Memorandum submitted by Julie Froud, Sukhdev
Johal, Adam Leaver, Professor Karel Williams, Centre for Research
on Socio Cultural Change, (University of Manchester)
This submission argues that private equity is
part of the agent problem in present day capitalism whereby financial
intermediaries make large fee-based deductions at the expense
of investors. Private equity portrays itself with a justificatory
narrative but the evidence on job creation and superior returns
is mixed and ambiguous. The history of private equity is one of
rapid expansion from small beginnings so there is no historical
record of successful exit from large investments like FTSE 100
companies. This is cause for concern because private equity is
now pitching for mass investment by pension funds and the appropriate
regulatory response is to enforce more disclosure about the private
equity funds and their general partners.
" ... the most that owners in aggregate
can earn between now and judgement day is what their businesses
in aggregate earn ... Indeed owners must earn less because of
frictional costs (which) ... ... are now being incurred in amounts
that will cause shareholders to earn far less than they historically
have ... Particularly expensive is the recent pandemic of profit
arrangements under which Helpers receive large portions of the
winnings when they are smart or lucky, and leave (owners) ...
.with all of the lossesand large fixed fees to bootwhen
the Helpers are dumb or unlucky"
Warren Buffet: Letter to shareholders 2005 pp.18-19
on the deductions of intermediary "helpers" such as
private equity general partners.
1.1 This submission answers the Treasury
Select Committee's request for an analysis of economic context
before turning to consider implications for regulatory environment
and taxation policy. Sections 2, 3 and 4 of this submission provide
evidence and argument about the economic advantages and disadvantages
of private equity, which we do by comparing industry claims with
(complex) observable and hypothetical outcomes Section 5 and 6
address regulatory questions about whether the current regime
is suitable and whether there is sufficient transparency on the
activities, objectives and structure of private equity funds for
all relevant interested parties. It presumes the reader understands
the private equity business model and, on that basis, presents
an alternative view of private equity (PE) which is novel in two
ways. First, it challenges the narrative of the private equity
lobby and the use of numbers in mainstream finance debate about
the social and economic benefits of private equity. Second, it
highlights the issues about value extraction by intermediary general
partners in private equity.
1.2 Issues about high pay and the pay/performance
relation in business predictably concern moralistic churchmen
and trouble making leftists. But investment gurus like David Swensen
of the Yale Investment Office or Warren Buffet of Berkshire Hathaway
have also raised the issue of intermediary charges and deductions
from the owner/investor's point of view. Thus, Swensen (2005,
p.23, pp 218-9) is a critic of active stock picking by mutual
funds which then deliver inferior returns to passive funds because
of management fees and transaction costs incurred to play the
active game. He argues much the same is true of LBO funds. As
our opening quotation shows, Buffet in his 2005 letter to shareholders
explicitly extended the argument to hedge funds and private equity
whose "2 and 20" fee structures ratchet up the charges
(see section 5.1-5.3).
1.3 Will company picking by private equity
general partners be any more successful for the mass of owners/capital
providers than stock picking by active US Mutuals? The answer
is as yet unclear. The one economic certainty is that the current
up scaling of private equity will allow intermediaries to make
large deductions regardless of performance. Why is this consequence
not obvious to all owner/investors? It is because the PE trade
has produced a self-justificatory narrative about job creation
and because mainstream finance diverts onto inconclusive historical
numbers about earnings. Both deflect attention from serious issues
about the scale of fee deductions on large investments and by
2. THE JUSTIFICATORY
2.1 British private equity has a trade association,
the BVCA whose EU counterpart is the EVCA which both lobby the
political classes and address civil society mainly through the
media. Modern lobbying works by explaining how business needs
to be encouraged by appropriate regulation so it can deliver worthwhile
social objectives. The lobbyist must thus construct a story about
social benefits (profits and returns figure mainly in a separate
story for investors and fund managers). The justificatory narrative
of PE is about aggregate job creation (plus sales and investment
growth). Thus, the EVCA claims private equity has created 1 million
new jobs as its contribution to the Lisbon agenda and the BVCA
frames its submission to your committee with "key facts"
which begin with the claim "private equity creates jobs"
which is then supported by headlines about how private equity
backed companies over the past five years have grown employment
by 9% per annum or four times as fast as FTSE 100 or FTSE 250
companies (BVCA, p. 4).
2.2 The BVCA story about more jobs is simple
and the same factoids are endlessly repeated. But the story quickly
becomes more complex at an aggregate level if analysis engages
more closely with complex source numbers in the CMBOR data set
and considers problems about the interpretative standard. As the
Work Foundation argues, the jobs outcome all depends on whether
we consider change of management (MBI not MBO), the number of
years after transaction, whether wages are considered and what
is the comparator and the implied counterfactual (Thornton, 2007,
pp.14-17). Because the evidence is inconclusive, the BVCA narrative
of social benefits has never supplanted competing narratives especially
from trade unions like the GMB about private equity as job cutting
and asset stripping where cases like Birds Eye or the AA figure
2.3 To get some perspective on these stories,
we must consider the levers of profitability in the private equity
business model. The business of private equity is trading in used
companies which are typically held for three to give years and
the levers of value over this period are diverse.
(a) Resale value depends on whether stock
market has moved up and/or trade buyers are active at point of
(b) Operating value can be realised either
via cost recovery through organic or acquisition led growth or
via cost reduction at the expense of labour in mature business.
(c) Balance sheet value through asset stripping
such as sale and lease back of property in retailers who own their
The importance of the different levers varies
from one case to the next as do the effects. The consequences
for labour or the balance sheet will vary from company to company
and period to period according to:
(a) Business maturity and industry consolidation
which frame the possibilities of sales growth.
(b) The stock of realisable wealth in the
balance sheet which can offer an easy way of extracting value.
(c) How exit through resale factors in windfall
gains or losses from conjunctural change not management effort.
2.4 So everybody can have their company
story with a moral about good or bad private equity; and no doubt
many stories are dramatic simplifications. However, the sad cases
about stripping assets and loading debt onto Debenhams or the
labour stripping and intensification at the AA should not be edited
out or ignored because they are a warning about what PE will do
in some instances. There is no guarantee that such levers will
not be used or will only be used by an irresponsible fringe of
3. BUT ARE
(PE) SHAREHOLDERS HIGHER?
3.1 The question of how the returns are
obtained is secondary for academic professors of finance whose
first question is whether returns on private equity are higher.
Thus, a forthcoming academic review of exited buyouts in the UK
from 1995-2004 claims an "average return of 22.2% net of
market index returns, on the enterprise value of the firm".
Within an orthodox agency framework, higher returns are then attributed
to the incentive effects of "enhanced equity ownership for
management" and "improved monitoring by private equity
firms" (Wright et al, 2007) compared with publicly listed
companies. Putting aside the interpretation, the immediate problem
is that it is difficult to put ones trust in such profit numbers.
3.2 Mainstream finance identifies outcomes
and relations by applying empiricist techniques to large data
sets which in this case must be historical because the typical
PE fund is open for eight to 10 years. The techniques work best
when the data set, as in the case of the FTSE 100, includes a
large slice of economic activity whose composition is changing
slowly. The problem is that, as figure 1 shows, PE is on a hockey
stick curve of expansion at nearly 20% per annum from small beginnings
and modestly sized deals over the past 15 years. The number of
UK deals is much the same at around 1500, the divisions and companies
have become much larger. The results on the UK or US deals of
the 1990s are no guide to what will happen at point of exit with
giant companies like the TXU utility or Boots bought in 2007 when
PE is flush with money to do ever larger deals which may not generate
resale profits five years down the line.
Figure 1: The upscaling of private
equity: global private equity deal volumes 2001-05 ($ billion).
3.3 Just as important as the average rate
of return on private equity is the variability of returns between
funds (driven in turn by variation in return on individual investments
within funds which are what we would expect given many levers
and important differences between companies). The fragments of
publicly available evidence suggest that the US pension funds
which got into PE in the 1990s did not succeed in investing only
in successful funds. As table 1 shows, in the case of a US public
employee pension fund like Calpers in the 1990s, 40% of its PE
funds generate nearly 90% of its total PE return between 1990-98.
Thus, PE is double jeopardy for pension funds because PE general
partners must pick used companies and pension fund managers must
either pick individual PE funds or PE houses of general partners.
If PE expands to claim a significant share of pension fund investment
the likely collective consequence is more cross section variability
in the returns of UK pension funds that logically should then
set high PE hurdle rates to compensate for the illiquidity and
risk of PE fund investments.
Table 1: Variability of Calpers returns
1990-8 (ranked by multiple of return and split into equal funds).
|Quintile 1||Quintile 2
||Quintile 3||Quintile 4
|Cash in||1,068,511, 011
|Cash out plus remaining investment||605,920,682
|No. of funds||18||18
accessed 25 April 2007.
3.3 PE was originally represented as an alternative investment
which offered diversification benefits because PE returns are
uncorrelated with public equity. But the expansion of PE has already
been carried to the point where this is doubtful. PE increasingly
does large deals which involve buying PLCs from the stock market
and then resells to the stock market after three to five years
or resells in deals where the stockmarket is a bench mark; so
profits on resale are levered down in bear markets or up in bull
markets as in the 1990s or 2002-07.
3.4 Furthermore, it is increasingly difficult to believe
that the current expansion of PE is sustained by the record or
prospect of high or uncorrelated profits on private equity. The
key enabling condition is surely excess liquidity and the wall
of money which makes it possible to raise 70% of the purchase
price of giant companies in the form of cheap debt at around 8%.
It is troubling that the FSA is unable to find out who ultimately
buys and holds this debt because periods of excess liquidity usually
end in a credit crunch as imprudent lenders and panicky asset
holders try to get back to cash. Meanwhile, the ready availability
of debt is surely an ongoing incitement for PE houses to either
overpay for companies or be careless about what they buy.
4. HOW PRIVATE
4.1 The consequences of PE for jobs or profitability
are complicated in the past and unknowable in the future insofar
as the current conjunctural conditions of cheap debt and rising
equity will surely change. But looked at another way, PE reformats
the business world because its use of debt and commitment to transactions
redefines value creation. PE starts by rearranging ownership claims
for value capture because funding business purchase with 70% debt
must cap returns to the majority of capital providers and levers
upside potential for the minority who hold private equity. PE
is then about value extraction insofar as operating businesses
can sell assets like property and be loaded up with debt for the
benefit of the 30% with private equity, who will finally benefit
from the commitment to sell the whole business in three to five
This modus operandi has effects elsewhere right across the
public company sector insofar as FTSE 100 or S&P 500 firms
defensively sell assets like property or gear up so as to become
less attractive targets for PE.
4.2 With PE now scaled up to purchase FTSE 100 firms,
we should note that giant public companies in the FTSE 100 have
typically relied on equity with a 30/70 debt/equity ratio which
more or less inverts PE practice. In comparative terms, this looks
to be conservative because both the S&P 500 and CAC 40 run
on 50/50 debt equity splits. But what happens if UK giant firms
go further into debt either defensively or after PE purchase?
To explore the consequences, we simulated FTSE 100 returns to
equity over the past 20 years on a capital base of 70/30 debt/equity
with the debt priced at 3.75% over Bank of England base rate.
The graph below can be read as a counterfactual about returns
in an average FTSE giant firm which embraced the PE model of leverage
and debt based funding; it is hardly a generalisable model for
the FTSE because it implies large scale de-equitisation and an
insatiable appetite for bonds with modest returns.
(We did not simulate increased operating profits because (a) UK
PE has no track record of raising profits in giant firms and (b)
ROCE in giant firms did not increase in response to previous pressures
for shareholder value).
4.3 In figure 2, the counterfactual story of the average
FTSE is straightforward. Rearrangement of ownership claims works
reassuringly for equity holders in the good years because leverage
produces better returns on equity from 1993-2000. But, this same
leverage may be alarmingly unsustainable over one or two cycles
because returns on equity are inferior in minor turn downs like
1990-91 and 2002; and there would be questions about ability to
meet obligatory payments on debt in the event of serious turn
down like 1979-82.which would then trigger large scale enforced
restructuring. In the average FTSE 100 business, 70/30 leverage
debt is attractive to owners like PE partners with good timing
who buy on the upswing or at least hope to exit before the next
cycle bottoms out; it is unattractive to managers who wish to
remain in control of operations in an ongoing business over the
next couple of cycles; just as breached debt covenants or difficulties
about making interest payments may be a nasty surprise for those
who bought investment grade debt from PE.
Figure 2: A simulation of the effect on the return
on equity (RoE) for UK FTSE 100 companies if they were re-leveraged
from 30:70 to 70:30 debt: equity.
Source: authors' calculations based on FTSE 100 company annual
report and accounts.
Note: the simulation was done by applying typical private
equity leverage (ie 70% debt) to the FTSE100, assuming a cost
of debt of Bank of England base rate plus a 3.75% margin.
4.4. In a leveraged world, if British pension funds or
Chinese investors are not heavily exposed to debt default, we
may finally have crash without panic as in the aftermath of the
US tech stock crash in 2000. But more subtly, if all business
is about value creation, leverage redefines what business means
by the creation of value. Leverage ensures that PE businesses
have a point concept of value creation ie the question is about
how much value can be created by and at the point in time when
the business is sold; and the major determinant of value creation
will be transactions in assets including the sale of the company
as a whole (with everything that happens after a three to five
year holding period irrelevant). Traditionally unleveraged giant
firms operated with a flow concept of value creation ie the question
is about how much value can be created going forward on the basis
of sustainable product market positions and operations which create
value by selling goods and services to consumers. PE is about
normalising the alternative point concept of value through transactions
which was introduced into the UK by acquisitive conglomerates
like Hanson, in the 1980s.
5. INTERMEDIARY CAPITALISM
5.1 As PE speeds up transactions, it feeds the elite
of working rich financial intermediaries for whom present day
capitalism is a kind of golden age (see Folkman et al 2006). Every
sale or purchase of a corporate business generates fat fees for
two sets of investment bankers, corporate lawyers and accountants.
As transactions are about realising huge sums, buyers and sellers
pay bankers or lawyers' fees without question in much the same
way as the seller of a house pays the estate agent's commission
out of holding gains. Every newly purchased PE business then passes
into the hands of PE general partners whose standard intermediary
fee is 2% of funds invested and 20% of carry, ie profits over
and above a pre-defined hurdle rate. This conventional fee structure
is objectionable because it represents pay without performance
and ensures gross overpayment of partners in the larger houses
as individual investments and funds are upscaled.
5.2 The flat fee of 2% on funds managed is not in any
way performance based and will in itself generate huge deductions
for general partners insofar as PE starts to deal in giant firms
in the FTSE 100 and S&P 500. Again some simulations are useful
in understanding the scale of value extraction from the individual
giant company and table 2 presents the results. Suppose PE buys
an average FTSE 100 company with 30% of purchase cost from PE
funds which are then counted as funds invested. A flat fee of
2% on that base would extract some £18 million per annum
which is probably 3 times as large as the £5 million or so
paid in current annual salaries of a FTSE CEO and his senior management
team. The CEOs management team draws its pay for devising strategy
and managing operations in a giant company which employs 40,000
or more subject to remuneration committee and public scrutiny
of the relation between pay and performance. Via a flat 2%, general
partners draw three times as much for allocating capital and monitoring
management in a giant company, without any pay for performance
qualifier despite the very variable record of past returns on
PE. Current PE trade gossip suggests that the flat fee in the
largest houses has slipped to 1.5% or just below but that still
generates massive deductions and PE retains the power to levy
other, additional fees.
5.3 The bonanza gains for individual general partners
come not from 2% flat rate but the 20% of carry. The carry only
generates gains for partners in successful funds but there is
no necessary connection with performance attributable to PE. The
profit share out of carry depends on profits exceeding a hurdle
rate but that result can of course include windfall gains such
as those made in a bull market by selling out on a rising market.
Furthermore, the standard 20% above hurdle is deducted regardless
of size of deal and fund so that PE general partners make more
out of running larger funds and doing deals on larger companies
which are not proportionately more difficult to set up and control.
Table 2: Management fee at 2% per company S&P500
(1980-2002) and FTSE100 (1983-2002)
by the 2%
|management fee charged on equity and debt
|management fee charged ONLY on equity||S&P500
|management fee charged ONLY on equity WITH debt/equity split @ 70:30
Source: CRESC, University of Manchester.
Note: Nominal data, not corrected for inflation.
Table 3: General partner rewards in the PE business
||Large buyout fund
|Funds under management||£250-£500 million
|Management fees (% of committed capital)
|Carry (% carried interest on fund performance)
|No.||No. with carry
||% of carry||No.||No. with carry
||% of carry|
Head office staff
(over 5 years)
||Bonus||Carry (over 5 years)
Source: Anonymised private equity funds' management accounts.
Note: Care has been taken to ensure that these figures on
private equity are representative of typical funds in these two
size groups, but they are not averages. Each set of figures is
based on a set of private equity (internal) management accounts,
supplied by an actual fund, which were then checked by an experienced
industry insider familiar with differently sized funds, who vouched
for their representativeness. The number of large funds is still
sufficiently small so that insiders could possibly identify an
individual fund if they knew its size and number of partners.
To make this impossible we have anonymised the data by expressing
it in terms of ranges, rather than point observations. This was
necessary because the management accounts were provided to us
on the strict understanding that the fund to which they relate
would not be identifiable. While these results could not be replicated
by any kind of desk research, we are reasonably confident that
they are representative in that any similar sampling of fund accounts
would disclose similar relativities.
5.4 Table 3 above, based on management accounts, bring
out the effects of upscaling because it shows how general partners
in successful mid-sized funds can expect the carry to generate
£5-15 million pounds on top of their salaries while general
partners in large, successful funds can expect $50-150 ie 10 times
as much. This has the potential to create a new plutocracy.
5.4 Defenders of PE often argue that PE solves the agency
problem of the public company whose principal/shareholders are
ineffectual at disciplining managers/agents. They overlook the
basic point that the ultimate owner/principals barely figure in
pension fund capitalism which is operated by tiers of agents in
the form of trustees and fund managers of different kinds. All
PE does is to add another group of agents in ways which threaten
to aggravate the agent problem which concerned investment gurus
like Buffet and Swenson before PE became an issue. And, it is
not easy to obtain redress for inappropriate and excessive fees
paid to general partners because PE breaches all the principles
of good governance about checks and balances with separation of
powers and the systematic involvement of outsiders as non executives.
The PE partners not only enforce the standard fees but can levy
additional imposts for "consultancy"" and such
like; as when Celanese was billed for the due diligence costs
of the PE house which acquired it.
6. MORE REGULATION
6.1 Increasing public disquiet has led to often confused
demands for more disclosure by and regulation of PE These demands
raise large issues about the differential tax treatment of debt
and equity, the use of complex holding structures with parent
companies in offshore tax havens, and the taking of partner rewards
as capital gains after short holding periods which allows PE general
partners to avoid paying income tax at 40%. Outside private equity,
these issues are of course relevant to many of the other actors
in a financialized economy whose fundamentals are very seldom
discussed in public. There has, for example, never been a broad,
honest discussion in the UK about how income tax is voluntary
for the working rich.
6.2 Amidst these confusions, the PE trade has parried
demands for regulation and disclosure by suggesting that disclosure
should be focused on the (larger) companies which PE invests in,
not the funds themselves. It is important to have more information
about the individual investments, especially because PE is now
entering into purchases of giant companies where the exit route
is not clear. But, insofar as PE aggravates the agent problem,
the crucial requirement is for more disclosure about PE houses,
funds, general partners and practices in the hope that publicity
without formal regulation would inhibit the fee based depredations
6.2 Such depredations would not be a matter of public
interest if the investors in PE were a few rich men and women
who gullibly accepted the promises of each new group of agents.
In this case we need only observe that "a fool and his money
is soon parted" and add the point that rich fools make more
lucrative targets. But the scale and basis of agent fees is a
public interest issue when PE is pitching to attract mass savings
from pension funds and promoting the attractions of PE as an alterative
investment. Of course, no pension fund is obliged to pay those
two and 20 fees but willingness to do so is of course influenced
by the justificatory narrative and claims about higher returns
which frame private equity as an opportunity. Furthermore, in
our form of pension fund capitalism, the ultimate contributor/owners
and their trustees are institutionally disempowered as agents
generally take decisions on their behalf so that public regimes
of disclosure and regulation are a necessary defence.
6.3 What should disclosure cover? Inter alia, for larger
individual investments, maybe of FTSE 250 size or larger, we need
(1) Annually the total and itemised charges in fees and
(2) Cumulatively at point of sale the proportion of the
final gain arising from transactions in assets.
For the houses and funds themselves we need to know much
more about the rewards of partners and the relation to performance
variations so that the relation between general partner reward
and investor returns can be publicly discussed. The question of
the tax regime on capital gains would also need to be considered
in such discussions insofar as partners take most of their reward
as capital gains after short holding periods because general partners
effectively retain more of their gross than ordinary citizens.
6.4 If PE fees are reasonable and performance related,
why should PE general partners object to disclosure? If they do
protest, surely the rest of us need to know more because we are
the owners and they are our agents.
Folkman, P, Froud, J, Johal, S and Williams, K (2006) Capital
market intermediaries and present day capitalism, CRESC Working
Paper 25: Manchester (cresc.ac.uk).
Swensen, D (2005) Unconventional Success, Free Press: New
Thornton, P, (2007) Inside the Dark Box, Work Foundation:
Wright, M Jensen, M, Cumming, D and Siegel, D (2006) The
Impact of Private Equity: Setting the Record Straight.