Option on an option on an option
Sitting on my desk is a prospectus for a fund of private equity funds. It offers me some of the best names – Blackstone, Permira etc. I have just received a large cheque for my holding in Equity Office Properties and, if a similar bidding war for Sainsbury’s takes place, I will have a lot of cash to reinvest.
But wait a moment. Was it not Blackstone that just bought Equity Office and are not the names in the frame at J Sainsbury almost exactly those in my fund of funds? The prospectus invites me to buy Equity Office Properties and Sainsbury from myself, at prices around twice what I recently paid.
If management and business operations remain much the same, as does the underlying ownership structure once you drill down through the layers of fee-collecting intermediaries, it is hard to see where value is being added. If financial engineering of the business is not the explanation, can the answer lie in financial engineering among investors?
The private equity promoters propose layer upon layer of debt, leveraged by non-recourse finance. What I get is an option on an option on an option. But the same finance theory also tells us that you do not increase the value of an investment portfolio by increasing gearing: once again the greater risk exactly matches the greater prospect of return.
Perhaps the sophistication of modern financial structures means that the distribution of risks and the design of governance structures can be finely tuned to the needs of individual investors and the businesses they fund. Or perhaps there is a miasma of complexity and confusion in which everyone persuades themselves that the uncertainties of business have been landed on someone else. Make up your own mind: but I have decided to keep my cheque book in my pocket.
Given the recent research suggesting that LBO fund performance is no better, allowing for gearing and cheap borrowing, than the public markets, it's a valid question.