Select Committee on Treasury Written Evidence


Memorandum submitted by the Association of Investment Companies

EXECUTIVE SUMMARY

  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 sector.

ABOUT THE AIC

  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.

PRIVATE EQUITY IN CONTEXT

  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 stripping".

  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 issues.

THE REGULATORY ENVIRONMENT

  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 and transparency.

  19.  Some of the targeted changes it should adopt include:

    —  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 shareholders—and 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 informed.

  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 development.

  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 Listing Rules.

  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.

TAXATION

  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 authorities.)

  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 UK economy.

  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.

ECONOMIC CONTEXT

  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.

CONCLUSION

  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:

May 2007





 
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