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Sainsbury, Boots and madness

• Robert Peston
• 28 Mar 07, 12:20 PM

Most private equity firms claim that they contribute more to the businesses they buy than the injection of relatively cheap debt 鈥� although, as I explained here on 15 February, much of the super-normal returns they鈥檝e generated over the past few years has come from little more than loading up their investments with borrowings at a time when markets are rising.

Thus it has emerged from Blackstone鈥檚 recent filing with the SEC, prior to the imminent flotation of its management company, that it has probably borrowed in the order of $80bn for its portfolio of companies over the past three years or so. That鈥檚 on a par with what even Gordon Brown has been borrowing recently.

This process of 鈥渓everaging up鈥� balance sheets isn鈥檛 rocket science. Listed companies could do it without selling themselves to private equity investors 鈥� but on the whole choose not to do so, because their conventional institutional shareholders generally don鈥檛 like the risks that come with the increase in borrowing.

There鈥檚 something unsettling about the contrasting appetites for risks of the institutional shareholders on the one hand and the debt-providers, which are often the same institutional shareholders wearing a different hat (as well as hedge funds and investment banks). The debt-providers lend on repayment terms and at rates of interest that imply that they are blind to the risks perceived by equity providers.

The recent trend for some loans to private equity to be so-called 鈥渃ovenant-lite,鈥� giving only limited rights to the lenders to demand repayment when the going gets tough, may be the manifestation of the acute phase of market madness.

It鈥檚 a mania induced by excessive global liquidity. Or to put it another way, there is so much cash sloshing around the system looking for a home that much of it has been and will be lent or invested stupidly.

Another manifestation of this madness may be the attempts by private equity to buy Alliance Boots and Sainsbury. In both these cases, if the bids are successful, the current senior executives and their respective operational strategies are expected to be retained. The only big changes will be to their balance sheets: property will be stripped out, debt will be piled on.

There鈥檚 something intrinsically fatuous about deals that appear to be driven by simple financial engineering. It鈥檚 not as if either of these companies is in dire straits or in need of a structural overhaul, as shown by trading statements and have issued today.

The corollary won鈥檛 please the critics of private equity: it鈥檚 that if private equity bids a bit more than Sainsbury鈥檚 and Boots鈥檚 respective current share prices (say 575p for Sainsbury and 拢10.25 for Alliance Boots), it would be rational for their shareholders to sell. If these are deals driven by the under-pricing of risk, then it鈥檚 a fool who doesn鈥檛 sell that risk when given the opportunity to do so.

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