Select Committee on Treasury Written Evidence

Memorandum submitted by SVG Capital plc


1.   Is the current regulatory regime for private equity funds suitable?

  1.1  In its latest Discussion Paper[40] the FSA considers the current regulatory treatment of private equity to be sufficient and appropriate. With regards to investors in private equity funds we believe the current regulatory regime reflects the unique nature of access to this asset class. The best protection for investors in private equity funds is through careful due diligence of the GPs and the capability to closely follow developments in the market. Thus while many individuals have indirect exposure to private equity, the funds themselves are only open to sophisticated market participants like insurance companies, large or specialized asset managers and pension funds.

2.   Is there sufficient transparency on the activities, objectives and structure of private equity funds for all relevant interested parties?

  2.1  We believe there is sufficient transparency in private equity to apply the due diligence which is essential to the private equity model. GPs have a substantial interest in giving sufficient access for LPs to carry out their diligence. Were a fund not to give sufficient access and transparency we would find it difficult to approve such an investment to our portfolios.

  2.2  Some members of our group represent publicly listed structures that invest in private equity and have a clearly defined transparency and governance structure for end investors and the public. This structure yields considerable value for our investors.

  2.3  The growth of private equity has brought requests from other stakeholders such as employees, pension trustees and unions for improved transparency. Private equity's strength as a model lies in its long-term vision for creating value and motivating parties to achieve that vision in portfolio companies. As the end investors in these companies it is in our long-term interests to ensure that all of the stakeholders have sufficient transparency.

  2.4  We therefore strongly support the Walker Commission's efforts to define a voluntary code of conduct on transparency for private equity firms. We believe these efforts will go a long way towards meeting the interests and demands of the stakeholders described above.

  2.5  Transparency at the regulatory level has been well-addressed by the FSA in its recent discussion paper. The FSA seeks to maintain a balance between the regulation of private and public markets. It emphasizes the need to consider the efficiency and proportionality of proposed regulation. The paper also makes clear that the risks presented by public equity are relatively low and that the FSA's interests mainly involve monitoring. We support this view and would be pleased to consider any proposals which sought to improve the FSA's ability to monitor the industry.

3.  Has there been evidence of excessive leverage in recent transactions and what systemic risks arise in consequence?

  3.1  There have been several pronounced cyclical trends in the average credit statistics[41] for LBOs during the last market cycle between 2000 and 2006. Average debt levels as a multiple of EBITDA have risen (from 4.4x to 5.5x) but senior interest coverage levels are broadly the same (from 3.5x to 3.4x). Higher debt levels have supported higher purchase prices as a multiple of EBITDA (rising 20% including fees) but the average equity contributed to those deals has risen 15% as well indicating only a small increase in gearing levels.

  3.2  These averages cover a large, diverse and rapidly growing market (Europe—€30 billion in 2003 to €116 billion in 2006). Metrics for individual deals vary widely, and it is possible some current deals have leverage which is higher than can be supported by fundamentals. Evaluating appropriate leverage levels is highly dependent on the specifics of company and industry-level circumstances. As investors, leverage levels are something that concern us and we monitor them carefully. However, we believe company management and GPs are best at matching the knowledge of a firm's operating risks and its choice of financial structure.

  3.3  Managers exercise considerable care with regards to business cycles when choosing investments. Particular attention is paid to the cover of free cash flows over interest payments and the stability or risks to these coverage levels. A further restraint on unwarranted leverage is that investors in the debt of private equity-owned companies are able to exercise extensive diligence and reviews of the operating company as compared to those who invest in public companies. In our view the LBO-sponsored companies are particularly well placed for changes in economic conditions as these companies are chosen for the resiliency of their cash flows irrespective of the operating environment.

4.   What are the effects of the current corporate status of private equity funds, including both their domicile and ownership structure?

  4.1  The partnership ownership structure is time-tested and has evolved because of its suitability for private equity techniques. The structure allows LPs to invest over long-term horizons while providing significant flexibility for GPs in investment selection while encouraging management to focus on corporate strategy rather than day to day share prices. This structure has proven to be beneficial for investors in maximizing their returns while limiting exposure to their original commitment.

  4.2  From the investors' perspective the domicile does not play a significant role in our investment decision-making process.


5.   Is the current taxation regime for private equity funds and investee firms appropriate?

  5.1  Private equity funds operated as limited partnerships are tax transparent for end investors. This treatment is appropriate as investors are liable for tax on capital gains or income they receive and should not be double taxed. Thus investors pay tax rates consistent with their own tax status whether as individuals, pension funds, or companies. This means that the tax status of private equity is not preferential to other forms of ownership.

  5.2  The treatment of tax deductibility of interest on borrowing for investee firms has received much attention recently. It should be noted that the tax treatment of these payments is the same as for listed companies or other privately-held companies and is not preferential for private equity owners. The benefits of deducting interest as an expense for corporate investment has an important effect on companies underlying cost of capital. Restricting this benefit would increase the cost of capital, lower investment and would thereby affect long-run productivity performance.

  5.3  Public pension funds are a significant beneficiary of private equity performance. They are the largest UK source for commitments to UK private equity funds in 2005 (£1.5 billion)[42]. Changing the rules for interest tax deductibility could negatively impact returns for these funds.


6.   Are developments in the environment and structure of private equity affecting investments in the long-term?

  6.1  The benefits of private equity to productivity and economic competitiveness are considerable. Successful private equity investment requires improved performance at the operating company level. This improvement takes place through the reallocation of corporate resources, a refocused strategy and/or improvements of operational fundamentals. Thus through the successful practice of private equity the economy as a whole sees improved performance and productivity.

7.   To what factors, including the current macroeconomic context and position in the economic cycle, is the current rise of private equity attributable?

  7.1  Over the last four years the growth in commitments to private equity (from €29 billion to €90 billion) and investments by private equity funds in Europe (from €27 billion to €50 billion) has been strong[43]. This growth has been driven by improvements in the business cycle and a secular fall in credit risk premiums for corporate borrowing. Both the private equity-driven LBO market and the public market for M&A has benefited significantly from these trends.

  7.2  Fund-raising for private equity funds has followed the broad success of private equity managers in generating returns. High returns, (both realised and unrealised) over the last five years have encouraged existing investors to increase commitments to later funds, while outperformance of other asset classes has encouraged new investors, whose allocation to private equity has been historically low, to increase their exposure.

8.   What are the economic advantages and disadvantages of a firm being owned by private equity funds as opposed to being publicly listed?

  8.1  Private equity ownership benefits firms through an alignment of incentives between ownership and management and gives them the time to deploy multi-year strategies. Carrying out a unified and focussed strategy allows management to create long-term value within the company. Under private equity ownership, management can focus on the business and does not need to respond to share-price volatility. Driving this value creation strategy is fundamental to providing a successful exit for investors. The private equity structure brings together these incentive structures with a long-term investment horizon. The combination of these attributes gives the private equity portfolio companies the freedom to execute bold strategies, to uncover operational efficiencies or to change direction within a maturing industry.

  8.2  The disadvantage of private equity is that the partnership life is limited usually to between 10 and 12 years. This limited life requires that private equity funds dispose of investee firms during this period regardless of their future growth potential.

May 2007

40   "Private equity: a discussion of risk and regulatory engagement", Newsletter 06/6, November 2006. FSA. Back

41   Source: Statistics in section 3 are provided by S&P Leveraged Loan Commentary and Data unless noted otherwise. Back

42   Source: BVCA. Back

43   Source: EVCA/ Thomson Financial/ PricewaterhouseCoopers. Back

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