Monday, July 11, 2011

What’s missing from Cameron’s public services white paper

Private equity firm Blackstone escaped most of the blame for Southern Cross’s demise on Monday (see previous post How Blackstone made its £600m from Southern Cross) but the techniques it used to make its windfall raise serious questions about whether private equity firms are appropriate owners for public service providers.  

The questions are relevant now because David Cameron has just published his White Paper on public service reforms, detailing plans to open nearly all public services to the private sector – schools, hospitals, rehabilitation, childcare, council services, visa application centres etc - with virtually no safeguards against financial engineering or against brave new social enterprises being swamped by big business (see Peter Holbrook's post).

The White Paper has some good suggestions, such as allowing social enterprises, charities and employee-led mutuals to compete for services whose provision had grown stale under the state.

But it contains big contradictions, mostly relating to the role of the private sector and highly relevant to private equity. Here are some suggestions for making it safer.

Ironically, the paper was launched on the same day that struggling Southern Cross threw in the towel and said it would hand control of its care homes to its landlords (the second time in a little over a decade for some of its homes). With this fresh in mind, here are some of the contradictions in the paper:

- After mentioning the government’s “huge respect for public service ethos”, the Paper says that ownership models do not matter. But the form of ownership is a big factor in corporate culture and in determining whether staff are motivated by money or by something else. Is this just lip service?

- It says public services must be sustainable in the longer term but calls for more innovation in financing public service providers. If innovation means turning assets and income streams into huge one-off payments for private equity firms and other financial engineers, as we saw with Southern Cross, it will not be very sustainable.

- It says providers will be encouraged to use a new register of public assets to “make innovative proposals for the better use of publicly owned assets”, but does nothing to stop private firms from simply selling public assets, or using them for complex and ultimately costly asset-backed financing.

- It denies any ideological preference for either sector. It then derides public provision as "take what you're given" and "Whitehall knows best" but fails to mention any of the downsides of the private sector, such as the extra cost of paying dividends and the extra risks of bankruptcy. Brushing these under the carpet does not seem very impartial.

- It sets out to reduce bureaucracy and improve quality using “payment by results”. This is bound to skew the delivery of services towards easily quantifiable targets, such as number of visas processed or hours of care invoiced, and ignore qualitative aspects such as providing correct information to visa applicants or ensuring that care-givers give quality care that recipients really appreciate. It replaces the unselfish ethos of public service and quality with a self-interested focus on bureaucratic box-ticking in order to get paid.

- It will create a continuity regime for failing providers with few comebacks for failed management, which risks creating another industry prone to moral hazard and bail-outs.

Keep the financial engineers out

The best argument for allowing private equity to get involved with public service provision is that it might bring new capital. This is true, but if much of it leaves in the form of windfall payments, it rather undermines the industry's case. If much of it is transferred from public stakeholders, such as customers and taxpayers, it is untenable.

The next best argument is that private equity could turn around failing providers or fund new entrants. These are useful functions and do not rely heavily on financial engineering as a source of profit, making them suitable for venture capital rather than LBO houses.

The government recognises some of the problems. The white paper says there is a need for regulators to ensure financial management and robustness, while the Department of Health is proposing insurance bonds for care home operators to fund continuity of care in a failure. But it's not enough.

To capture the benefits of private sector involvement safely, the White Paper needs a few basic safeguards:

- a ban on extractive financial engineering (eg by hidden increases in operational leverage)

- strict limits on financial leverage

- restrictions on the sale or mortgaging of public assets, including the use of opco-propco structures

- personal liability for failing directors, including professional bans and civil and criminal liability for the worst offenders

- a continuity-in-failure regime that avoids moral hazard by haircutting debtors and clawing back excess profits

- overriding corporate objectives with a statutory public service delivery obligation.

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