Prem Sikka: The $63.2 trillion shadow banking sector is likely to be the site of the next financial crash

Private equity is a key part of shadow banking and has taken over many companies. What private equity entails are private equity firms that use funds raised from institutional investors to acquire and engage in buyouts of businesses.

Prem Sikka is Emeritus Professor of Accountancy at the University of Essex and the University of Sheffield, Labor Member of the House of Lords and Editor of Left Foot Forward..

Britain’s media headlines are dominated by a deepening cost of living crisis and a two-horse Tory circus to be the next prime minister. Meanwhile, the financial sector is incubating the next economic crash.

Deregulation, shady practices and the hunt for quick money were the main causes of the financial crash of 2007-08. The state provided £1.162 billion in cash and guarantees to bail out the industry. However, no real lesson has been learned.

The $63.2 trillion shadow banking sector will likely be the site of the next financial crash. Private equity is a key part of shadow banking and has taken over many companies. What private equity entails are private equity firms that use funds raised from institutional investors to acquire and engage in buyouts of businesses. They get their money from insurance companies, pension funds, banks, local authorities, trusts and wealthy individuals.

The £895bn of quantitative easing has significantly increased the resources available for private equity.

Private equity firms operate like banks but are not subject to minimum capital requirements, leverage controls, or stress tests, although a company’s failure can destabilize the regulated industry . The recent collapse of the US company Archegos Capital Management shows that the domino effects spread very quickly and had negative effects on the capital buffers of Goldman Sachs, Morgan Stanley, UBS and Credit Suisse.

In 2021, 803 UK private equity buyout deals worth £46.8bn were completed. The investment is welcomed by many as it has helped save some jobs, but private equity also poses a threat to jobs, pensions, the tax base and the wider economy.

On average, private equity retains its stake in a company for 5.9 years. There is no long term commitment to any company, place, product, workers or community.

Financial engineering, high debt, tax avoidance and opacity are key tactics for extracting high returns in the short term. A favorite tactic is to inject funding through secured debt, i.e. the private equity becomes a secured creditor. This means that in the event of bankruptcy, the investment capital must be paid first. Unsecured creditors recover little, if anything, of the amounts owed to them.

Bernard Matthews, Bonmarche, Cath Kidston, Comet, Debenhams, Flybe, HMV, Maplin, Monarch Airlines, Payless Shoes, Poundworld and Toys R Us are just a few of the victims of predatory private equity practices.

Pension plans are plundered. The demise of the Bernard Mathews poultry business is a typical example. In September 2013, private equity acquired a £25m stake in Bernard Matthews. The company received a secured loan from its private equity controllers. In 2016, its assets were sold. Private equity made a profit of £13.9m. The key was clearing out amounts owed to unsecured creditors, including a £75million deficit on the employees pension scheme. 700 employees lost part of their pension rights.

Struggling mattress company Silentnight has appointed KPMG as trustee to enable its rebuilding. Instead, KPMG’s partners agreed with a private equity firm to sell the business at a low price by dumping its pension obligations. 1,200 employees lost part of their pension rights.

High street retailer Debenhams has been gutted by private equity. 12,000 jobs were lost, but its private equity controllers collected over £1bn in dividends. Its pension scheme was at a deficit of £32 million and employees lost part of their pension rights.

During Thames Water’s private equity takeover in 2006-2017, debt rose from £2.4bn to £10bn, mostly from tax haven subsidiaries. Some £3.186 billion was extracted as interest charges and a further £1.2 billion in dividends. She only paid £100,000 in corporation tax. The company regularly dumps raw sewage into rivers.

In 2020, private equity acquired Asda and it is now controlled from a purpose-built company in Jersey. In 2021 rival supermarket Morrisons was also acquired through private equity and is now controlled by a Cayman Islands entity. The usual tactics of profit shifting and tax avoidance will follow.

Private equity has made its way into retirement homes. A report said that “nursing home groups have been stripped of their real estate and forced to rent (sale-lease-back) it”. Thus, returns are increased by forcing care homes to pay rent. In addition, nursing homes are riddled with debt and interest charges account for about 16% of nursing home costs. Dividends are high, but staff salaries are low, resulting in high staff turnover, making it difficult to provide personalized service to residents. Too many care homes fail to meet basic standards of care.

The private equity operating edifice is built on shaky foundations of debt, and what a leading asset manager has described as “Ponzi and pyramid schemes”. Some private equity firms mistakenly inflate their profits by selling companies to each other – and paying higher prices without regard to the real value. Their solvency ratios may be illusory.

Alarm bells are ringing. The Bank for International Settlements says rising interest rates will make it difficult for private capital and shadow banks to service their debts. A series of corporate bankruptcies will follow. Almost all sectors of the economy will be infected.

The recently released Financial Services and Markets Bill contains no plans to regulate shadow banking or private equity, and will in fact undo many of the post-crash reforms of 2007/08. All roads to financial crashes are paved with the obsession with deregulation. Have we learned anything from history?

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