Hedge funds and Private Equity - PES

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The increased level of debt resulting from LBOs leads to large-scale tax avoidance and a
concomitant loss of revenue for the state. This in turn results in a reduction in state investment
in infrastructure and education.
It also leads to further weakening of the viability of state social security. LBO operations also
require increased state expenditure due to job losses and reductions in purchasing power,
placing additional burdens on government. If average job losses total 4% in a secondary buyout,
we will see further examples of the social and fiscal consequences of the growing number
of tertiary buy-outs as the exit cycle speeds up.
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Advocates of these financing models defend the high leverage ratios of business acquisitions
by arguing that loans make sound business sense. Interest paid on these funds can be claimed
as business expenditure, which reduces a company’s liability for corporation tax and municipal
trade tax. Besides, the debt is not serviced from the company’s hidden reserves but from its free
cash flow 38 .
But this is a very narrow-minded and fragmented LBO argument. The fact is that LBO burdens
the companies with the cost of borrowing the funds and companies ultimately fund the acquisition
themselves and are heavily indebted as a result.
According to the rating agency Fitch Ratings, the indebtedness of European companies acquired
by private-equity firms has risen sharply. In the first quarter of 2005, Fitch Ratings assessed the
liabilities assumed by companies at 5.5 times the value of their cash flow; this figure had peaked
at 5.6 times cash flow in the fourth quarter of 2004.
Major damage to national economies cannot be ruled out, should the private equity sector overheat
– many investment banks, rating agencies, central banks and even representatives of the
sector itself could suffer. Risks could thus affect the banks involved in financing, or – if they securitise
these loans – other capital market agents.
And suddenly, we see the hedge funds and LBOs enforcing each other in a very unhealthy way:
To a certain extent, the latter are hedge funds which already operate in high-risk areas, which
could cause more significant disturbances in the capital markets in the event of LBO investments
failing to pay out.
38 See Die Zeit of 12 May 2005, p. 28.