Learning the right lessons from the MG Rover Collapse: The 'Private Equity Business Model' still needs effective regulation.
Blogged by David Bailey, Alex de Ruyter and Ian Clark
Last year's BIS Report on the collapse of MG Rover laid bare some of the ways in which Phoenix Consortium engaged in financial engineering and extracted value from the carmaker before it went bust.
At the time of the report's publication many of us called for reforms so as to ensure proper accountability especially in relation to the 'private equity business model' (PEB Model) which Phoenix adopted, and to make a repeat of such a failure more difficult.
We've seen no progress since then, as a new paper by Alex de Ruyter, Ian Clark and myself make clear in the latest issue of the Cambridge Journal of Regions, Economy and Society, which has just been published.
This study provides a forensic analysis of the arguments contained in the BIS report and makes recommendations for policy reform and better regulation.
Firstly, let's remember that the objective of private equity investors is to make money. This can be done in one of two ways, either:
1. Renewing the value of existing assets and later selling an investment as a re-listing or in the secondary private equity market; or
2. Extracting value from a business while possibly securing it as a going concern, selling it via a re-listing or in the secondary market, or integrating the business into a larger group by way of its acquisition in a joint venture.
In either case investors will secure returns and revenue streams for themselves as a result of financial engineering. In the second case it goes something like this:
The A, B, C of Re-Structuring in the Private Equity Business Model
1, Investors A want to buy firm B.
2, A creates an investment vehicle called Car. Car is funded by loans which are turned into equity.
3, Car buys company B. Car becomes the shareholder of B taking the firm private. Car pays its investors - the new owner-managers of B, that is A, a salary and a bonus.
4, Car loans B funds at commercial rates, these loans are eventually re-paid to Car (a legal entity) by B, that is, to A the individuals (the ultimate beneficiaries) who own B via Car.
5, Car creates an off-shore investment trust called D for its employees and families outside GB territory and pays money into this trust as it secures revenue, its only employees are A. Car also sells and leases back B land and property transferring some of the revenue streams from this D.
6, Car also set up a property vehicle E to manage the land sale which is owned by A. A secures a commission for this work. A and Car are the same but the firm and investment vehicle are contractually, legally and hermetically sealed from one another.
7, A deposits the commission in a parallel employee trust F in the same territory as D.
8, B sells some subsidiary operations at historic cost to G. G is owned by Car +1 other.
9, G sells the subsidiary at market value on the open market, the revenue accrues to Car, Car deposits the revenue stream from this in D.
10, The individuals who make up A who created Car and own B and who are the trustees of D and E and F and G are either paid a fee or a salary by all of these entities.
The MG Rover case was quite unusual, though, in the sense that it was not highly leveraged. In other words, the Phoenix Four (later termed the Phoenix Consortium with the addition of a 5th person) only borrowed around ÃÂ£60,000 each to secure the 'special purpose investment vehicle' (Techtronic), which acquired MG Rover from the Phoenix 4.
The debt finance effectively came from BMW's 'dowry' to MG Rover which might even have been interest-rate free. However, despite this, the financial engineering entered into by the Phoenix consortium was still a classic example of value extraction in the PEB Model in line with the scheme above, as detailed in this latest academic paper.
In the short-term the money loaned to MG Rover by BMW ensured that the firm would not fail, as it had sufficient capital to pay the wage bill and keep the business as a going concern.
MG Rover was unusual in a second sense. Whilst PVH was not necessarily backed by substantial leverage, while rolling out the PEB Model it had considerable stakeholder support in the form of politicians and trade unions.
Because of this, there was little real opposition to or scrutiny of the manner in which PVH secured generous financial rewards and secured and ring-fenced MGR assets at historic cost before divesting itself of them at market value.
And in many respects it could be argued that the trade unions were effectively 'duped' in a way they were not at other more controversial private equity buy-outs such as that at the AA. Indeed, it was only after MG Rover's collapse that the GMB union made public its concerns about the deficits in the firm's pension fund.
But the MG Rover case was unusual in a third sense: the absence of leverage and the 'full-on' stakeholder support buoyed the short-term business plan to run the firm out of the BMW dowry-cum-loan and revenues derived from car sales, whilst the extraction of value via asset sales and transfers was less transparent as was the value of the financial rewards taken by PVH.
All this is highly relevant as today - over 5 years after MG Rover's collapse - the private equity sector remains pretty much an unregulated actor.
Despite much discussion on the issue at the UK and EU levels, a whole range of key issues remain unregulated, including the use of off-balance sheet instruments (so-called special purpose investment vehicles) and the absence of any transfer of undertakings legislation designed to protect employee interests in the case of transfer to a new employer
And as long as policy elites in government circles - linked to the City - support the unregulated PEB Model, there could be more failures like MG Rover.
We would like to see the suggestions made by the BIS inspectors actually followed up - and sooner rather than later. For example, improvements could be made to auditing and reporting standards that would increase transparency in financial statements, and the issue of 'going concern' may also need looking at again.
In addition, while the BIS report also acknowledged that the transfer of assets and tax losses between companies with the Rover Group was in accordance with accounting standards, readers of the firm's financial statements would have been better informed had the "true or potential value of these assets been explained".
In other words, a shift towards making such disclosures mandatory would improve understanding of a company's financial performance.
But in addition to these issues of regulation and transparency, there is a fundamental issue of distribution and the extraction of value by a minority.
This needs tackling by securing wider stakeholder oversight of 'special purpose investment vehicles' (like Techtronic), for example by securing recognised trade unions some representation in PEB Model-backed investment vehicles as distinct from merely union support as in the case of MG Rover.
A related and final issue is the nature of our wider financial system. That system is now made up of huge financial beasts which cannot easily be distinguished as banks of different types, hedge and private equity funds, re-insurers or credit default swap brokers.
Put simply, the institutional distinction between different types of banks and those institutions trading in various types of securities has all but disappeared to the extent that the labels are interchangeable: all do all of the different types of trading.
Legislative restrictions are needed to reduce the power of these institutions over the real economy. Currently the interchangeable roles of branded financial institutions enable them to trade products and fund special purpose investment vehicles without oversight.
Legislative reform, we argue, is still required to ensure that no British bank (or financial institution which contains a bank) can own, invest in, or sponsor a private equity fund which is unrelated to serving its own customers for its own profit.
This will restrict the trading activity of British banks in off balance sheet instruments, special purpose investment vehicles or securities markets such as credit default swaps which if they result in distress and flight - as in the MG Rover case - are now effectively secured by the taxpayer.
We don't just need to break up the banks but we need to limit what they can actually do.
Private equity and the flight of the phoenix four - the collapse of MG Rover in the UK, by David Bailey, Ian Clark and Alex De Ruyter, appears in the latest issue of the Cambridge Journal of Regions, Economy and Society (Journal copyright Oxford University press: reuse will require permission).
The research behind this article was funded by the Economic and Social Reserach Council (ESRC) under award number RES-000-22-2478.