The financial lessons of Southern Cross
Any kind of overhead that is fixed or rising, at a time when revenues are under pressure, can bring down a business.
And in the case of Southern Cross, it is not the burden of large debts that threatens its survival. In fact what is striking about the financial performance of the UK's leading care-home provider over the past few years is that its net debt and interest bill has fallen very sharply.
What has done for Southern Cross is all the rent it has to pay on its 750 care homes, at a time when revenues from local authorities for residential care for the elderly is under pressure. Which is why it has unilaterally imposed a reduction of a third on the rents it is prepared to pay landlords.
Now to add to the pressures on the private care-home industry, some of Southern Cross's landlords operate their own care homes. In other words, Southern Cross's woes are adding to the woes of other private-sector care home providers, including Four Seasons, which is Southern Cross's nearest rival.
And in case you are interested, we all have a stake in Four Season's survival. It went to the brink less than two years ago- and only survived when its banks led by Royal Bank of Scotland wrote down by a half the £1.6bn they were owed.
RBS, which is 83% owned by taxpayers, ended up with a 40% stake in Four Seasons, when it converted some of Four Season's loans into shares. So you could argue that the private care-home industry is already semi nationalised.
Now it is reasonable to trace the travails of Southern Cross and Four Seasons back to the fashion of the boom years prior to the crash of 2007/8 of heaping huge debts on businesses.
At the time, it was incredibly cheap to borrow, so there were huge financial incentives - for private equity firms in particular - to strip the assets from a business by replacing equity with debt.
And if a business like Southern Cross succeeded in paying off those debts, that was in part because it sold valuable assets, in its case property. And in selling off the property, Southern Cross was left with a new burden, a massive rent bill.
It is also reasonable to think of the activities of many private equity firms as the equivalent of remortgaging a house. They would take a business, and then borrow huge sums against the assets in that business, to release the equity in that business for the benefit of the private equity firms' partners and backers.
As is by now well known, the partners of private equity firms such as Blackstone, KKR, Permira, TPC, CVC, BC Partners among many others became wealthy beyond most people's wildest dreams - to the tune of tens of millions of pounds, hundreds of millions of pounds and in some cases billions of pounds.
There were massive tax incentives for them to heap debts on enterprises. The resulting business, with its higher debts, would pay very little or zero corporation tax, because the interest on the debt was deductible from profits - and would therefore wipe out any taxable corporation tax.
If the debt finance was used to pay dividends, those dividends would be tax free, if the recipients were offshore in tax havens.
And as and when the private equity firms paid out gains from the buying and selling of businesses in their funds, those gains - called the carry - would be taxed at an incredibly low rate of capital gains tax.
For those who have persevered with my blog since its inception four and a half years ago, you'll remember me banging on and on about the huge tax breaks for private equity firms for much of 2007.
To jog your memory, official tax policy for many years actually encouraged private equity firms to heap massive debts on important businesses.
The reason private equity was allowed these tax breaks is that for a long time, the Treasury - under the then chancellor Gordon Brown - believed that the buying and selling of whole companies by private equity increased the efficiency of those companies, and simultaneously created a valuable new industry for the City of London.
The evidence for the extent to which private equity increased the sustainable productivity of the businesses they acquired is disputed.
However, interestingly, there is no evidence that more private-equity-owned companies went bust in the great recession of 2008-9 than other kinds of firms - although there is plenty of evidence of private-equity-owned companies with large debts feeling very vulnerable.
So Woolworths, for example, was a listed business when it collapsed. HMV, which seems to have recently survived by the skin of its teeth, is a listed business. And EMI borrowed far too much when controlled by the private equity firm Terra Firma and is now in the hands of its bankers, Citigroup.
Perhaps less in doubt is that the most successful private equity firms, including those listed above, have proved pretty adept at selling out of potentially vulnerable companies when the going was good.
So Blackstone of the US created Southern Cross in its current shape, having disposed of the care-home group's properties. But it no longer owns Southern Cross, having floated it on the stock market in 2006. So Southern Cross's current agony is not Blackstone's agony.
But, for all the cleverness of private equity firms at selling out at the top of the market, it is the perception that they bank the profits, but aren't around to clear up a mess they've in part created, which is doing serious damage to their image.
As for the current government, the problems at Southern Cross pose a series of policy questions. Here are some of them:
- Should George Osborne as chancellor revisit an idea he floated in opposition of placing limits on how much businesses can borrow, if they want to be able to deduct interest payments from tax (what's known in the trade as tighter restrictions on thinly capitalising businesses)?
- Has the Treasury done enough to increase the tax payable by private equity partners on their carry and to increase the tax payable in general by private-equity partners and their backers who are not domiciled in the UK, so that tax system doesn't favour their kind of financing and investing techniques over others?
- Should local authorities or government bodies be obliged to assess in a more rigorous way the financial strength of care home operators and other providers off essential services, before placing valuable contracts with them?
- After the forthcoming NHS reforms, will commissioning bodies awarding valuable contracts to health providers from the private sector be able to obtain assurances that the finances of these private healthcare companies are stronger than Southern Cross's.