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Focus on…Private equity |
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This month, private equity faced unprecedented attack from politicians and the press. This article examines the challenges facing the industry in the UK today. |
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Six month ago, private equity was virtually unknown outside business circles. In 2007, as a number of high profile deals hit the headlines, the industry has had to cope with assaults on various fronts: » It is currently the subject of a parliamentary enquiry by the Treasury Select Committee. » HM Treasury is reviewing some of the tax rules which apply to private equity transactions. » The FSA has just published the results of its enquiry entitled “Private equity: a discussion of risk and regulatory engagement”. » Sir David Walker, at the instigation of the British Venture Capital Association (BVCA), has formed a high level working group to review transparency and disclosure in the industry. So, what is private equity and why is it generating such criticism? What is private equity? Put simply, private equity is external investment in unlisted companies. This broad category includes: » investment in start-up and entrepreneurial companies, commonly referred to as venture capital; » investment in existing companies being bought by management, commonly referred to as management buy-outs; and » high value acquisitions involving a large element of debt, commonly referred to as leveraged buy-outs (LBOs). These often involve the delisting of quoted companies, known as public to private deals. Even the unions agree that investment in entrepreneurial companies and management buy-outs is a “good thing”. On the other hand, LBOs involving established companies have drawn much criticism and it is these sorts of deals which have raised the profile of private equity. In the news recently have been: » the £11billion plus Alliance Boots takeover led by private equity house Kohlberg, Kravis Roberts (KKR); » the failed takeover of Sainsbury’s by an alliance of four private equity houses (CVC, KKR, Blackstone and Texas Pacific Group); » the takeover of the AA by Permira and CVC (which is about to be sold to Saga in the first UK merger between two private equity owned companies); and » the takeover of Travelodge by Permira who sold out in August 2006 to Dubai International Capital. And private equity is having an impact on publicly owned companies: earlier this month Cadbury Schweppes announced a reorganisation of its business and 7,000 redundancies in order to fight off a takeover by private equity. How does private equity work? Private equity deals are financed partly by equity (that is subscriptions for shares and loan notes) and mostly by debt. The general split is 30% equity and 70% debt. The equity element is met by the private equity fund (normally a limited liability partnership) which comprises outside investors, such as pension funds, and the private equity house itself. Usually, the private equity house, known as the general partner, will provide 20% of the equity financing. The debt element is met by bank lending, often divided into senior, mezzanine and junior loans. Why is private equity a problem? The criticisms surrounding private equity fall into three broad categories: » it is perceived as enjoying unfair tax advantages; » its destabilising effect on the economy of the country; and » the lack of transparency. Taxation of private equity Two main tax issues have been raised. One is the tax treatment of the reward structure in the private equity industry and the other is the tax treatment of debt. In both cases, private equity houses say there are no special rules for their industry: it is just that private equity benefits disproportionately from the rules which apply to everyone. Carried interest The rewards earned by private equity fund managers can be astronomical which has lead to accusations that they are forming a class of “super-rich”. But the real criticism is that they are not paying enough tax on their earnings. Fund managers’ pay is divided into two elements. The first is income (salary, bonuses etc) which is taxed as such. The second is known as “carried interest”. This is the amount of profit from the fund which goes to the manager. Since the manager has invested in equity, the gain is taxed under the capital gains tax regime. Taper relief rules mean that carry is taxed at an effective rate of 10%. Contrast this with the 40% higher rate tax which they would pay if it were classed as income. This is where the cries of tax inequality come in, and not just from the unions. Nicholas Ferguson of SVG Capital (the largest investor in KKR funds) has publicly stated that it is wrong that his cleaner pays a higher rate of tax than he does. Unsurprisingly, this quotation has come to haunt the private equity industry as it attempts to defend its position before the Select Committee. In their defence, private equity houses have pointed out that taper relief is not confined to private equity; the rules apply to everyone. Private equity houses invest their own money. They run the same risk as their investors; some would say more as the investors normally have to be paid before the private equity house gets its carry. Carry is a capital gain and should be taxed as one. This argument has faltered slightly in the face of two memoranda of understanding between the BVCA and Revenue and Customs from 2003. The documents were negotiated when Schedule 22 of the Finance Act 2003 made changes to the taxation of employment related securities bringing them within the income tax regime. The first memorandum provides a “safe harbour” for private equity deals, setting out the conditions which must be satisfied for equity gains to continue to be taxed as capital rather than income. The second sets out when carried interest will be treated as falling outside the Schedule 22 regime. The Treasury Select Committee was extremely interested when the latter document was brought to its attention by the unions. It expressed the view that a good way forward would be to withdraw the memorandum and leave each private equity house to argue its case on a deal by deal basis. The private equity houses giving evidence gave cogent arguments against this withdrawal, not least the increased administrative costs for Revenue and Customs. The Committee’s final recommendation will depend upon the submission by Revenue and Customs on the matter but there is a real likelihood that in the future carry will be taxed as income. Tax treatment of debt The difference in the tax treatment of debt and equity is less an issue of social justice and more one of business unfairness. The basic tax advantage of debt over equity is that interest payments on debt are tax deductible (although, the interest payments are taxed in the hands of the recipients). Those whose interests lie in the public equity markets (such as the London Stock Exchange) where the split is usually 70% equity to 30% debt say that equity is doubly penalised: equity transactions also incur stamp duty of 0.5%. The Government has recognised that there may be cause for concern here and is reviewing the current rules that apply to the use of shareholder debt where it replaces the equity element in highly leveraged deals. A report is due to be published by the next Pre-Budget Report. The current Government has not yet been persuaded to review stamp duty on share transactions, nor the general principle that interest should be treated as a business expense and deductible from taxable profits. On the other hand, at an ABI conference in May, the shadow chancellor George Osborne indicated that the Tories would abolish or cut stamp duty on shares should they come into power. Economic effects of private equity The high levels of debt being carried by private equity owned companies has long been a cause for concern. There is no doubt that private equity has been able to take advantage of historically low interest rates but the fear is that companies are at risk of failing should economic conditions change. In its report published this month, the FSA identified excessive leverage as being of medium high risk significance. As a result, it intends to conduct a survey of leveraged lending activity within the UK semi-annually, starting in the first quarter of 2008. There is also a concern that private equity is undermining the effectiveness of the public markets. There is no question that private equity is outperforming the public markets and therefore drawing investment away from them. However, before the Select Committee, the London Stock Exchange was relaxed about the threat so it is unlikely that any changes will be proposed in this area. Finally, the unions presented evidence to the Select Committee to the effect that private equity is a threat to pensions because companies must service high levels of debt instead of paying into their pension funds. They argued that this has lead to increased pressure on the public purse which must meet the liability of collapsed pension funds. The unions’ argument was undermined when it was pointed out that many private equity investments are funded by pensions. The Select Committee forced the unions to admit that they would need to try to influence pension trustees about their investment choices. The catch-22 situation for the unions is that they want their pension funds to participate in the growth enjoyed by private equity investments, but they believe that private equity ownership is detrimental to their members’ interests. It remains to be seen whether pension funds do actually divert investments away from private equity. Transparency Arguably, one of the reasons for the success of private equity (and the currently popularity of public to private deals) is that the target company is removed from the glare of the public markets. This is coupled with a close alignment between management and ownership. As a result, the provision of information to shareholders is generally good but communication with other stakeholders, particularly employees, needs to be improved. When the unions came before the Committee earlier this month they were able to point to numerous examples of redundancies following a private equity takeover, which they say were not publicised before the takeover took place. The GMB complained they were quickly derecognised by the AA following its takeover. In short, they claimed that private equity passes risk to employees. When the issues raised by the unions were put to them, the private equity houses admitted they had not done a good enough job with their employees. This area is likely to be improved when guidance on transparency and disclosure is produced by Sir David Walker’s high level working group. It is to be hoped that the Committee is satisfied with a voluntary code in this area and does not pursue its other line of enquiry, namely that TUPE should apply to share sales. What next? The next few months should be interesting for the industry. The Select Committee will report back with its recommendations, the Treasury review is likely to lead to changes in the tax regime and the Walker guidance on transparency and disclosure will result in new reporting procedures. The industry will also have to get used to greater FSA scrutiny. With this increase in regulation and the likelihood of further interest rate rises adding to the cost of borrowing, is this the end of the private equity bubble?
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