"Securing the long-term future of the Guardian" was the headline on the cover of Guardian Media Group's (GMG) 2008/09 annual report. Not long after, in March 2010, the group's chief executive Carolyn McCall announced she was leaving after 24 years to become chief executive of easyJet. "A person close to Ms McCall... acknowledged that she was departing at a critical time, but said she and her board were confident that 'the Guardian is secure, totally secure,'" reported the FT.
Was that the sound of someone protesting too much? What would it mean, anyway, for the Guardian to be "secure"? During the six years ending 31st March 2010, Guardian News & Media (GNM)—the subsidiary of GMG that publishes the Guardian and Observer—generated cash operating losses averaging £15m a year. Throw in capital expenditure and other investment, and the amount of cash it "burned" every year rises to £38m. Like all newspaper companies, GNM is suffering from falling sales and the effect of the internet on revenues. It has invested heavily in a highly regarded website, while taking a stand against charging for it. This decision has financial consequences. "Securing the long-term future of the Guardian" means plugging that annual gap, indefinitely (although annual losses are expected to reduce in size).
Yet starting in mid-2006, GMG chose an unconventional way of doing this. Over the course of two years, right at the top of the business cycle, it put more than half the Guardian's "inheritance" (valued at around £1bn) into two risky leveraged buyouts (LBOs) in partnership with Apax, a leading private equity group, plus another £170m into other risky ventures. It makes for an uncomfortable juxtaposition. The Guardian, Britain's leading liberal newspaper, has generally taken a strong stand against exotic financial engineering and been sceptical about private equity, yet all the while its parent, GMG, has been taking advantage of some edgy financial dealings to secure the newspaper's future.
It is too early to say what the final results of GMG's excursion into private equity will be, but the signs so far are mixed. Although the estimated value of its portfolio has fallen by only about 6 per cent (£60m) since 2007, this includes writing down almost £200m on investments of £470m made between 2006 and 2008. McCall told the FT on 11th June that GMG's board would soon "address 'a very important strategic issue' regarding future investments." But why was GMG pursuing this strategy in the first place?
Think of the Guardian as a spendthrift heir in a Victorian novel. He's no rake—instead, he's an earnest young man with a habit of do-gooding, which is expensive. Fortunately, he has a large inheritance to fall back on, administered on his behalf by a wise old uncle.
The real-life Guardian's uncle is a charitable organisation called the Scott Trust. It was created in 1936 after the death of CP Scott, the legendary editor and owner of what was then the Manchester Guardian. The trust's aim is to "secure the ongoing editorial independence of the Guardian." It owns the Guardian Media Group, which comprises the Guardian and Observer (bought in 1993), and a collection of other assets which exist to secure the future of the newspapers.
Regional newspapers used to be an important part of the empire, with the Manchester Evening News as the flagship. But in February GMG sold its regional interests to Trinity Mirror for a pittance (£45m, of which only £7m was cash). GMG has owned stakes in television companies—Anglia, Endemol and GMTV, but sold the last ones in 2000, although it retains an interest in Channel M, its TV station for Manchester. In 2001, it began investing in radio and has continued this expansion.
GMG's most successful investment by far has been in Auto Trader, the car listings magazine and website set up in 1976 by John Madejski (now one of Britain's richest men and chairman of Reading Football Club), taking full control in 2003.
Trader Media, Auto Trader's parent company, was unusually successful in managing the transition from print to a digital format. Its online transactions now make up 90 per cent of its revenue, and cash operating profits run at about £120m per year. When McCall took over as CEO of GMG in 2006, Trader Media, valued at about £1bn, was its most valuable asset, contributing all of its cash operating profits. The 11 directors of the Scott Trust, in their collective capacity as the Guardian's uncle, were responsible for deciding what to do with Trader Media at a time of persistent losses at the newspapers. Their agent was the 13-person board of GMG directors.
On 5th May 2006, three days before McCall's elevation to CEO, Paul Myners, then GMG's chairman, announced it would raise cash by selling a minority stake in Trader Media on the stock market. Almost a year later, in March 2007, GMG had a change of heart and instead sold a 49.9 per cent stake in the company to Apax Partners, a leading private equity firm.
Among other ventures, private equity companies engage in leveraged buyouts: using borrowed money to buy businesses, run them for a few years—and then sell them on. Apax has been doing this for 30 years and is a well-established player in the field; its companies employ more than 270,000 people and have a value of [euro]68bn (£56bn).
But what made GMG change its plans for Auto Trader? McCall told Prospect that market conditions had changed. "We were advised that the stock market route was uncertain... that a deal with a private equity firm would bring greater certainty than the stock market, as well as a higher valuation for Trader Media." And more cash up front.
How did this work? First, GMG and Apax loaded almost as much debt onto Trader Media as they could. This remortgaging exercise generated about £400m of cash for GMG. Next, Apax paid GMG £284m for 49.9 per cent of Trader Media (if this looks cheap given a valuation of £1bn, it is because of the increase in Trader Media's debt).
Overall, GMG received £700m in cash while keeping its majority stake in the company. It took a modest bow in its annual report: "We have been able to take advantage of the strong appetite for quality media assets and retain a majority stake in this superb company, from which we expect continued growth." GMG was looking forward to having its cake and eating it.
What did GMG do with this cash? By late 2007, cracks were appearing in the economy and customers were lining up outside Northern Rock branches. But Apax and GMG were planning another leveraged buyout. In March 2008, GMG spent about £300m of the Trader Media proceeds on a 29.54 per cent stake in Emap, a publisher of mainly trade magazines. The exact purchase price of Emap has never been fully disclosed, but press reports suggest a figure of £1.26bn, probably including £600-700m of debt.
GMG did other deals in 2006 and 2007, spending another £208m on buying smaller companies. An estimated £170m of that went on expanding its radio interests and establishing a new division called the property services group. This involved selling software to Britain's independent estate agents—not good timing in mid-2007. (Admittedly, the core of the new division consisted of Trader Media units that GMG took on because Apax did not want them. But presumably these could have been sold instead.) And, as radio stations need buoyant advertising revenues, expansion into that sector also turned out to be poorly timed. Finally, in mid-2008, GMG put £200m into a "long-term investment fund" spread around between various fund managers.
So, in 2006, almost all of the Guardian's inheritance was in Trader Media. By 2008, GMG had redistributed the £1bn across five areas (Trader Media, Emap, radio expansion, the new property services division and the investment fund). In the space of two years, Myners and McCall—with the backing of the GMG and Scott Trust boards—spread the Guardian's eggs among more baskets and created a pot of extra cash.
But they also took on a lot of debt and expanded into two highly cyclical businesses badly exposed to the downturn. In 2006, the Guardian's inheritance carried about £350m of debt, from Trader Media. Two years later, the LBOs had saddled it with about £1.4bn of debt (equally divided between Trader Media and Emap, and shared with Apax). None of this needed to appear on GMG's balance sheet as it accounts for the investments as "joint ventures." While GMG talked about "diversification" and "reduced risk," most of the money was still invested in British media businesses. And more than half of it was invested in two leveraged buyouts—hardly low-risk.
So how has the strategy fared? Last year, the Daily Telegraph reported that Apax wrote down its investment in Emap from £300m to zero in 2009. In other words, less than a year after putting £300m in Emap, Apax decided the investment was worthless (at least for now). At the time, GMG glossed over the fact, but its 2009/10 annual report contained a writedown of £96m: a third of what it had invested.
GMG's stake in Trader Media was worth about £280m after the deal with Apax in 2007. It may be worth more today—let's use £400m as a working guess. On that basis, the Guardian's nest-egg is worth about £940m in 2010—a fall of 6 per cent since 2007. The main losses are around £200m on the investments made in 2006-07—the £96m writedown on Emap and £99m on the radio and property services divisions (to use GMG's own figures). This is offset by a gain of £120m on the company GMG already owned (Trader Media) and a gain of £20m on the long-term investment fund.
But what could GMG have done instead? In principle, rather than selling just half of Trader Media in 2007, it could have sold the whole company—presumably at the same valuation that Apax put on it. Then it could have used the £1bn to set up a permanent endowment, or foundation. This is the kind of investment fund that supports well-known American universities. And Britain even has a direct precedent: the Wellcome Trust.
When Henry Wellcome died in 1936 (coincidentally, the year the Scott Trust was created), he left the shares in his pharmaceutical business to a trust whose objective was to support "research for the benefit of mankind." For 50 years, the trust used funds from the business to pay for its research grants. Then, in 1986, the trustees decided to diversify. They floated a 25 per cent stake in the company on the stock market. By 1995 the trust had sold most of its holdings in the company, leaving it with a pot of money worth £6.8bn. The trust has invested the endowment fairly conventionally across a spread of assets: shares, property, gilts, and so on. As of September 2009, it was worth about £13bn. This allows it to give away about £600m, or almost 5 per cent of the endowment, every year—in effect, the endowment's income.
In principle, GMG could have used the £1bn proceeds from selling Trader Media in March 2007 to create an endowment like the Wellcome Trust. Suppose its managers had immediately invested the cash in the FTSE index. Even after the financial crisis it would still have been worth around £900m in June 2010. Although this is less than the current value of the inheritance, of about £940m, money invested in the FTSE would be producing an income stream for the newspapers—at present neither of the two LBO investments produces any cash, because it all goes to servicing the debt.
Suppose this hypothetical "Scott/Guardian Trust" paid out the same roughly 5 per cent annually as the Wellcome Trust. With £900m of assets, it could contribute about £45m a year to the Guardian—as it happens, not far off the average sum (£38m) that GNM consumed each year from 2005 to 2010.
To be fair, tax and legal complications would have made it hard for GMG to pursue an endowment strategy in 2007. But why opt for private equity? Was it seduced by the promise of super returns? McCall disagrees: "GMG had been familiar with private equity going back to 1998, when BC Partners became its partner in Auto Trader." And GMG's advisers came out against a flotation in 2006-07. But advisers often have an inkling of what their clients want to hear.
McCall says the deal with Apax "allowed Trader Media to invest generally in the growth of the digital side of its business (autotrader.co.uk) to a degree that would not have been possible had the business been floated." One idea appears often: "GMG is not fast enough at change," McCall told Press Gazette in 2007. And private equity companies are notoriously ruthless about it. "The partnership between GMG and Apax has brought increased impetus for change," wrote McCall in her report on Trader Media for the year ending March 2008.
Private equity firms like Apax claim to be able to run companies better. They also claim to generate high returns. In its 2008 annual report, Apax stated that, for the 15 years ending December 2008, it had generated a net internal rate of return (IRR) of 28.1 per cent, or 30.1 per cent over ten years. Compared to annual returns on the stock market of, say, 10 per cent, this sounds very enticing. But an IRR cannot be compared directly to the stock market. It is a widely used financial calculation. But it tends to overstate the actual return that private equity investors earn. Some investors in private equity are aware of the difference; were the GMG managers?
Moreover, there are two big differences between GMG and Apax. First, Apax's historic profits came from investing in LBOs over an extended period—ten or 15 years. GMG's investments in Trader Media and Emap spanned just one year: March 2007 to March 2008. And what a year it chose.
The second key difference is diversification. When Apax invested £584m in Trader Media and Emap, it only put down about 4 per cent of its chips. But GMG bet its house—its investments in Emap and the remortgaged Trader Media together made up 58 per cent of the Guardian's inheritance.
If GMG chose the endowment option, it could be slimmed down to its core business, GNM, while a separate group, similar to the Wellcome Trust, ran the endowment. But then some GMG managers would be out of a job.
In any event, rather than shrinking, GMG expanded. Debt-swollen balance sheets allowed senior managers to become involved with running a larger media empire. McCall herself got to chair the boards of two big leveraged buyouts (Trader Media and Emap), as well as running GMG.
Private equity's mystique doubtless added to the attraction. But the profits private equity managers generate are less impressive than most people think. Recent studies show that these profits come mainly from using lots of debt and picking the right companies. When a report I wrote recently—"Private Equity, Public Loss?" (Centre for the Study of Financial Innovation)—pointed this out, the evasive reaction from the private equity sector suggested this is a sensitive issue. Private equity managers do sometimes improve companies. The GMG view is that Apax's involvement helped Trader Media, for example. But it is important to separate this from the additional impact of high debt and simply picking the right companies.
And one effect of the LBOs is that GMG has been profiting from (legal) financial wizardry of kind that the two great liberal newspapers—and their leading commentators like Will Hutton and Larry Elliott—frequently condemn. For example, Trader Media has been minimising tax by asserting that equity is debt by structuring some of its equity as borrowings on its balance sheet. Also, Trader Media reported a £28.6m "net gain on debt buy back" during the year ended March 2009. This means it repaid 50p in the pound to one or more of its lenders desperate for cash. It will help make the Guardian slightly more secure. But GMG's profit is someone else's loss—which may at some point rebound on the taxpayer.
In July 2006, GMG's annual report made no mention of private equity. Eighteen months later, over half of the Guardian's inheritance was invested in two LBOs at the top of the market. Co-investing with Apax may have increased Trader Media's value and given GMG some insights into managing change. To date, it has also brought £96m of impairment (writedown) charges on GMG's £300m investment in Emap, so the benefits were not cost-free.
What does this story show, then? Twenty years ago, a book dubbed private equity companies "barbarians at the gate." Since then, they have turned into the rock stars of the business world. GMG's story shows that the barbarians have become respectable and insinuated themselves into the most unlikely corners of the economy and the liberal establishment.
It is too early to judge the longer-term financial results of the strategy. The Guardian's future is probably secure. After all, £260m of cash is available to it immediately, split between cash and the investment fund. In due course, Emap and Trader Media (quite a success story) will presumably be sold and turned into cash, too. The radio and property services divisions have some value as well. But an alternative approach may have served it better. Diversification out of Trader Media was the right thing to do in principle, but it might have been wiser to start doing it in 2003. And when you diversify, it's important to choose your new investments well. GMG has taken almost £200m of impairments to date on £470m of new investments (Emap, radio, property services). McCall says that these impairments do not have any cash impact and do not reflect the "intrinsic value" of the businesses. Trader Media probably has benefited from private equity know-how, but the size of the impairment on Emap is a reminder that private equity's high debt levels are always risky. Although any homeowner knows that having a bigger mortgage means you will make more money if house prices go up, it takes an older homeowner to understand the damage a big mortgage causes when prices fall. But 30 years of deregulation, falling interest rates and increasing levels of debt have led many people to confuse rolling the dice with brilliance. Many bankers, hedge fund managers and homeowners think they've been clever rather than lucky. An ex-prime minister thought he had "abolished boom and bust."
The Scott Trust and its managers at GMG are meant to play the role of the Guardian's benevolent uncle: looking after its inheritance while the newspaper goes about its mission. How will they look back on the past few years? McCall's decision, along with three of her fellow executive directors at GMG, to accept a bonus for the year ended March 2010 seems to have been controversial within the company. McCall points out that she waived her bonus the previous year.
Individuals at GMG are ultimately accountable to the GMG board, which, in turn, is accountable to the Scott Trust. But who can hold the Scott Trust to account? Freedom from the demands of the stock market or an individual proprietor is one of the Guardian's great strengths. Where inheritance management is concerned, though, a less ambitious approach may be more appropriate than the one pursued over the last few years. GMG's financial dealings may have given the Scott Trust's trustees—as a US bank chief executive once famously remarked about his investment banking division—about as much excitement as they can handle. Not just managing these dealings, but also explaining them—both internally and externally—has presented quite a challenge. For an outsider, it is hard to avoid thinking that a more straightforward way to secure the future of the Guardian would be to run the inheritance less like a media conglomerate and more like a Wellcome Trust-like foundation. It will be interesting to see whether the Scott Trust takes any steps in that direction.
