The collapse of mobile phone retailer Phones 4U last week created some dark rumours. The main one wasthat the powerful network operators might have colluded to pull the rug from underneath the company.
Phones 4U founder John Caudwell called for an investigation into what he called these "multinational bully boys". However, the harsh reality is that those big network operators also have their own retail chains, and had no obvious reason to owe Phones 4U a living.
But this wasn't what caught my eye about this story.
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What interested me was that Phones 4U paid its current shareholders a £200m dividend only last year.
Now, I won't claim to be an expert on the company, but I suspect an extra £200m of equity might have gone some way towards shoring it up. It might also have funded some diversification to reduce Phones 4U's reliance on a tiny number of big companies.
So, why did they give it to the shareholders?
It doesn't seem to make much sense until you look at who actually owned the company.
Back in 2006, almost 20years after founding the company, Caudwell sold Phones 4U for £1.5bn (so we shouldn't feel too sorry for him!). The buyers were two private equity funds.
For me, the Phones 4U incident is another example of the shortcomings of the private equity business model.
This business model makes it impossible for companies to grow
Let's first be clear about what we mean by 'private equity'.
This is the more polite name for a technique originally known by the uglier title of 'leveraged buyout' (LBO). As you might have guessed from its name, an LBO involves buying a company using a lot of debt.
The technique really got going in the 1980s the most famous example from that era was the acquisition by KKR of US foods and tobacco giant RJR Nabisco. This saga was described in the book Barbarians at the Gate;the story was dramatic enough to turn into a film.
Like any deal that involves a lot of leverage or gearing, the LBO has big risks and potentially big rewards. The trick is to buy a business that has solid and predictable long-term cash flows. Which is exactly what RJR Nabisco had but which Phones 4U clearly did not.
The reason you need the consistent profits is because the LBO, or private equity buyer, uses the acquired firm's own earnings to pay for the purchase. The cash generated by the company isn't reinvested to grow its business; the number one priority is to pay down the debt that was used to buy it.
Now, if you get your market timing right and you also buy the right company, it can be very lucrative.
Think of it like buying a London house on a 95% mortgage ten years ago. With a strongly rising market and some debt pay-down, you look like a hero as your equity in the property rapidly builds.
If you got it wrong though and chose to buy in Dublin instead, that sliver of equity would have been quickly wiped out as property values collapsed.
Private equity is all about financial engineering making outsized returns from a small initial equity investment.
The tax system even lends a hand in the process. Interest payments on debt are tax-deductible, so the highly indebted LBO will pay far less, if any, corporation tax compared to the more conventionally financed business. Which seems a bit daft!
Private equity firms suck companies dry
A high point for the private equity industry was during the pre-crisis years in the middle of the last decade. Banks were keen to lend to just about anyone on generous terms. So debt was cheap and freely available to LBO investors.
We were in a bull market and the economy was growing, which meant highly leveraged structures had every chance of working.
These friendly background conditions meant that private equity produced good returns and started to look respectable, rather than like barbarians at the gate.
I remember hearing some great propaganda puffing up the industry. The private equity model was superior to public stock-market ownership, because it led to better management.
The private equity owners would be more patient, more focused, employ more talented managers, and do all sorts of wonderful things that conventional ownership couldn't do.
Institutional investors were seduced by this.
After the dotcom bear market, the search was on for 'alternatives asset classes' to invest in. Which helped migrate both hedge funds and private equity into the mainstream.
But what most private equity firms were really doing was ripping the cash out of companies during the good times. So even after the original acquisition, debt had been paid down to more normal levels, the private equity owners would go back and borrow more.
This would regear the balance sheet and allow them to pay themselves a special dividend out of the borrowed funds.
This is the 'dividend recapitalisation' technique which put Phones 4U in such a weak financial position with that £200m payout last year.
Companies need to keep reinvesting in themselves to survive
As Phones 4U has shown, the good times don't last forever. And some industries just don't have the reliable profit stream that makes private equity funding even halfway feasible.
Which is why having a more prudent balance sheet structure makes sense for the vast majority of firms that don't have bullet-proof businesses.
It's also worth remembering that even relatively mature companies need to invest some capital to stay competitive. I'm sure it's no coincidence that initial public offerings (IPOs) floated on the stock market by private equity owners have tended to struggle on average.
Most will have been starved of investment, being kept lean and mean in order to meet their private equity owners' demands for cash.
So, let's recognise private equity for what it is: a rather cynical exercise in financial engineering. I've never been able to see it as a strategy for fostering healthy growing companies.
