Truly growing a business versus making a quick buck

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Rather we are talking about someone we can refer to as a parasite capitalist. A parasite in the natural world is an organism of some kind which seizes onto another healthy and prospering organism in order to sponge off it without needing to put in any effort of its own. And in the business world, a parasite capitalist is the company or individual who latches onto the success of another company and uses normal business practices to appropriate that wealth for itself.

But before the parasite capitalist gets going, someone must build that healthy and successful company. And this will take real work. For example, there is the case of Sir Kenneth Morrison. He was an entrepreneur who did well over a remarkable span of 60 years or so, building up the eponymous supermarket chain.

For many years Morrisons was a thrifty and well managed supermarket chain based in Bradford in the North of the United Kingdom (UK). Sir Kenneth founded it when he took over his dad’s small grocery shop in 1952, and he invested gradually and innovatively in the business from those early days.

For example, in 1958 Morrisons had opened its first small shop in Bradford’s city centre. This was something of a retail revolution at the time for the area, being the first store in town to have self-service, the first store in town to have prices posted on individual products, and the first store in town to have separate checkouts. The company continued to grow year on year, opening its first full supermarket in 1961. This idea of the supermarket was also an innovation for the time in the UK.

Over the years Morrisons introduced further innovations such as staff loyalty schemes, petrol stations attached to the supermarkets, own-brand products, and its own M Local convenience stores. Morrisons also signed a deal with budget clothing retailer Peacocks, to open a concession in a Morrisons store in Bradford. Similar Peacocks sections were rolled out into other stores before Morrisons launched its own children’s-wear brand ‘Nutmeg’ into 85 stores. Some of these ventures and innovations were more successful than others, but over the years Morrisons were able to build up a solid core of customers who enjoyed the ambience and décor of the stores, and the wide choice of fresh and packaged goods available in their stores.

As his company grew, there was one principle which Sir Kenneth was always careful to observe. This was his insistence that any growth be funded mainly by profits earned, rather than by borrowing the money from outside. This meant that the company would avoid needing to pay any loan interest, and any expansion would always be within its own means. There might not have been anything wrong with borrowing if it was done judiciously, and maybe growth could have been faster if it had been financed in this way from outside. But by eschewing outside financing as a rule, Sir Kenneth ensured that any expansion would always be on stable and fully sustainable lines.

And in any case, there is a case to be made for expanding at a slow and steady pace. It can sometimes be a mistake to expand too fast, even if the money is there. For example, if one is going to open a new store, are there enough trained and experienced staff to run the new premises effectively, thus ensuring that previously established standards are maintained? But in any case, by the time Sir Kenneth retired in 2008, his company was well established as one of the big four supermarket chains in the United Kingdom (UK), and he had amassed a personal fortune of almost £1.6 billion.

However, having considered these key business principles which will help someone who has ambitions to build a business, we must also recognise that there are also many who prefer not to work hard at it at all. Because of this reluctance to work, some might suggest that the world of business is not really for them. However, they would disagree. These are those parasite capitalists referred to previously. These are the types who simply prefer to use short cuts to make their business fortunes, rather than working at it over time. They do this by manipulating and exploiting businesses which already exist, rather than creating a new one themselves. “After all,” they would say, “why work hard at building a company when you can play around with one which someone else already built?”

One of the financial vehicles used to help the parasite capitalist operate his short cut type of financial management is the Private Equity Fund (PEF). Calling it something like this has the effect of making the parasitic element less obvious. I mean, even if one is going to be a parasite, it is probably good policy not to overly advertise the fact. It’s much better to use a less suggestive title, and that’s where the label PEF comes in.

In the field of finance these days, the PEF is usually a limited partnership, and it will invest in and restructure private companies. Private companies are those which are not publicly traded on a stock exchange. To achieve this, often the first thing the PEF does is to invest in the target company and then take it private. To do this, private equity capital is invested into the target company by the PEF which provides some or all the working capital required to buy out enough of the previous shareholders, and then the new management will decide on their investment strategies to make money out of their new investment.

So far, so good, one might say. The previous shareholders have sold their shares and have presumably received the value of their shares, and maybe they have received a premium as well. But now that they are out of the picture, the PEF has a challenge. It has bought a company, taken it private, and it now must demonstrate to its own shareholders that it can make good investment returns for them on this deal. Otherwise, there was no point in making this investment in the first place.

In fact, financial commentators have noted that the PEF will probably need to make “better than good” investment returns for their shareholders. Let’s be quite clear about the fact that these folk are in it for high returns on their money, and only for high returns on their money. In fact, over the years this sort of PEF approach has tended to result in a very “short-term” exploitative approach to company management, with everything being done to maximise short-term profits. Sometimes this is even done at the expense of helping the company towards long-term growth, which would in time have delivered good long-term profits. But the PEF has a different agenda from the previous management, and it is often not geared towards the good of the company.

One illustration of such a PEF investment is our previous example of Morrisons. In the autumn of 2021, American PEF Clayton, Dubilier and Rice (CDR) took Morrisons over for £7 billion. Since this price represented a 60% premium on the share price at the time, let’s just say that observers wondered whether there was a possibility that they had paid too much money for it. And the question then arises, how is it possible to make money on a deal if one has already paid too much even before one has begun?

The profit forecasts are looking even worse in this case because of one specific action which CDR took right away in order to pay for Morrisons. They funded its purchase by taking out a loan from Morrisons itself. This is a favoured trick of the PEF brigade, and if this sounds a bit weird at first, the following is a description of how it works. Let’s just say that, in addition to the money they already possessed, CDR needed an extra £2.8 billion to pay for the Morrisons shares. So, they borrowed this extra £2.8 billion from a bank, and then once they had completed the purchase, they now had complete control of all Morrisons’ affairs.

They then used this complete control to get Morrisons to take out a loan which went onto the Morrisons balance sheet. Then they used this borrowed money to repay that £2.8 billion loan which they had taken out in the beginning. However, whereas Morrisons’ net debt obligations stood at £3.2 billion before the CDR takeover, they had now increased to almost £6 billion after the acquisition due to this loan.

This meant that from the very start of the new regime, Morrisons would be much less profitable than it had been before, because it now had to pay interest on an extra £2.8 billion of money borrowed. There are many who think that this is a bizarre way to run a business. But the CDR shareholders still wanted the large investment returns which they were promised. So, what began to come next was a bout of asset stripping with stores and other assets being sold off to make some quick cash. Thus, the business began to shrink rather than grow.

Another little PEF trick would be to dip into Morrisons’ property portfolio. The fact is that because the supermarket chain was built up over the years without incurring any mortgages or other large debts, Morrisons owned the freehold of its stores and its warehouses. But these could be sold, and indeed some of them were sold quickly, and then they were leased back from the buyer. This resulted in a nice influx of quick cash to satisfy the voracious demands of the CDR shareholders, but it forever saddled Morrisons with a hefty rental bill to go along with the large loan interest bill.

No one should expect a company run like this to be making any decent profits in the near term, and certainly not the kind of profits which Morrisons used to make. In fact, the group’s latest results underline concerns about private equity takeovers, which often tend to load businesses with debt. The supermarket chain slumped to a £1.5 billion loss during its first full year in private-equity ownership. It made an operating loss of £58 million before exceptional items for the 65 weeks to 30 October 2022, according to a trading update from the chain’s parent company filed at Companies House. But a substantial portion of its £1.5 billion pre-tax loss for the period was related to finance costs of £593 million, which included interest payments on external debt, as well as interest on its lease liabilities and interest payable on loans to group companies.

But if the financial results were not looking too good some 18 months after the takeover, things have equally deteriorated in the stores themselves. Shoppers are not happy, and let’s face it, one doesn’t need the business acumen of a Warren Buffett to realise that if one is running a supermarket chain, one needs to keep ones’ shoppers happy. These people were a loyal clientele which Sir Kenneth had built up over the years, as he provided groceries to one generation after another.

But to meet its profit targets, CDR could only see that it needed to cut its costs, and so current shoppers found themselves confronted by a frustrating mixture of gaps on shelves, prices that kept on rising, a less-rewarding loyalty scheme, fewer staff, increasingly unkempt stores, and more and more dreaded self-checkouts which have never been popular with the British housewife.

For it is a fact that the British housewife would rather have a brief chat with the cashier than be forced to work out how to scan each item in her shopping trolley. This is the social side of doing the shopping, and being aware of this comes from walking around in the stores and getting to know ones’ customers. Sir Kenneth had made checking out an easy task and a pleasure over many years, and now these Americans were coming along and telling housewives that they would have to do all the work themselves. Not only that, but they would probably have to pay even higher prices for the privilege.

Reports are now emerging in the local press and on social media platforms that things are far from good in the world of Morrisons. In stores across the country shoppers are remarking on such items as a notable absence of staff on the famed fresh food counters, a solitary member of staff overseeing the deli, the pizza, and the salad bars all at the same time, and meat and fish counters which are not staffed at all. The “Market Street” counters, with expert butchers, bakers, and fishmongers, had previously been a core part of Morrisons’ service since the 1980s. They had always given it a point of difference from all its rivals. But alas, no more, it would seem.

Said one shopper who is a retired employee, “They are losing all the staff. Workers who have been there for years are saying they can’t face this anymore. It’s no longer a happy workplace. No one is pleased with the way the takeover has worked out.” As a result, it should probably surprise no one that shoppers are voting with their feet. “Since they sold the business, it’s not only expensive but there’s hardly anything in there,” said one disgruntled customer who had been shopping at the Bradford store for many years.

In life, it turns out that some people are just too clever by half. They think that they can make a quick buck without putting in the necessary work. A company like Morrisons had been built up steadily and profitably, not only by Sir Kenneth, but also by a steady stream of competent managers. As such, the company possessed a large portfolio of property, a good cash flow and a business free of large debt. Unfortunately, as we have seen, this also meant that it represented a juicy plum to our parasite capitalists in the business market.

But exactly how juicy was it in the clear light of day? When discussing the Morrisons case, a senior retail analyst pointed out the following facts. “Although supermarkets may be so-called “cash-generating machines,” nevertheless their tight profit margins mean that there is little room for any error.” In his opinion, this fact alone means that a supermarket chain makes for a very poor PEF investment target. He continued, “If you put a low-margin investment-hungry business into the hands of investors looking for above-average returns, and then on top of that, you give it a huge debt burden, it is not going to be that attractive. And if you then look at Morrisons’ current debt burden and then you add in a sharp rise in interest rates, you are looking for trouble.” And on top of all that, let’s not forget that various analysts had suggested at the time that CDR had probably overpaid, leaving even less wiggle room for errors if it wanted to yield high level returns.

And as if all that were not enough, along came Russia’s War in Ukraine, bringing large-scale inflation across the board in Europe. This meant that even Morrisons’ die-hard loyal shoppers began to seek out cheaper prices as every supermarket dropped their prices simply to keep their customers. Thus, profit margins were squeezed even further.

With every store which has closed, or is now showing signs of decline, this issue has become one of national importance. Jobs are now being lost, and local High Streets are looking more threadbare and destitute than ever. Nadine Houghton, the national officer of the GMB union, said, “We see too many High Street institutions being preyed upon by highly debt-leveraged capital. From Morrisons to Asda to Debenhams to His Master’s Voice Stores (HMV), these deals risk hard-working people’s jobs. The government and the Competition and Markets Authority have a responsibility to perform proper due diligence and to stop private equity bandits playing fast and loose with the lives of workers to make a quick buck.” And she is correct. For it is in towns and cities across the country that the social ruin caused by these PEF people is most apparent. Good jobs have been lost and thriving communities have been left with abandoned stores and declining town and city centres.

When CDR’s bid for Morrisons was accepted, it promised that it had no plans to sell off any significant amounts of its valuable store estate to raise cash. However, those promises, which were not legally binding, are starting to ring hollow as the store sales have already begun. Retail experts say Morrisons is looking to raise up to £1 billion from asset sales to reduce its debts and fund investment.

But frankly, after what they have done to what was a thriving well-run business, this also rings hollow. What kind of investment can possibly make up for all the value which has been dissipated and destroyed? And any cash flow which is realised is being used to pay more to their shareholders rather than to make any true investment in anything for the future. In short, the business is being run into the ground.

There are certainly people who have worked hard and put in the effort to build a worthwhile business, and Sir Kenneth Morrison was a great example of such a person. However, it is sobering to realise how quickly such an enterprise can be ripped apart and destroyed if it falls into the wrong hands.

May 15, 2023 `);

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