Select Committee on Treasury Written Evidence

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 losses—and large fixed fees to boot—when 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 large funds.


  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 prominently.

  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 sale.

    (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 stores.

  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 PE houses.


  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).

  Source: Citigroup.

  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 1Quintile 2 Quintile 3Quintile 4 Quintile 5Average/Total
Multiple0.571.11 1.551.952.7 1.53
Cash in1,068,511, 011 1,736,110,7131,290,147,011 1,346,411,020999,797,7266,440,977,481
Cash out plus remaining investment605,920,682 1,926,893,7792,000,841,269 2,630,286,0702,704,137,029 9,868,078,829
No. of funds1818 191918 92

  Source:, 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.


  4.1  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 years.

  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.


  5.1  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%

mill mill%mill mill
management fee charged on equity and debt S&P500$1,337,265$7,292,556 18.3$2,675$116
FTSE100£122,920 £946,04213£1,229 £61
management fee charged ONLY on equityS&P500 $709,931$7,292,5569.7 $1,420$62
FTSE100£100,065 £946,04210.6£1,001 £50
management fee charged ONLY on equity WITH debt/equity split @ 70:30 S&P500$401,179$7,292,556 5.5$802£35
FTSE100£36,876 £946,0423.9£369 £18

  Source: CRESC, University of Manchester.

  Note: Nominal data, not corrected for inflation.

Table 3:  General partner rewards in the PE business model

Mid-market fund Large buyout fund
Funds under management£250-£500 million $8-$16 billion

Management fees (% of committed capital) 1.75-2.25% 1.75-2.0%
Carry (% carried interest on fund performance) 20% 20%
No.No. with carry % of carryNo.No. with carry % of carry

Full partners
Investment executives
Head office staff






BasicBonus Carry
(over 5 years)
Basic BonusCarry (over 5 years)

Full partners
Senior executives









  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.


  6.1  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 of agents.

  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 to know:

    (1)  Annually the total and itemised charges in fees and deductions.

    (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 (

  Swensen, D (2005) Unconventional Success, Free Press: New York.

  Thornton, P, (2007) Inside the Dark Box, Work Foundation: London.

  Wright, M Jensen, M, Cumming, D and Siegel, D (2006) The Impact of Private Equity: Setting the Record Straight.

May 2007

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