Hedge funds and Private Equity - PES

Here is a quite well known “flow” of decisions used by LBO funds to maximize their cash flow:
Normally the target company is bought by a series of local holding companies. Each holding
company is partly debt financed and owned by the next holding company, and the “upper”
local holding company is owned by a Luxembourg holding company.
In the case study of Viterra it is described how 90 % of the leverage buyout was financed by
loans – an unusual high percentage for the purchase of stakes in a company.
The Luxembourg holding company is owned by the private equity fund, which is normally a
limited partnership domiciled in an off shore centre. The limited partnership will distribute the
profit of the investment to the participants in the partnership (the investors of the private equity
fund).
Soon after the acquisition of the target company, it is taken private and de-listed at the stock
exchange. One of the purposes of this exercise is to avoid the disclosure regulations of a
publicly listed company.
Soon after the acquisition the balance sheet of the target company is pressed for liquidity,
both in terms of assets and by new loans in the target company. All this money is distributed
as dividend to the holding company, which is the direct owner of the target company. This
holding company has often arranged bridge financing, and this bridge financing is redeemed.
The direct holding company can also distributed the received dividend to the next holding
company, which can redeem their financing or just pay the interest on its loan. By this the
target company is in reality self-financing its own take-over.
However, this type of financing is not only arranged through dividends. The takeover process
included substantial expenses to financial advisers, lawyers and other consultants. Often the
expenses of a take-over are about 5% of the sum of the acquisition of the target company.
Traditionally such expenses should be paid by the buyer, but in cases of a leverage buy-out,
the LBO manager decides that the target company will have to pay these expenses.
This type of financing, where the target company actually pays for its own take over, is of course
not without consequences. The target company will be much more dependent on the general
economic climate, and it will have problems financing necessary investment for new markets and
new products, innovations and R&D.
1.4 The Effects of Debt Financing
As a rule, target enterprises are burdened with a high level of debt as a result of leveraged
buyout financing and dividend recaps by private equity funds. Their own capital is transformed
into debt through the dissolution of undisclosed reserves and the sale of investment objects,
which the private equity funds deem to be unnecessarily tying up capital. The enterprise is thus
stripped of assets that could serve as a buffer in the event of a market slump, marketing difficulties
or management errors, or could be used for investment in the sustainable development
of the enterprise and innovation or human resource management and training. The strategic and
planning horizon of enterprises is shortened as a result of the influence of private equity funds.
When the debt can no longer be serviced, the target enterprise can be pushed to the edge of
bankruptcy.
Part II – Six concerns about our European social market economy
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