September 29, 2011

Predator v Wealth Creator … Or Not?

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"Are you on the side of the wealth creators or the asset strippers?" Ed Milliband asked the Labour Party conference (September 27, 2011).

Milliband tells a morality tale with two sides. On the good side are the producers, who "train, invest, invent, and sell." On the bad side are "the predators ... just interested in the fast buck, taking what they can out of the business." The example is "what a private equity firm did to the Southern Cross care homes. Stripping assets for a quick buck and treating tens of thousands of elderly people like commodities to be bought and sold. They may not have sold their own grandmothers for a fast buck. But they certainly sold yours."

In reality, the Southern Cross story is not one of asset stripping. There are two ways to think about this, one simple and one more complicated, but they lead to the same conclusion.

Here's the simple story. In 2004 Blackstone, a private equity firm, bought Southern Cross for £160 million. When Blackstone sold its last stake in 2007, Southern Cross was profitable, solvent, and worth £770 million. This was a story of asset growth, not assets stripped.

Now for the more complicated story. Over this period, Blackstone actually bought, amalgamated, restructured, and eventually sold three care providers: Southern Cross, NHP, and Ashbourne Care. Before acquisition, all of these companies were already operating predominantly on leased property. This included NHP, but the latter owned the property company as well as the care provider, with the latter leasing its homes from the property company. Blackstone separated out the property company and sold it. The care provider continued to lease the same homes, but these were now under the ownership of RBS, which sold them on to the sovereign wealth fund of Qatar. Southern Cross itself also sold off and leased back 21 properties -- a small number within its eventual total of 750 homes.

Why did this make sense? At this time the housing market bubble was inflating rapidly; a collapse was inevitable. Blackstone did exactly what my colleague Andrew Oswald was recommendingfor private families: sell property, put the proceeds into shares, and move into rented accommodation. What Blackstone did was not strip assets but change their form -- property for cash, which could go into business expansion.

In the process the Blackstone directors made a huge amount of money. Where did this money come from? It did not come from selling anyone's grandmother. Blackstone's profits came from two sources. One was a rationalization of the assets of the three care providers. On this, you'd have to say that Blackstone took a long view of the future of the care industry. You could call that view right or wrong, but it was a long view. The other source of Blackstone's profits was from selling near the peak of the housing bubble. Here there was a clear loser, but it was not the customers or shareholders of Southern Cross, who were saved from a huge capital loss. It was the Qatari investment authority, which was holding the homes when the crash came.

Why then did Southern Cross fail subsequently? As a public company, Southern Cross saw its revenue squeezed by government austerity, and allowed its occupancy rates to sag, while at the same time borrowing too much. You could blame it on circumstances, or on poor management, but it was not a result of asset stripping, which did not take place.

If Southern Cross is not a good example of asset stripping, then what of Ed Milliband's larger point? Asset stripping does happen; aren't we all its victims? Here we need a little precision. Some asset stripping is criminal. Suppose the employees of a company steal the roofing and wiring and sell off the materials on the side. The victims are the shareholders. That's rightly against the law. But that's not the point here. Milliband was talking about legal asset stripping by the owners of a business. What this means is that you buy a business and, instead of operating it, you sell off the property, the machinery and stocks, sack the employees, and take the cash.

You have the right to do it; does that make it right?

It sounds terrible.

But think for a moment: why would someone do that? You would make money on it, only if the market value of the parts of the company were greater than the value of the company as a whole. If that were not true -- if the value of the company as a going concern exceeded the sum of values of its parts -- you'd make more money by keeping the company going and either running it yourself, or hiring someone to run it for you, or selling it to someone else who would do just that.

In technical terms, when the market value of the parts of the company exceeds the value of the company as a whole, its Tobin's q is less than one. Now, any first year textbook will tell you that, if Tobin's q is less than one, you can increase the value of the company as a whole by shrinking its capital -- not replacing it as it wears out, or selling it off. Oh -- that sounds like asset stripping!

There are three points of interest. One is all the economics textbooks that tell us that what the world calls "asset stripping" is a normal response to a normal situation. Of course, that in itself doesn't make it right.

Another interesting thing is that you can't decide to become an asset stripper without taking the long view into account! How's that? Think: If the company is truly worth more in the long term as a company than the disposal value of its parts now, someone will be willing to pay you that value now, to take it off your hands as a going concern and prevent you from breaking it up. And you will make more money by selling it on than by breaking it up and selling the parts. So it is the logic of the market that makes you take the long view into your calculation.

Finally, the ability to make that hard decision -- if it's better to break up and sell the assets than manage the company for the long term -- is essential for the long term health of the market economy. If we can't run down declining industries, we would still all be mining and weaving -- and we would all be as poor as the miners and weavers of today's global economy. In fact, we would be poorer, because today's miners and weavers can at least afford mobile phones that are designed and produced by people who gave up mining and weaving long ago for something more productive.

To conclude, asset strippers are not the predators of the market economy. They are the carrion eaters, the recyclers. Nobody wants to cuddle a vulture, and no party conference will ever give them a cheer. Yet they play an essential part in the global ecology. It's not a case of predator v. wealth creator, or even asset stripper v. wealth creator. All play their part.

- 2 comments by 1 or more people Not publicly viewable

  1. Dave Marsay

    The actions of people like Blackstone seem to improve profit at the expense of increased risk to our grandmothers. How does an unregulated free market price in this risk?

    13 Oct 2011, 15:20

  2. Mark Harrison

    Thanks for your comment. A good question, but I’m not sure that it is the right one here. One point I made was that it is hard to blame Blackstone for whatever caused the Southern Cross pile-up. A further point is that I have only read of a couple of Southern Cross homes scheduled for closure—one because of poor design and low occupancy, another the centre of an abuse inquiry. So I am not clear that risks to our grandmothers have increased; closing such homes might even be good for them.

    13 Oct 2011, 16:07

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I am a professor in the Department of Economics at the University of Warwick. I am also a research associate of Warwick’s Centre on Competitive Advantage in the Global Economy, and of the Centre for Russian, European, and Eurasian Studies at the University of Birmingham. My research is on Russian and international economic history; I am interested in economic aspects of bureaucracy, dictatorship, defence, and warfare. My most recent book is One Day We Will Live Without Fear: Everyday Lives Under the Soviet Police State (Hoover Institution Press, 2016).

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