth investors really do want to help us save the planet by becoming our largest landowners and foresters. Maybe, from the Cayman Islands, pine trees just look cooler to them than to us. Maybe they are not just getting in early on a sure-to-rise bubble: the carbon market.
What Shaxson (and others) describes is the standard business model for private equity funds, with lots of real world examples. It is a business model that ordinary New Zealanders need to know about and understand better. It seems very different from Treasury's rosy-eyed aspirations for investment in New Zealand, shared by a friend I tried to explain all this to the other night.
Not In National Interest
The important question is: Is this kind of financialisation of the ownership of NZ's productive companies, lands and forests in our national interest? Will these investors hold our values, support our social welfare, protect our environment, honour our Treaty, share our future? Or will they and their financial advisors be here today, gone tomorrow, taking the fruit of our labour and gambling with it?
This Government's amendments to the Overseas Investment Act will tighten the investors' character test by adding criminal convictions, including for tax evasion. There is already a tighter "benefit to NZ" test for rural land, including a counterfactual (better than expected if bought by a New Zealander) - but there is no "benefit to New Zealand" or counterfactual test for buying up significant New Zealand business. The Minister's "national interest" test just passed is great, but its use is discretionary and limited to certain strategic industries. And CAFCA has always argued that the $100m-$500m thresholds for requiring OIO consent are far too high.
Since 2017, residential property can only be owned by overseas persons if they are New Zealand residents. This will help reduce speculation, but also, we will know who these people are. If something goes wrong, we can give them a call. As we can with business owners who are New Zealanders or residents. This is far from the case with the new private equity owners of our significant businesses and forests; the anonymous beneficiaries whose financial interests will determine future employment and environmental impacts in our communities.
Hidden behind multiple company structures, with corporate trails ending in airport buildings with hundreds of other companies, in tax havens and secrecy regimes, these anonymous owners have no relationship with the resources they exploit. In the recent decision against marine iron sand mining, the Court of Appeal acknowledged that kaitiakitanga is necessarily based on whanaungatanga (Warne, E-Tangata, 14/6/20). The Court quoted Joe Williams, first Māori Justice of the Supreme Court, that: "No right in resources can be sustained without the right holder maintaining an ongoing relationship with the resource". And with us.
Beneficiaries of New Zealand Foreign Trusts must now be publicly named, to discourage their use to hide assets or avoid tax. So too should be the ultimate beneficiaries of private equity funds and companies that buy up our forests and businesses. Not just in the interests of global tax reform, but also to provide greater transparency for New Zealanders. All overseas investment consents should have to meet a "benefit to New Zealand" test with counterfactuals. The new Ministerial power to decline applications, if need be, "in the national interest" should apply to all overseas investment in our businesses, forests and land.