Memorandum submitted by the Association
of Investment Companies
1. Investment companies provide an excellent
mechanism to gain access to private equity. The Association of
Investment Companies (AIC) estimates that the sector currently
has around £15 billion invested in this asset class and envisages
this will increase in the future. Investment companies offer an
alternative to limited partnerships and may have wider benefits
in terms of accessibility and transparency, as well as enabling
competition in this market. The Association of Investment Companies
(AIC) recommends that the development of private equity investment
companies should be supported by policymakers interested in developing
the private equity market in the UK.
2. Private equity is a legitimate business
arrangement and the AIC recommends that those policymakers should
not be predisposed to one form of ownership over another, but
should seek to provide a supportive regulatory and tax regime
for all UK businesses.
3. The Financial Services Authority (FSA),
in its capacity as the UK Listing Authority, is currently reviewing
the Listing Rules, a key regulatory mechanism governing the investment
company sector. This review offers the potential to enhance the
commercial environment within which private equity investment
companies operate. The AIC recommends that appropriate liberalisation
of the Listing Rules should be adopted to support the sector.
4. One of the benefits of investment companies
as a means of accessing private equity is their high levels of
transparency for key stakeholders and the wider public. Where
policymakers are interested in transparency, the AIC recommends
that they should support investment companies as a way of accessing
this asset class.
5. The level of leverage adopted in private
equity transactions is a commercial matter for the parties involved.
The fact that private equity transactions may adopt leverage has
no special policymakring relevance over and above those related
to any other business arrangement.
6. Where investment companies are involved
in private equity they facilitate wide access to this asset class.
7. There are a number of adjustments which
can be made to make investment companies more tax-efficient. For
example, the AIC recommends enabling more efficient investment
in interest-bearing securities through the tax system. This will
enhance the competitiveness of investment companies and their
ability to bring diversity and competition to the private equity
8. The AIC represents some 300 investment
companies, including UK investment trusts, offshore investment
companies and Venture Capital Trusts (VCTs). The vast majority
of these are listed on the London Stock Exchange (although we
also have three members traded on AIM). Investment companies invest
in shares and other assets with the aim of spreading risk and
providing an investment return.
9. Investment companies provide an important
alternative vehicle to private equity funds based upon limited
partnerships. Overall there are 20 London listed investment companies
dedicated to private equity with assets of around £10 billion.
We estimate that around £3 billion more of private equity
is held by other investment companies with general mandates. In
addition, VCTs, which are focussed on small private businesses,
hold just over £2 billion of assets. In total therefore the
investment company industry invests around £15 billion in
private equity. The total assets under management of the investment
company sector amount to just over £90 billion.
10. Investment companies represent a relatively
small part of the total UK private equity market in comparison
with limited partnerships. However, we anticipate that their role
will expand and recommend that the Select Committee should support
this trend as listed funds can provide investors with excellent
investment returns and portfolio diversification at the same time
as maintaining high standards of transparency and allowing wide
access to this asset class.
11. The UK economy benefits from the development
of, and competition between, different ownership structures. For
some businesses private ownership is appropriate; others are better
suited to a public listing. Indeed, over its lifetime, a business
may move between these two situations according to its stage of
development and the prevailing commercial environment. The AIC
recommends that the Government should not be predisposed to one
form of ownership over another but should seek to provide a supportive
regulatory and tax regime for all UK businesses.
12. The AIC has been disappointed by emotive
claims that private equity destroys value by "asset stripping"
and that it creates unemployment. Companies bought by private
equity funds may well sell non-core assets. However, this will
be done to help them create stronger, more focussed, businesses.
The purchaser of the assets also benefits as it acquires resources
it can seek to add value to. Such transactions benefit both parties
and make each commercially stronger. This is a very different
proposition from the negative impression implied by the term "asset
13. Job losses following corporate restructuring
are not unique to private equity involvement. A private equity
transaction is simply a stimulus for reviewing the approach a
business should adopt to ensure its continued success. In common
with any exercise of this nature, the objective is to focus resources
on certain activities, improve efficiency and productivity and
create a stronger business. Failure to take such action risks
businesses becoming moribund and uncompetitive. In the long term
this will threaten all the jobs supported by the company and its
suppliers. Successful restructuring of this nature can create
stronger companies employing more people. Although job cuts do
have a serious impact on those involved, the long-term prospect
of commercial success and greater levels of employment should
be welcome in the increasingly competitive global marketplace.
14. The objective of private equity investors
is to purchase a business, transform it, operate it for a limited
period and then sell it to make an investment return. The process
must create strong businesses attractive to the next set of investors
or else it will not be successful. Private equity investors have
no interest whatsoever in destroying the value inherent in a business
they purchase. This would be contrary to their fundamental objectives.
15. Many of the criticisms aimed at private
equity are either unfounded or relate to business practices common
to all modern commercial organisations regardless of their ownership
structure. Though there may be specific issues related to private
equity which deserve consideration, the AIC is keen that consideration
of these should not be inappropriately coloured by extraneous
16. The AIC's comments are focussed on the
environment for London listed investment companies holding private
equity, not limited partnerships.
17. Is the current regulatory environment
for private equity funds suitable? Yes, overall the regulatory
environment for investment companies is suitable. It provides
proper investor protection, public transparency and accessibility
for a wide range of investors while maintaining the competitiveness
of the investment company structure.
18. A key regulatory mechanism governing
investment companies are the Listing Rules, governed by the FSA
in its capacity as the UK Listing Authority (UKLA). These rules
are currently under review by the UKLA. The AIC is fully supportive
of the UKLA's intention that the review should result in targeted
changes to increase the commercial flexibility available to listed
funds while maintaining proper standards of consumer protection
19. Some of the targeted changes it should
Removal of restrictions on "control":
Currently investment companies are not allowed to control the
companies in which they are invested. Traditionally this has served
to separate investment entities from trading companies (which
have to meet different standards to secure a listing). In the
modern listing environment this is inappropriate as other rules
(notably a requirement to publish an investment policy which explains
how the entity intends to spread investment risk and how this
has been achieved) secures the necessary differentiation. The
UKLA has announced its intention to remove the headline restrictions
on control but the AIC recommends it should go further and also
remove "guidance" that threatens to maintain unwelcome
restrictions. Supporting the AIC's proposal will: reduce compliance
costs; help funds deliver returns for shareholders; and maximise
the competitiveness of the underlying business (so delivering
greater economic growth and employment).
Maximise access to feeder funds:
The current review also presents an opportunity to give investment
companies a greater freedom to invest in unlisted private equity
"feeder funds". Under these arrangements the investment
company takes a stake in an unlisted, diversified "master"
fund. Current rules prevent this where the investment company
does not control the master fund (which will not be possible where
the master fund is much larger than the listed vehicle). However,
a requirement for control is unnecessary to protect the interests
of the investment company's investors. At one level the lack of
control is just another element of risk which is disclosed and
which investors have to assess. Also, if the master fund changes
its policy and this is out of tune with the listed company's objectives,
the listed company can simply withdraw its money and seek other
ways to fulfil its investment remit.
The current feeder fund restrictions are unnecessary
and the AIC recommends that they be removed. One key benefit is
that this will allow retail investors' exposure to assets which
traditionally require substantial lump sums as a minimum investment.
At the same time the liquidity requirements of a London listing
will mean that they will be able to redeem their investment as
required. It may also be the case that the liquidity available
through a London listing will allow them to secure an exit at
a lower discount to the net asset value of the company than might
be available if they had invested in private equity through other
routes (including a company listed on another market).
20. Liberalising the Listing Rules in a
targeted way will ultimately help enhance the attractions of London
as a venue for listing these funds, so allowing UK investors to
gain exposure to private equity while enjoying the benefits of
a proportionate regulatory regime.
21. Is there sufficient transparency on
the activities, objectives and structure of private equity funds
for all relevant interested parties? Yes, investment companies
provide sufficient transparency for relevant parties. The critical
parties are: the Board of directors (who ensure the objectives
of the fund are being delivered by the manager and have legal
duties to uphold shareholder interests) and the investors themselves
keen to monitor the performance of their investment.
22. Where the investment company manages
its own portfolio the board will receive regular updates from
the investment manager (whether they are in house or outsourced).
This will include information on all key aspects of the operation
of the fund, performance of key assets, the progress of transactions,
gearing levels etc.
23. Where the investment company invests
in another fund, or range of funds (based upon limited partnership
structures) the fund manager/board will receive updates from the
managers of the vehicle they have invested in. This information
will be sufficient to make the strategic assessments they need
to make on behalf of their shareholders (if they did not receive
satisfactory information it is difficult to see that they would
be prepared to invest).
24. The activities of an investment company
are also very transparent to their shareholdersand indeed
to the markets and public more generally. Investment companies
must prepare an annual report, including financial statements
which set out the progress of the company. The front half of the
report will include a variety of narrative statements, including
the Chairman's and Manager's reports. The precise content of these
will vary between companies but is likely to include a range of
information including: sectoral and geographic breakdowns of the
portfolio, information on significant transactions (purchases
and disposals) and top holdings of companies and any funds they
are exposed to.
25. Investment companies will also prepare
a half-yearly (interim) report. Since January 2007 they have also
been required to publish two Interim Management Statements (in
effect short quarterly statements in between the annual and half
year reports) giving information on material transactions and
other significant developments that affect the company.
26. Apart from these periodic reports investment
companies listed in London are also required to make a range of
real time announcements on various issues, including price sensitive
developments and directors' dealing in the shares of the company.
These are also made public.
27. Investment companies therefore provide
very high levels of transparency for their shareholders and the
broader public. This might include potential investors but also
other stakeholders with an interest (such as employees of the
businesses the investment company owns).
28. The AIC is unsure that there is a public
interest case for all private equity vehicles to provide substantial
levels of public information. After all, the disclosures required
by investment companies reflect the fact that they are publicly
listed and disclosures are required to maintain a fair and orderly
marketplace. These disclosures can be accessed by other interested
parties but this is a supplementary benefit, not a core reason
for them. However, insofar as there is an interest in the activities
of the private equity sector, meeting the requirements of a listing
does mean that investment companies are very transparent. Where
policymakers are interested in transparency the AIC recommends
that they should support investment companies as a means to accessing
this asset class.
29. Has there been evidence of excessive
leverage in recent transactions and what systematic risks arise
as a consequence? The AIC does not comment on specific transactions.
However, we are concerned that some of the recent discussion regarding
leverage used in private equity transactions has not been properly
30. Gearing (leverage) has an impact on
the success, or otherwise, of specific private equity transactions.
However, the level of gearing used in a particular transaction
is a matter for the commercial judgement of the institution(s)
involved. There may be situations where the calculation on the
desirable level of gearing is flawed and this creates a sub-optimal
outcome. For example, in theory, gearing could be too high, meaning
that debt servicing costs could restrict cash flow for operational
31. However, the AIC is extremely sceptical
about external claims that gearing levels are excessive. While
the overall level of costs may seem high, this has to be set against
the wider benefit of securing capital at a lower cost than is
required by equity financing. Over-reliance on equity capital
may mean that the business in question has adopted a capital structure
which is too expensive.
32. Drawing a realistic conclusion on appropriate
levels of gearing depends on a huge number of variables. The hostile
views of external critics are likely to have based their arguments
on counter-factual assumptions which must be viewed with extreme
caution. Ultimately the measure of success or failure is whether
or not, when the business is sold, it is a sufficiently attractive
commercial proposition to secure the required investment return
and is economically attractive to its next owner.
33. The concern of policymakers should be
to create a regulatory environment which allows different ownership
and funding structures to be adopted so that different strategies
are able to compete. This will allow successful approaches to
flourish. This will create the best employment and economic consequences
for UK plc. Ultimately it is unlikely to be useful for policymakers
to focus on discrete issues such as the level of gearing used
in specific transactions.
34. Levels of private equity leverage are
only relevant from a policymaking perspective in relation to the
regulation of lenders. However, the normal commercial action of
the market ie the combination of due diligence undertaken by banks
and the increasingly common practice of distributing/syndicating
debt, should reduce the potential that the private equity market
creates any particular regulatory risks. Insofar as there are
risks, the regulatory regime is designed to ensure that debt providers
can manage the risks of default.
35. Ultimately the lender is best able to
assess the market's capacity to distribute its risk and the creditworthiness
of the borrower. These decisions must be taken within the context
of the lender's own regulatory obligations.
36. No systemic risks arise from the use
of leverage in private equity transactions.
37. The AIC recommends that any regulatory
concerns about the regulation of UK lenders should be examined
in the round (although it is not at all clear that the development
of private equity has any relevance per se to prudential regulation
of banks and other lending institutions).
38. What are the effects of the current
corporate status of private equity funds, including both their
domicile and ownership structure? The AIC believes that the investment
company structure offers a number of benefits to potential investors.
39. They are traded on a stock market (such
as the London Stock Exchange) which matches potential buyers and
sellers to facilitate trading. The market is independent of the
manager of the vehicle and allows investors to redeem their investment,
in effect, on demand.
40. If investors select shares listed on
a regulated market they enjoy the same standards as other publicly
listed shares. For example, those listed on the London Stock Exchange
benefit from the standards set by the relevant European Directives
(such as the Transparency Directive and the impending Shareholder
Rights Directive) and those established by the UK authorities.
These standards are set independently of the scheme manager. This
gives investors an alternative to arrangements available through
limited partnerships. The availability of these types of product
may be particularly valuable for smaller investors seeking access
to private equity.
41. Purchasing listed shares also means
that investors' potential liability is also limited to the amount
they paid for their shares.
42. The domicile of a private equity vehicle
may have an impact on its governance arrangements. It is difficult
to generalise about the quality of competing regimes as different
standards will apply according to their home state. Where investment
companies are domiciled in the UK, for example, they will be subject
to the provisions of the Companies Act 2006, which recently modernised
UK company law. It includes a wide range of provisions, such as
the codification of director's duties and introduction of the
concept of "enlightened shareholder value" which requires
boards to consider the views of a wider range of stakeholders
(such as employees and suppliers) than was previously the case.
43. Different jurisdictions have different
company law requirements. However, we note that where an investment
company lists in London this will impose some common standards
regardless of the company law requirements in their home country.
Perhaps the most significant from a governance perspective is
the need for a full independent board, which is required by the
44. In terms of ownership, we note that
investment companies are widely held. Their shares may be purchased
by both institutional and retail investors. Unlike many limited
partnerships they do not require a large upfront sum (sometimes
measured in hundreds of thousands of pounds) to enter the fund.
The entry cost will depend upon the prevailing market price of
the relevant shares. Dealing costs in publicly traded shares are
not likely to represent a significant barrier to entry.
45. The AIC does not have a specific breakdown
of who owns private equity investment trusts. However, we do estimate
that the sector overall is owned roughly 50:50 between traditional
institutional investors and the retail market. For the purposes
of this estimate we would include "execution only" private
investors, those who invest with advice (including through an
IFA) and investors who have had purchases made on their behalf
by discretionary wealth managers as "retail" investors.
Where private equity investment companies are concerned we would
anticipate that the level of institutional investment would be
higher than seen in the sector overall. The key exception to this
would be VCTs which, because of the tax incentives, are overwhelmingly
owned by retail investors.
46. The AIC's comments are focussed on the
tax position of UK domiciled private equity investment companies,
known technically as "investment trusts". (Overseas
investment companies do not fall within the reach of the UK tax
47. Is the current taxation regime for private
equity funds and investee firms appropriate? The current taxation
regime for investment companies is not appropriate. Ideally collective
investments such as investment trusts are tax transparent. This
will mean that the investor in the vehicle is no worse of, from
a tax perspective, than they would be if they had invested directly
in the underlying assets themselves. This is welcome from a policy
perspective as it creates incentives for investors to pool their
capital to secure access to a diversified portfolio of assets
and fund management skills and secure economies of scale. This
should facilitate higher levels of savings and investment in the
48. Critical areas where private equity
investment trusts are not tax transparent include:
VAT on fund management expenses:
While there are some high-profile investment trusts which manage
their own private equity portfolios, many investment trusts choose
to subcontract their fund management function to external managers.
Currently they pay VAT on this expense, which hinders their competitiveness.
The AIC believes the imposition of VAT on investment trusts is
contrary to the principle of fiscal neutrality (ie that businesses
competing in the same market should be subject to the same tax
treatment) and European law. It is currently challenging the UK
Government's position on the charging of VAT on management expenses
incurred by investment trusts in the European Court of Justice.
The AIC is confident of the legal basis and the policy grounds
for adjusting the interpretation of the VAT regime for investment
trusts and recommends that the Government should move as quickly
as possible to remove this tax burden going forward and to reconcile
claims for repayment of VAT already paid in error.
Tax treatment of bond income: Investment
trusts currently pay 30% tax on income received from interest-bearing
securities (such as bonds). This means that, where interest income
is received, they are not tax transparent. This skews investment
decisions by investment trusts towards purchasing equity rather
than corporate debt. It may also give them less freedom in comparison
with other vehicles to structure their investments as they wish.
This paper has already addressed the contention that private equity
transactions are too highly leveraged and argues that such a conclusion
is not credible. Levels of debt used in private equity transactions
should be left to the market to determine. Given this, it is inappropriate
that investment trusts should have less commercial freedom than
their competitors to use leverage as they wish. The AIC has been
in contact with HM Treasury to discuss the potential to reform
the tax treatment of income received by investment trusts to enhance
their tax efficiency. We recommend that moves to secure reform
in this area should be widely supported as this will maximise
the competitiveness of investment trusts in comparison with other
vehicles, including limited partnerships. (N.B the benefits of
such a reform would also accrue to the broader investment trust
market, including those not engaged in private equity activity.)
49. Addressing these tax issues will enhance
the competitiveness of investment trusts operating in the private
equity sector and allow them to compete more effectively with
limited partnerships. They will therefore be better able to deliver
benefits related to access and transparency highlighted above.
50. This paper already addresses a variety
of issues regarding the economic context in which the private
equity sector is operating. We do not have anything to add to
this analysis. We would simply reiterate our recommendation that
UK policymakers should create an environment in which businesses
can thrive regardless of their ownership structure.
51. The AIC would be pleased to provide
further observations on any of the points raised in this paper
if it would be helpful. In the first instance any queries should
be addressed to: