Nothing ventured... by Paul Gosling

6 Sep 07
& nothing gained. Or so say the growing army of private equity investors in public services and assets. Paul Gosling explores the pros and cons of such partnerships for the public sector

07 September 2007

... nothing gained. Or so say the growing army of private equity investors in public services and assets. Paul Gosling explores the pros and cons of such partnerships for the public sector

The contentious world of private equity might seem a planet away from the public sector but it isn't. In a range of services, including utilities, education, health, social care, leisure and support facilities, private equity-owned companies are not just contractors but owners of what used to be public assets.

This involvement ranges from the peripheral to the massive. On the small scale is local authorities' sale of their dilapidated assets to these companies, such as underused leisure centres to private equity-based leisure firm Esporta. At the very large end of the spectrum lies the privatisation of the former Defence Evaluation and Research Agency.

Six years ago, Dera was split in two. The largest part was privatised as Qinetiq, although the government retained 56% of the shares. A significant chunk of the equity was initially sold to US private equity firm Carlyle, which was chosen as the partner to prepare for Qinetiq's initial public offering. By the time Carlyle disposed of its remaining shares in February this year, it had turned a £42m investment into a £300m profit.

This type of return across UK industry has put private equity into the headlines and under the spotlight of the Commons Treasury select committee. The National Audit Office is also investigating the Dera privatisation, including the price of Carlyle's original holding, and will report later this year.

Now one of the most pressing tasks of Chancellor Alistair Darling is to decide whether to raise the tax levied on private equity partners. At present, those involved in one kind of private equity deal leveraged buyouts borrow most of the capital. The interest cost is tax exempt and partners also benefit from a very low rate of capital gains tax. As a result, the firms and their members can make millions of pounds in profits, yet pay little in tax.

There are, though, other types of private equity. Venture capital puts in the investments for start-ups, expansions and sell-offs all of which can emerge from the public sector. Private equity as distinct from a loan is invested in exchange for a stake in the company. Some investors look for an exit in a year or two, while others are content to wait a decade or more.

Despite the recent crisis in the capital markets, there remains a large amount of private equity money awaiting further speculative investment. Labour MP and private equity critic David Taylor suggested to Public Finance that there could be £200bn available to buy further public sector and other assets.

Private equity has already grabbed a stronghold over what was once the preserve of the public sector. An example is Liberata, one of the UK's largest business process outsourcing companies, which is now 99% owned by US private equity house General Atlantic. Seventy per cent of Liberata's clients are in the public sector, including the Learning and Skills Council and the Ministry of Justice. Another customer is Sandwell Metropolitan Borough Council, where Liberata is working with BT to run the Transform Sandwell Partnership a £300m, 15-year outsourcing contract.

Sandwell's Labour-controlled council says 500 council staff will be transferred to the new company on existing terms and conditions, and some 450 jobs might be generated through the use of a newly built operations centre to provide services for other clients. The contract will lead to improved support services and consequently better frontline service provision, the council says, which would have been unaffordable without an external partner.

Robert Gogel, chief executive of Liberata, told Public Finance: 'Typically the driving force [for outsourcing contracts] is to go out and get value for money.' He says its clients expect improved quality and lower costs by contracting out such services as tax collection, benefits payments and payroll, while benefiting from reliable and advanced IT systems.

According to Gogel, these objectives are made easier by having a private equity owner. 'We have got a unique shareholder,' he says. 'It's not a hedge fund, it holds its shares for six or seven years.' Gogel adds that because the owners have a medium-term investment horizon, they are less concerned about quarterly earnings and more interested in sustained growth. And, because General Atlantic invests only in outsourcing and technology businesses, its appointed directors provide specialist expertise.

Barclays Bank's five private equity funds have also invested heavily in public sector assets, in particular by putting in the capital for a range of public-private partnership schemes, including Building Schools for the Future and Local Improvement Finance Trusts, which provide new primary care centres for the NHS. Altogether they have raised more than £1bn for PPP and Private Finance Initiative projects.

They have also invested in joint ventures with the Ministry of Defence and in Ryhurst, an asset investment and management company that provides community hospitals for the NHS.

Nick Salisbury, head of structured finance at Barclays Bank, believes that only private equity can give the public sector the current level of investment it needs. 'PLCs don't like to commit long-term funds to projects,' he says. 'Building Schools for the Future will probably commit primary or secondary funds for 25 years, and building contractors might not want to commit money in that way. If they did, it would usually be as a means to an end, to obtain the contract. But many will then recycle that equity as quickly as they can to get a return. They don't usually see themselves as long-term holders [of equity investments].'

Barclays is also an investor in the private equity fund Bridges Ventures, which has a specific community benefit purpose. Other investors include the West Midlands and South Yorkshire municipal pension funds; All Souls College, Oxford; Co-operative Financial Services; and the government itself. Bridges' investments include a company offering administrative services to primary care practices and Key Real Estate, which provides affordable homes for nurses and doctors employed by Plymouth Hospitals NHS Trust.

Much private equity investment in public services is through one of these 'funds of funds' though not all the investors have the same objectives. Pension funds are big investors in private equity in some former public assets particularly water and other infrastructure, which produce reliable returns not just now, but for several decades ahead, matching their profile of increasing liabilities as the population ages.

David Hall, director of the Public Services International Research Unit at the University of Greenwich, says this type of fund has put billions of pounds into such assets as water companies, housing, schools and health centre buildings.

Hall has conducted extensive research into private equity involvement in European public services, but remains 'uncertain' about the medium to long-term impact of the investments. 'If there is genuinely a different category of private equity emerging, which is infrastructure funds looking for long-term income streams, then it's not necessarily worse than various other forms of privatisation that we have seen,' he concedes.

What does disturb him is the developing use of leveraged finance in the water and waste industries. When water was privatised, it was financed almost exclusively through share issues, and was largely debt free. Now, though, the industry much of it owned by private equity has on average 70% debt, with some water companies owing even more.

In the waste management sector, he says, the trend across Europe has been for some of the largest private equity partnerships including Blackstone, KKR, CVC and Terra Firma to buy companies and sell after two or three years to international conglomerates, aiding consolidation of the industry and providing the private equity houses with quick returns.

Concerns about private equity have been put most forcefully by John McDonnell MP in his unsuccessful attempt to become a Labour Party leadership candidate. McDonnell told Public Finance: 'Private equity involvement in the public sector has epitomised the short-termism of the current market, generally seeking to generate short-term profit by ruthless cuts in jobs, wages and conditions, increasing charges and even targeting pensions, leading to a longer-term decline in the quality of service delivery and the loss of democratic control.

'In years to come, the PPP and PFI schemes and all the other privatisation devices promoted within our public services by Gordon Brown over the past decade will be looked back upon in the long term as one of the most inefficient, managerially incompetent and wasteful follies ever entered into by a government of any political persuasion.'

But defenders of private equity claim that one of its main functions has been to achieve synergies by buying businesses and enabling overheads to be cut often by selling companies on to other private equity houses that have similar investments. This, it can be argued, either aids business efficiency or erodes a competitive market.

What emerges is a level of confusion, and perhaps contradiction, about the impact of private equity on the working of public services. What is not in dispute though is that private equity has developed a central role in the public service marketplace even if it often goes unnoticed.

Share and share alike: how private equity owns and runs public services

Several water companies are owned by private equity, including Thames Water the UK's largest water provider. Thames is owned by Kemble Water, a consortium led by Australian bank Macquarie's European Infrastructure Funds. Cognita is the UK's largest private schools company, set up by former chief inspector of schools, Chris Woodhead and owned by private equity house Englefield Capital.

Another leading provider of independent schools in the UK (and the Middle East) is Gems, owned by Middle East private equity firm, Abraaj Capital.

ZooBiotic is a spin-off from Bro Morgannwg NHS Trust, which sells maggots as a sterile treatment for infected wounds. It has been financed by private equity, including from PUK Ventures the specialist fund established by Partnerships UK, the body set up by the government to promote public-private partnerships.

Annington is the largest private owner of residential homes in the UK, having bought the Ministry of Defence's married quarters stock. It is owned by Terra Firma Capital Partners.


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