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November 06, 2015

Plunder, profit and private equity - a Trojan horse and the future of regulation

Ancient Greek myth tells the story of the Trojan War, according to which Greek soldiers defeated the city of Troy they had besieged for ten years by means of a giant wooden horse in which soldiers were concealed. The unwary Trojans, thinking it a gift, brought the horse into the city and out popped the soldiers, who pillaged the city, murdered the inhabitants and left Troy in ruins. A Luxembourg court will shortly decide whether the alleged looting of a Greek mobile phone company by two large private equity funds, Apax and TPG, was a financial Trojan horse carried out by fraudulent means.

That decision will presumably impact on a civil lawsuit by the same creditors which will be heard in a US court next year. But it should also serve as a warning to what the financial vultures circling a Greek economy bled dry by successive 'bailouts' may bring. And it should prompt a fresh look at the EU's Alternative Investment Fund Manager Directive (AIMF Directive), which ostensibly safeguards against 'asset stripping' by private equity investors, in view of another potential leveraged buyout bubble.

In 2005, two private equity giants, Apax and TPG, bought the Greek mobile phone company TIM Hellas, a profitable company with low debt, in a deal which was 80% debt financed. Hellas was then bundled together with another mobile operator into a company which was parked in Luxembourg and renamed WIND Hellas.

Within a year, according to the Economist, the debt burden on the new entity had increased 15-fold through the issuing of new debt instruments called "convertible preferred-equity certificates" (CPECs), a 'hybrid' construction which can be booked as either debt or equity, depending on who's asking. The funds quickly recouped their initial equity investment by redeeming the CPECs, whose issue was funded by borrowing, and then tried to flip the now heavily indebted company to a new owner. When they failed to find a buyer, they ramped up their cash withdrawals by redeeming the CPECs at 35 times the value at the time they were issued. Within 18 months, the Economist reports, the two funds had taken out more than 20 times their initial equity investment.

In 2007, WIND Hellas was sold to an Egyptian investor for €3.4 billion, a nearly 150% increase over the 2005 purchase price. Two years later, the new owner, unsurprisingly, declared bankruptcy. The creditors behind the lawsuits claimed the alleged CPEC scam sucked €974 million out of the company and that the operation, code-named 'Project Troy' by the funds, was "a state-of- the art Trojan horse designed to financially infiltrate TIM Hellas and Q-Telecom and then systematically pillage their assets from within by piling on debt in order to make large distributions to equity owners". The Independent quoted one of the creditors (SPQR Capital's Bertrand des Pallieres) in the lawsuit saying: "You cannot take €1bn out of a company that has no reserves. It would open the door to the wholesale looting of companies." The private equity funds have denied any wrongdoing, and the courts will decide.

The WIND Hellas story took place at the height of the leveraged buyout bubble, just before the Lehman Brothers bankruptcy triggered a global financial crisis. Private equity funds have diversified far beyond buyouts since the financial meltdown, with extensive activities in real estate and financial markets. In many respects, the former buyout houses are the new financial conglomerates. They are the world's largest owners of hotel properties. The world's largest brewer, AB InBev, which will become even larger through the acquisition of SAB Miller, is owned by a private equity fund, Brazil's 3G. 3G teamed up with Warren Buffett's Berkshire Hathaway in the USD 28 billion buyout of food maker Heinz, in a deal which was loaded with debt. Heinz has since laid off more than 25 percent of its global workforce.

The Luxembourg court will be examining the alleged financial vandalism at Hellas as a tax issue only. It should also be viewed in the light of the 2011 AIFM Directive, which in principle prohibits a private equity fund or funds for a period of two years following their acquisition or effective control of a non-listed company from doing what Apax and TPG did to WIND Hellas. In practice, however, the Directive is riddled with so many exceptions and loopholes as to render it ineffective; 1,700 amendments gutted the original text. The acquired company, for example, must be registered within the European Economic Area or the rules do not apply. And there are multiple ways of rebranding debt-funded distributions to shareholders to evade the formal restrictions - the internet is full of advice from the funds on how to do it.

The size of the buyout deals has declined post-Lehman, but leverage ratios in some deals are back to their pre-2007 levels and the dodgy debt instruments which were used to pump out cash to private equity owners by piling new debt on to an acquired company's balance sheet are back as well.

The Directive, which came into effect in 2013, must be automatically reviewed in 2017, but there is no need to wait until then to begin a public review in Europe and to start a debate in North America which the crisis failed to trigger. Current debate about private equity focuses on fees, not on the business model. This task is all the more urgent in the light of the potential impact of TTIP, CETA and TISA, trade deals which threaten democracy and will undercut future efforts to rein in debt bubbles and dubious financial 'products'. The door to financial looting remains wide open.

A version of this article appears on the Social Europe website.