Select Committee on Treasury Written Evidence

Memorandum submitted by the British Private Equity and Venture Capital Association


1.1  The BVCA

  The BVCA—the British Private Equity and Venture Capital Association—is the industry body for the UK private equity and venture capital industry. It represents virtually every UK based private equity and venture firm. The UK industry accounts for over 50% of the European private equity and venture capital market.

1.2  Private Equity and Venture Capital—A Definition

  In the UK, continental Europe and much of the rest of the world, "private equity" means the equity financing of unquoted companies at many stages in the life of a company from start-up to expansion or even management buy-outs (MBOs) or buy-ins (MBIs) of established companies. "Venture capital" is a term now used to describe a subset of private equity, covering the seed to expansion stages of investment.

  The key elements of private equity and venture capital are:

    —  investments in unquoted companies;

    —  equity capital by nature;

    —  medium to long term;

    —  targeted at companies with growth potential.

  Private equity is invested in exchange for a stake in a company and, as shareholders, the investors' returns are dependent on the growth and profitability of the business.

  The model for private equity is based on an alignment of interest between investors and company's management. A sense of ownership is at the heart of private equity philosophy. Since all shareholders are represented on the board, decisions can be taken rapidly and all parties have a clear focus on achieving the business strategy.

  The superior returns achieved by private equity investors have continued to attract funds from UK and foreign institutional investors, significantly increasing the flow of capital into this important and growing sector of the UK economy.

1.3  Private equity—some key facts

  Private equity creates jobs. In a recent survey (2 April 2007), the Financial Times analysed the thirty biggest private equity deals concluded during 2003 and 2004, and found that 36,000 new jobs had been created—an increase of 25%.

  Research commissioned by the BVCA shows that:

    1.  Over the past five years, jobs and sales in private-equity backed companies have grown faster than in FTSE 100 and FTSE 250 companies (9% per annum on average as compared with 2%).

    2.  Exports and investment have also grown faster than the national average—in the case of investment, up 18% per annum compared with the national average of 1% a year.

    3.  Over 90% of companies in which private equity has invested say that without private equity their business either would not exist or would have grown far less rapidly.

  The UK private equity industry has invested over £80 billion (over £60 billion in the UK) in around 29,500 companies since 1983. £11.7 billion was invested in 2005, in over 1,500 companies, of which over £6.8 billion was invested in over 1,300 companies in the UK.

  It is estimated that firms currently backed by private equity employ c1.2 million people.

  Private equity is an increasingly important component of the UK financial services industry. It is estimated to account for 7% of the total annual turnover of the UK financial services industry. Over 10,000 highly-skilled professionals across over 1,000 firms are engaged directly or indirectly in private equity-related activities.


2.1  The regulatory environment

  In its recent Discussion Paper 06/06 "Private equity: a discussion of risk and regulatory engagement" the FSA concluded that its "current regulatory architecture is effective, proportionate and adequately resourced". The BVCA agrees with this assessment.

  Transparency as between the private equity firm and its investors, and the flow of information to investors regarding the companies in which the private equity fund has invested, already meets very high standards. In response to concerns in relation to transparency and accountability to society at large, the BVCA has recently announced the setting up of an industry working group, chaired by Sir David Walker, which will look at ways in which levels of disclosure by companies backed by private equity could be improved, and draw up a voluntary code of practice.

  The current corporate status of private equity funds—ie the fund structures available to private equity funds established in the UK, or managed from a UK base—and more generally the regulatory, legal and fiscal framework in the UK have all been conducive to the successful growth of private equity in this country, which in turn has contributed greatly to the prosperity of the UK financial sector and its supporting organisations.

2.2  Taxation

  The taxation of the participants in private equity flows from the underlying activity of making long term investments in unquoted companies.

  Portfolio companies, individuals within portfolio companies and PE managers are subject to a wide spectrum of tax legislation including that relating to corporation tax, employment taxes, capital gains tax and VAT. These tax rules are the same as the rules applied throughout the economy as a whole and there are no special concessions for private equity.

  The BVCA believes that legislators should also be mindful of the increasing international competition from other major jurisdictions to attract talent and capital away from the UK and that the tax regime should actively encourage enterprise and long term investment associated with PE and also to help promote the UK as a hub for international PE.

2.3  The economic context

  Private equity in the UK has benefited from a lengthy period of stability and growth in the economy as a whole, the wide availability of investment opportunities across the range of small, medium-sized and large businesses (in turn reflecting the strength of the UK's technology base, the UK's large stock of mid-market businesses and the position of London as a major international finance centre for larger businesses) and the continued development of an entrepreneurial culture in the UK.

  Private equity structures involve a close alignment of interests of shareholders and management. Benefits to management of a private equity-backed company include not only the provision of capital but also the availability of strategic business advice, financial advice and practical support.

  Private equity enables a long term view to be taken in cases where substantial reorganisation or a change of strategic direction is required, enabling the necessary changes to be made away from the glare of publicity and the short-term concerns of stock market participants. The typical hold period for a private equity investment is three to five years, much longer than the average hold period of institutional investors, of 15 months, and hedge funds of three months. This enables private equity firms to work on a longer term horizon.


 (a)   Is the current regulatory regime for private equity funds suitable?

  The FSA published Discussion Paper 06/6 "Private equity: a discussion of risk and regulatory engagement" in November 2006. The FSA concluded that its "current regulatory architecture is effective, proportionate and adequately resourced". The BVCA agrees.

  The private equity industry in the UK is fully regulated by the FSA, in contrast with the position in a number of other jurisdictions. Every private equity investment manager or investment advisory firm established in the UK must be authorised and regulated by the FSA.

  The FSA has established a centre of expertise in the regulation of private equity. Regulated firms must comply with requirements relating to systems and controls and regulatory reporting. They must observe conduct of business rules and meet minimum capital requirements. They must also comply with laws designed to prevent and forestall financial crime and market abuse. The key executives working for private equity firms must be individually registered with the FSA and changes in the ownership of and control of authorized private equity firms is subject to FSA consent.

  Most private equity and venture capital funds are established onshore. The promotion of interests in the UK in most fund vehicles (onshore and offshore) is heavily regulated and the pool of limited partners is effectively limited to investment professionals, institutional investors and a very limited number of high net worth individuals.

  Aside from the private equity firms themselves, the FSA manages potential systemic risks through supervision of the institutions which lend to private equity-backed companies, including specifically monitoring exposures to leveraged buy-outs.

 (b)   Is there sufficient transparency on the activities, objectives and structure of private equity funds for all relevant interested parties?

  The issue of transparency needs to be considered in three separate aspects:

    —  Relationship between the private equity firm and its investors: The relationship that any private equity firm has with its investors is completely open and transparent. The terms on which private equity funds raise capital are fully negotiated and agreed by all investors before they invest.

    —  Flow of information to the private equity firm and its investors regarding investee companies: Levels of disclosure about the performance of companies in which the private equity firm has invested are much higher than in public companies. Private equity and venture capital firms report to their investors regularly, typically quarterly. The reporting about the companies in which they have invested goes far beyond, is far more detailed and far more up-to-date than how a public company reports to its shareholders.

    —  Availability of information to other parties including employees of investee companies and the wider public: Private equity-backed companies produce the same detailed accounts as any private company. There are no special exemptions or rules for private equity-backed companies. Large private equity-owned companies (in common with any privately owned business) are not currently required to provide operating and performance data of the same quality and depth as listed companies, and do not have to report against the same timescales, the higher standards for listed companies having developed out of the need for the stock market to have appropriately detailed information on a timely basis as a basis for informed dealings.

    The BVCA has recently announced the setting up of an industry working group, chaired by Sir David Walker. The working group will look at ways in which levels of disclosure in companies backed by private equity could be improved, and will be drawing up a voluntary code of practice. It should be emphasised that it is the BVCA's belief that care must be taken to avoid private equity backed businesses being unfairly disadvantaged against other privately owned companies.

 (c)   Has there been evidence of excessive leverage in recent transactions and what systemic risks arise in consequence?

  The FSA's recent Discussion Paper DP 06/6 "Private equity: a discussion of risk and regulatory engagement" gave significant attention to the potential risks arising within the private equity market as a consequence of "excessive leverage". For the present purposes this Discussion Paper and the BVCA's response to it represents the most up-to-date available review on this subject and the relevant material is summarised below.

  In the Discussion Paper the FSA noted that the amount of credit that lenders are willing to extend on private equity transactions has risen substantially. Lending limits are increasing, multiples are rising, transaction structures are being extended and covenants are weakening. The FSA summarised the arguments both for and against the higher leverage levels currently being employed, in particular with respect to the larger transactions, and the concerns as to the consequences of such higher leverage. It was recognised that there is an argument that leverage levels in UK firms, particularly in public companies, are inefficiently low, and that in current transactions private equity fund managers are simply transforming the companies they back into capital efficient operations that can make the most of the flexible financing options associated with debt capital. The FSA pointed out that, on the other hand, there is a body of opinion that considers that leverage levels are being competed upwards as a result of an auction process as between private equity firms and the banks and increasingly appear to approach the limits of prudence.

  The FSA indicated uncertainty as to which of these two schools of thought was likely to be correct: if those who supported the negative view of private equity transaction leverage were correct, it was not clear whether there would be a gradual adjustment—taking the form of lower returns leading to reduced capital inflows and hence less competition for deals—or a sharp correction, which could involve a major transaction or group of transactions failing suddenly.

  In our response to the Discussion Paper, the BVCA questioned the use of the description "excessive" leverage, pointing out that to say that something is "excessive" implies a variance over a norm or standard which is fixed and clearly identifiable. A debt multiple of two times can be "excessive" in certain economic environments and equally a multiple of six times may be wholly appropriate in another environment. The level of leverage in a deal is a function of the outlook for interest rates and the confidence in the future earnings projections of the target investment, which in turn are driven by a range of factors like general economic outlook, market developments and competitor activity.

  The BVCA agrees that the fact that debt multiples may be rising has implications for banks but points out that this circumstance is not unique to private equity. Public companies too can take on significant debt as can any other private company whether or not private equity backed. Private equity transactions are negotiated between highly experienced and sophisticated parties and extensive due diligence is undertaken. Combined with widespread syndication of the credit risks, the BVCA considers that a failure which would undermine either the banking sector or the private equity industry is very unlikely indeed.

  In considering the possibility of a large business or cluster of private equity backed businesses failing, it is important to note that corporate failure is a consequence of market forces: when a business fails it is likely to be because the market for the products and services of that company has declined or because management at the business has not been able to grow the business. This is not a particular or unique feature of businesses backed by private equity. A decline in a market would have occurred anyway and a company failing because of a weak management team is arguably in a better position to recover if it has professional and experienced investors backing it, such as where private equity is involved. Jobs are more likely to be protected if an experienced investor is able to facilitate the removal of weak management and its replacement with those more talented. There is no evidence that private equity backed businesses are statistically more vulnerable.

  As is evidenced in the Discussion Paper, there is considerable uncertainty over both the possible outcomes of increased leverage and the consequences flowing from those outcomes. In the BVCA's view, it seems clear that even in a worst case analysis, while there may be individual private equity firms that will be forced to exit the market (being unable to raise new funds through poor performance) and whilst there may also be temporary turbulence in debt markets, a more systemic failure or a long term impairment in the debt or private equity market is very unlikely.

 (d)   What are the effects of the current corporate status of private equity funds, including their domicile and ownership structure?

  Private equity funds and their investors and managers exist in a variety of legal forms. The choice of structure depends on the location and tax concerns of the fund manager and investors as well as the protections, burdens and benefits afforded by the different legal and regulatory regimes operating in different jurisdictions.

  Private equity fund structures used by UK firms most commonly take the form of onshore limited partnerships, offshore limited partnerships (eg Jersey or Guernsey) or UK quoted private equity investment trusts or Venture Capital Trusts.

  In the most common UK private equity structure, the private equity fund takes the form of an English limited partnership established under the Limited Partnerships Act 1907. The limited partnership will usually be a Collective Investment Scheme ("CIS") under section 235 of the Financial Services and Markets Act 2000. Establishing and operating a CIS in the UK is a regulated activity: a separate entity usually performs this role, acting as the manager/operator of the fund. If it is based in the UK, the private equity fund manager will be regulated by the FSA.

  If the fund is established offshore, the UK entity will usually be an "adviser" rather than a manager/operator, but will equally be regulated by the FSA.

  The UK limited partnership offers advantages over other fund structure forms. EVCA's 2006 benchmarking report identified a number of key features of the UK limited partnership structure which made it an attractive vehicle for private equity houses, including tax transparency for investors and the fact that international investors need no local permanent establishment in the UK. While some of these characteristics are common to other fund structures in use around Europe, EVCA's report concluded that no other country's structure (with the exception of Ireland) included all these key features.

  Generally, the regulatory, legal and fiscal framework in the UK has been conducive to the successful growth of private equity in this country. The UK is recognised as a business-friendly environment. The tax regime, merger regulation and ease of starting a business have been identified as key aspects of the attractiveness of the UK.

  The attractions of the UK are evidenced by the proportion of non-domestic money managed in the UK and by way in which, in private equity, the UK has become seen as a gateway to Europe:

    —  The proportion of non-domestic money managed is higher in the UK than in any other country, reflecting the demand for UK-based GPs by non-UK based institutional investors (LPs). This demand, assisted by the development of the UK limited partnership, has led to more funds of funds and intermediary organisations locating in the UK.

  The attractions of the UK have resulted in the growth of a highly developed network of supporting organisations aiding the identification and execution of transactions. The Big Four accountants, mid-tier groups, lawyers, investment banks and small, specialist corporate finance houses all help drive deal flow and, in so doing, themselves have a considerable economic impact, generating an estimated fee income in excess of £3 billion each year. Furthermore, London's reputation as a leading financial centre means that many of the European industry's supporting organisations are located in the UK.


 (a)   Is the current taxation regime for private equity funds and investee firms appropriate?

  At the heart of private equity is a long term investment in unquoted companies and from this activity a wide spectrum of different tax rules apply to the companies, investors and individuals involved in this activity. All of these are general taxation rules that apply to other taxpayers across the economy.

  In the paragraphs that follow, we cover the taxation of portfolio companies, individuals at portfolio companies, investors and private equity managers.

  A typical fund structure is attached at appendix 1. The partnership structures do not impact the tax analysis; rather they ensure that investors will be taxed in the countries where they are based depending on status and local tax rules. The fund management entities and executives are taxed in the country where the investment activity is conducted. The portfolio companies are taxed in the same manner as other corporates.

Taxation of portfolio companies

  A portfolio company is subject to the same tax rules that apply to any other equivalent companies operating in the UK. Corporation tax, income tax, national insurance and VAT are all applied the normal way.

  Notably however, many of the reliefs aimed at smaller companies are denied to companies in a private equity portfolio because they are aggregated with other unrelated companies in the same portfolio so categorised as larger companies. The BVCA believes this is unfair and continues to press for a change in this position.

  Concern has been voiced over the tax relief on debt. The BVCA believes this concern is misplaced because:

    —  The tax deductibility of interest on debt is available to all companies. This is because debt encourages investment in the UK economy.

    —  Interest on debt, whilst tax deductible for the borrower, is taxable income for the lender which will be captured elsewhere in the tax system.

    —  Only debt which is arranged at arm's length is allowed a deduction by the borrower—debt raised at levels beyond normal commercial lending criteria does not attract a deduction for the borrower. This regime has been in place for many years but was strengthened in 1998 and March 2005. The regime prevents the tax treatment of debt being applied to equity.

Taxation of individuals in portfolio companies

  The senior members of the management team typically receive a salary and bonus which reflect market rates for those positions. This income is subject to income tax and national insurance as normal.

  The management team are normally required to invest in the company alongside the private equity investor and at the same valuation as the private equity investor. The amounts are often significant for the individual. This is to ensure an alignment of interests between investors and management. The investment by the management team is taxed mainly under the Capital Gains Tax regime to reflect the true nature of the transaction and the inherent associated risk of loss. For many years the UK tax rules have required that any discount on acquisition of shares by an employee is taxed as income. Therefore where an employee holds equity on favourable terms as compared to independent investors a tax charge will arise. From 2003 these tax rules were further strengthened.

Taxation of private equity fund management firms

  Private equity fund management firms are organised in a wide variety of ways (as a corporate or a partnership) and receive a mixture of fee income, investment income and capital gains. Corporate structures are taxable under the normal tax rules for companies and partnerships. Out of this income, private equity executives receive market rate remuneration (salaries/partnership profits/bonuses) which is subject to income tax and national insurance in the normal manner.

  Private equity executives also normally invest in the fund they manage alongside the institutional investors (pension funds, insurance companies, etc.) and also participate in a carried interest in the fund. The commercial intention and effect of this arrangement is that the private equity executives' interests are aligned with those of the institutional investors. The private equity executives stand to gain from the success of a fund and risk actual financial loss if the fund is a failure. The private equity executives only receive a return on their investment once all other investors have received a return of capital and a certain preferred rate of return. These long term investments made by private equity executives are subject to the normal capital gains tax rules—and investment income is taxed as a dividend or interest. In 2003 the law was changed as mentioned above with the effect of bringing carried interest within the charge to income tax. Employees who receive an investment at undervalue also suffer income tax and national insurance (along with the employers national insurance) on the amount of that undervalue. As with management equity, in 2003 the MOU was devised to allow for a formulaic approach to valuation of this investment, again simplifying what would otherwise be an unwieldy and burdensome valuation on a case by case basis.


  Key to investors' requirements is to ensure there are no additional layers of tax over and above the tax investors would pay if they had invested in the same entities direct. This is one reason for the use of a partnership as a partnership is not a taxable entity. Instead the partners are taxed on their shares of the partnerships income and capital gains.

International competition for human capital

  As well as the prosperity directly attributable to the retention of Human Capital through high quality of employment opportunities and the dynamism of "value creators" in the UK, the location of human capital is a key determinant in the general attractiveness of the UK as a business location—either as the headquarters of international businesses or the country location choice for a particular business activity.

  An active private equity industry attracts and retains talent both from overseas and within the UK. Private Equity is now seen as one of the key alternative investment platforms and has been a major part of the City of London's success over the last decade. Such success cannot be taken for granted. A recent survey by EVCA—The European Private Equity and Venture Capital Association—has demonstrated the fact that the UK has lost some competitive advantage against other EU countries as the most attractive place to do PE/VC business.

  Around the world, tax jurisdictions compete for human capital because of the general benefits brought to the economy. France and Germany, unlike the UK, both have specific regimes designed to tax private equity executive's equity gains at lower rates. Other countries follow the UK position and tax as capital gains but often with the benefit of a zero rate or deferral eg Holland, Switzerland, Spain and Sweden. The BVCA believes that the talent within the private equity industry should continue to be encouraged to remain in or move to the UK.


 (a)   Are developments in the environment and structure of private equity affecting investments in the long term?

  There is no evidence to suggest the growth and development of private equity in the UK is affecting the basic model or principle of investment. Typically investments are held over a 3 to 5 year period. There are examples of shorter periods of investment and there are examples of longer periods of investment. Overall, as government ministers have made clear, private equity firms tend to hold on to companies for longer than the average length of time that institutional investors hold shares.

 (b)   To what factors, including the current macroeconomic context and position in the economic cycle, is the current rise of private equity attributable?

  The UK private equity market is the largest and longest established private equity and venture capital market in Europe. On the world stage it is second in size only to the United States. It is also widely considered to have led the field in Europe in terms of having developed a favourable infrastructure for the industry.

  In additional to the structural factors referred to in section 3, economic factors that have contributed to this success are:

    —  The UK economy: UK businesses have driven considerable economic growth over recent years: the UK has seen above European average GDP growth as well as rises in productivity and employment. Private equity has shaped the UK economy, providing capital for businesses in industries, particularly in the service sector, which have recorded increased investment activity in the recent past.

    —  The availability of investment opportunities: In terms of the pool of potential investment targets, the UK has a large stock of companies, balanced between small, medium-sized and large businesses. In [2004], the UK accounted for the largest proportion of European seed and start-up investment. The UK also has the largest stock of mid-market businesses, while London holds a position as a major international finance centre for larger businesses. The UK also has a very open merger and acquisition environment free from the restrictions seen elsewhere.

    —  Entrepreneurial culture: In the UK, the continued development of an entrepreneurial culture is being pursued both via education and through the establishment and maintenance of structures and procedures encouraging entrepreneurial and economic activity.

 (c)   What are the economic advantages and disadvantages of a firm being owned by private equity funds as opposed to being publicly listed?

  Economic advantages of a company being owned by private equity include:

    —  the alignment of interests of shareholders and management, in a focussed way, that is inherent in the private equity structure;

    —  the provision of strategic direction to management of the business being backed, financial advice and hands-on practical support;

    —  the ability to tailor the capital structure and levels of investment to the needs of the company; and

    —  the close working relationship between the private equity firm and the company's management, with short lines of communication and clear targets and accountabilities, that is unparalleled in the public company universe.

  These advantages enable a long term view to be taken in cases where substantial reorganisation or a change of strategic direction is required, enabling the necessary changes to be made away from the need for the regular public announcements of results that is an inherent part of the life of a listed company.

  These advantages will often outweigh the benefits of public market ownership, principally the access to large amounts of long-term risk capital. It is however the BVCA's strong contention that for a dynamic economy and strong and vibrant public market and private equity market is required thereby allowing firms access to the most appropriate form of capital for its needs. The two markets are complementary rather than competitive.

  The economic impact of private equity is demonstrated by the BVCA's annual survey, "The Economic Impact of Private Equity in the UK", most recently published in November 2006. The key findings of this eighth report in the series reinforce those of the previous surveys, and demonstrate that private equity-backed companies are a significant driver of the UK economy and its global competitiveness:

    —  Private equity-backed companies create jobs at a considerably faster rate than other private sector companies. Over the five years to 2006-06, the number of people employed worldwide by UK private equity-backed companies increased by an average of 9% pa. This compares dramatically with FTSE 100 and FTSE Mid-250 companies, at 1% pa and 2% pa respectively. Furthermore, nearly three-quarters of companies said their growth was organic, rather than by acquisition, following private equity backing.

    —  Private equity-backed companies boost the UK economy. Over the five years to 2005-06, on average private equity-backed companies' sales rose by 9% pa, compared with FTSE 100 companies (7% pa) and FTSE Mid-250 companies (5% pa). Exports grew by 6% pa, compared with a national growth rate of just 2% and investment rose by 18% pa, compared with 1% nationally.

    —  92% of responding companies said that without private equity the business would not have existed at all or would have developed less rapidly.


  As European Commissioner Charlie McCreevy stated in his recent speech to the All Party Parliamentary Group for Private Equity and Venture Capital on 22 March 2007, "the track record shows that private equity firms are proactive in destroying inefficiency and waste, in identifying and leveraging upon sources of competitive advantage, in exiting areas where such advantage can no longer be sustained, in ridding companies of vanity assets and vanity management teams, and in changing management teams that under-perform. That is not the route to the destruction of employment. It is the route towards underpinning of competitiveness and to delivering sustainable growth in employment."

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