Monday, July 11, 2011

How Blackstone made its £600m from Southern Cross

Five years before Southern Cross failed, private equity firm Blackstone owned the company and its main freeholder for two years in which time it engineered a profit of £600m - pretty impressive given that the UK care home group had annual operating cashflow of only £50m. Blackstone has faced accusations of profiteering and worse ever since.

This post tries to explain how Blackstone made its money and where it really came from.

The background

Southern Cross was a care home “opco”, paid by local authorities to run care homes for about 31,000 elderly people. It leased most of its buildings from specialist landlords including the company formerly known as NHP, the largest of SC’s “propco” freehold owners. NHP was unusual as it also owned its own “opco” Highfield, inherited in the late 1990s when some previous care home tenants went bust in a previous round of financial engineering.

Blackstone bought both SC and NHP in 2004 in a pair of separate, leveraged buyouts that cost it £162m for SC and £950m for NHP. It made a few internal changes, such as transferring Highfield from NHP to SC, installing en-suite bathrooms in some of the bedrooms and refinancing both companies via massive offshore debt structures.

In 2006, it listed SC on the stock market for around £500m and sold NHP to RBS for £1.15bn. Its profit on the two deals was £600m, made up of £400m from SC and £200m from NHP.

After Blackstone left, SC’s new management expanded the company extremely quickly, taking Blackstone's methods to new extremes and adding some tricks of their own. When rates of bed occupancy fell and rents carried on rising, SC could no longer pay its rent. SC’s share price collapsed almost to nothing and its landlords including NHP (now owned by the Qatari sovereign wealth fund) started a long and messy round of negotiations, ending with the transfer of care homes from SC to its various landlords as going concerns.

Blackstone's original "buy-and-build" strategy has ended with SC being fragmented among 80 landlords.

SC made 3000 staff redundant and promised its anxious elderly residents that they would not be left in the street, a promise it has so far kept.

How did Blackstone make its money?

From my own research, Blackstone appears to have earned its windfall using these four financial engineering techniques:

1. First, Blackstone adjusted the operating leases between leaseholder and freeholder, both of which it owned. It extended any leases under 20 years to 25-30 years and replaced any RPI-linked and turnover-linked rents with a fixed annual ratchet. In the booming conditions of the time, this reduced SC’s short-term costs but restricted its longer term flexibility, since rent increases could not be reduced in down years. Another change (I don't know if this is down to Blackstone or someone else) was to prevent any rent review until 2020. This last change massively complicated negotiations with the landlords when the business eventually collapsed. Overall, the lease changes boosted the gearing capacity and therefore the resale value of NHP when it was in Blackstone's hands.

2. The second technique was to gear up. In round numbers, Blackstone contributed only £60m of its own equity for SC and £200m for NHP, around 20% of its total investment. The rest was borrowed, allowing Blackstone to gear its equity return 5x, in effect pocketing much of every pound of debt that the operating companies paid off.

3. The third was tax planning. Since debt interest is a tax-deductible, the large amounts of debt meant SC and NHP paid little or no UK non-payroll tax. If this had been equity finance, any dividends would not have been tax-deductible and the tax bill would have been far higher. The structure effectively forced the UK taxpayer to subsidise the deal. Further tax avoidance measures included a mind-boggling web of offshore holding companies and a technique of providing equity in the form of tax efficient “deep discount bonds”. These measures are widely used in the private equity industry to avoid tax.

4. The last and biggest technique was multiples arbitrage. Blackstone paid around 6x EBITDA for the care homes in 2004 and sold them for 9x in 2006. It could do this because it was packaging smaller care homes into a larger network that was visible to institutional investors, who were in the grip of a property mania at the time. No doubt many regretted it later.

Where did the money really come from?

Blackstone’s strategy was to capture for itself the nominal rise in value of a group of real estate assets. Assuming a typical 2 and 20 fee structure, staff at Blackstone are likely to have shared a £125m bonus for doing this, and transferred the remaining £475m gain to their investors.

Market theory holds that fund managers are rewarded for the social and economic value they create by directing capital to its most productive use. Their rewards represent a slice of the additional return that the capital earns from new marginal production and therefore commensurate with the social and economic value added. That's the theory, anyway.

In this case, Blackstone’s profit was earned from changing asset values. It can best be described as a transfer from people that owned the assets at other times, not a reward for boosting productivity.  

If anything, it may have diminished productivity by leaving the care home group heavily mortgaged and its managers focussed on caring for debts instead of residents. The result: higher bankruptcy risk, lower long-term capital investment and a shoestring budget for residents and nursing staff.

Even the £475m profit booked by Blackstone’s investors is hard to count as a social gain: most of it was simply shuffled from one set of institutional investors to another. Despite huge fees taken on the round trip, the net amount of institutional funding for the care homes industry hardly changed.

Blackstone did not trigger the failure of Southern Cross, which was carried over the edge by its subsequent management. The private equity group apparently "feels terrible" about what happened but has denied doing anything irresponsible.

Despite this reassurance, the fact is that over the ten years that include Blackstone and subsequent management, Southern Cross grew markedly less resilient. In 2001-2004, bed occupancy and rent cover averaged around 87% and 1.2x, levels the business was comfortable with for several years. Fast forward to 2011 and ratios were very similar at 85% and 1.2x but the business failed, with financial conditions now deemed “impossible”.

It is difficult to prove empirically who profited from this fall in resilience, but the question lingers like a bad smell. Either way, the prospects for future health privatisations are not good.

What is clear is that Blackstone succeeded in capturing all the asset price inflation of care homes that it owned only fleetingly, using elaborate financing and good timing to squeeze past and future asset price gains into its pocket, helped by lease alterations and leverage. Blackstone was smart enough not to cripple the operating company and to sell before the bubble ended but when subsequent, less-disciplined managers continued with the same financing techniques, the money machine inevitably collapsed.

So where did the money come from? Some came from taxpayers via the subsidies on debt, some may have come from squeezing operating margins but it seems most of Blackstone’s windfall came at the expense of other investors and creditors. Tough luck, you might say, that's how the market works and how we reward entrepreneurs for creating value. Unfortunately, even Blackstone agrees that, of all the things it did, earning £600m by making Southern Cross a better care home operator is not one of them.

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