Memorandum submitted by the British Private
Equity and Venture Capital Association
1.1 The BVCA
The BVCAthe British Private Equity and
Venture Capital Associationis 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 CapitalA
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
investments in unquoted companies;
equity capital by nature;
targeted at companies with growth
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 equitysome 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 createdan 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
2. Exports and investment have also grown
faster than the national averagein 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
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
fundsie the fund structures available to private equity
funds established in the UK, or managed from a UK baseand
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
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
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 adjustmenttaking the form of lower returns leading
to reduced capital inflows and hence less competition for dealsor
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
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
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
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 borrowerdebt 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
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
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 rulesand 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
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 locationeither
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 EVCAThe European Private Equity and Venture Capital
Associationhas 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.
5. ECONOMIC CONTEXT
(a) Are developments in the environment
and structure of private equity affecting investments in the long
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
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 , 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
(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
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;
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
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."