Memorandum submitted by the Association
of British Insurers (ABI)
1.1 This document is the response of the
Association of British Insurers (ABI) to the Treasury Committee's
invitation to submit evidence to its inquiry on private equity.
ABI members as institutional investors have around £1.3 trillion
of funds under management which includes around 20% of UK-listed
equities plus substantial other investments in UK financial assets
including fixed interest stocks and investments in unquoted companies.
1.2 Our Association is pleased to have the
opportunity to comment. The subject matter of this inquiry has
become very topical and we are pleased that the Committee has
instigated its inquiry. It is important that there should be a
balanced debate on a subject that is of considerable importance,
in a narrow sense, to investors and to the financial markets and,
in a broader sense, to the UK economic system including those
that are employed within it. Insurance companies themselves are
investors in private equity as well as investing on behalf of
third party clients. Some have an established presence in the
sector as fund of funds providers. Our response seeks to reflect
these various interests and perspectives.
2.1 Our Association has a strong interest
in ensuring that investment in UK business is successful and value
creating. Within this overall objective private equity has an
important role to play. Notions that private equity should have
its activities circumscribed or that the remuneration of those
operating in this sector should be regulated are misplaced. It
is, however, important that the sector should operate on a level
playing field with the rest of the investment industry. We believe
that effective tax treatment is the one area in which private
equity may derive an undue advantage, that this highlights the
imbalance of treatment of debt and equity finance, and that this
should be addressed.
2.2 It is right that private equity should
be transparent in its dealings and activities but it must be recognised
that a lesser level of transparency in respect of businesses not
owned by quoted companies is the natural state of affairs. As
private equity increasingly assumes ownership of larger businesses
it will find expectations regarding transparency will increase.
2.3 The Financial Services Authority has
already undertaken consultation on the regulation of private equity
and we support both their recognition that there are a number
of matters of concern that merit their thought and attention but
that disproportionate regulatory intervention should be avoided.
The interplay between private equity and the quoted equity markets
does also create the potential for conflicts of interest that
must be carefully managed by company boards of listed companies
on behalf of their shareholders.
3.1 The ABI and its members believe that
the existence of the private equity sector, or something like
it, is a necessary part of any open and efficient modern market
economy which needs accurate pricing of assets and businesses
in order to achieve efficient allocation of resources. However,
it also brings challenges, such as the conflicts of interest faced
by boards of companies in considering private equity buy-out proposals
where the existing management, often including executive directors,
will be retained by the private equity financier. Such conflicts
need to be dealt with and in most cases are.
3.2 Of greater concern would be if there
were any distortions that gave an unwarranted advantage to private
equity compared to the quoted equity market and its investors.
We consider that the unlevel playing field between debt and equity
finance does constitute such a distortion and provides the most
obvious grounds for a public interest concern in the scale of
activity of private equity structures for the ownership of UK
businesses. This apart, there are relatively few grounds for concern.
3.3 Considerable comment has been made about
the business methods and consequences that are characteristic
of private equity ownership. However, the evidence is mixed. On
the one hand there is plenty of evidence that private equity can
grow businesses and create employment as well as take decisions,
quite likely the right ones, to restructure businesses and sell
off assets to realise value for investors and to recycle capital
so that it may be more efficiently employed elsewhere in the economy.
This will benefit national economic performance and create sustainable
and remunerative employment as well as improving returns in the
value of funds that savers and pension fund members are invested
in. On the other hand, underlying performance of private equity
appears to be far from uniform. More understanding is needed to
enable definitive judgments to be made on the ability of the sector,
and those operating within it, to create value consistently.
3.4 Investors in both the quoted and private
equity markets are aiming to maximise creation of long-term shareholder
value. In practice, time horizons are relevant. Private equity
may have a more definite need to realise the value of investment
over the medium term or to generate cash over the short term.
On the other hand, the businesses concerned will be more insulated
from shorter-term influences that are relevant to quoted companies
and which are an inescapable characteristic of the operation of
markets which in turn confer the considerable benefits of liquidity
to investors and confidence in respect of the valuations of their
The regulatory environment
Q1. Is the current regulatory regime for
private equity funds suitable?
The publication last year by the FSA of its
discussion paper (DP06/6) was a commendable response to the growing
view that the regulatory regime for private equity needed, at
least, to be properly considered. One particular area of concern
they identified was unclear ownership of economic risk. We said,
in responding to the discussion paper, that it was a useful and
comprehensive study and balanced in its analysis and conclusions
and demonstrated, both as regards risks within the sector and
the impact that the sector has on other parts of the financial
system including the public equity market, that there are sound
reasons for the FSA to take a close interest. However, we fully
support the aim of avoiding disproportionate regulatory intervention.
Q2. Is there sufficient transparency on the
activities, objectives and structure of private equity funds for
all relevant interested parties?
It is also essential, though, that private equity
should operate, and be seen to operate, on a level playing field.
This is important to investors in the public equity market and
to those on whose behalf they invest, but there is also a growing
public interest as businesses owned by private equity increase
their share of output and employment within the UK economy. By
its very nature the private equity sector will place less information
in the public domain than will be the case for those corporate
actors participating in the public investment markets. This is
natural and it should not be assumed that participants in private
equity have an inherent desire to be secretive and achieve some
kind of advantage in being so. This should not, however, be used
as a justification for inadequate transparency, in particular
where efficiency of the markets requires an appropriate level
of transparency such as where buy-out proposals for quoted companies
are in prospect.
Q3. Has there been evidence of excessive
leverage in recent transactions and what systemic risks arise
One other important feature of private equity
is that levels of leverage are higher than would be appropriate
within the public equity markets where a greater level of predictability
as to financial sustainability of a company from its own resources
is necessary. Where difficulties arise remedial action can be
more easily be taken in private businesses, such as through refinancings,
assets sales or other disposals. Care must be taken in making
assertions that private equity is overly or excessively leveraged
as views about the appropriate balance between debt and equity
are, at least in part, subjective whilst, for the private equity
class as a whole, the balance will in fact reflect the overall
preferences of market participants. Nevertheless, it is likely
that leverage levels are higher than would be expected were it
not for imbalance between the relative fiscal advantages of debt
and equity finance. We also suspect that unclear exposure to economic
risk, identified by the FSA, will be particularly relevant to
the markets in private equity debt and derivatives thereof.
Q4. What are the effects of the current corporate
status of private equity funds, including both their domicile
and ownership structure?
The complex nature of corporate structures in
private equity does raise concerns that these have more to do
with claiming tax or regulatory advantage rather than contributing
to economic efficiency. In general we believe that clear capital
and ownership structures make it easier for market participants
to understand the business and its financial prospects, thus creating
rather than reducing investment value.
Q5. Is the current taxation regime for private
equity funds and investee firms appropriate?
The tax advantages of debt finance over equity
are material and have grown. This has created an unlevel playing
field which the private equity sector can take advantage of. It
would, though, be wrong for it to be penalised on this account.
Rather, a more fundamental reappraisal is needed of how the tax
system can ensure an appropriate balance in the treatment of debt
and equity finance, for the benefit of all investors. There has
been discussion about the extent to which anti-avoidance arrangements
should be used in the tax system to prevent excessive use of debt
where the reality is that a corporate entity requires genuinely
committed equity capital. However, the more enlightened approach
should be to consider why debt finance should enjoy particular
tax advantages compared to equity, or vice versa, and to reassess
whether some degree of convergence should not be sought. The introduction
of the dividend imputation system in the 1970s achieved much in
this regard but the effect of more recent changes has lost some
of the advances that were made then.
The economic context
Q6. Are developments in the environment and
structure of private equity affecting investments in the long-term?
There is no reason in principle why businesses
in private equity ownership should be run in a manner that reflects
a different focus on long term versus short-term benefits to the
business and its owners than would be the case for quoted companies.
In the quoted sector, institutions may sell part of their shareholdings
in companies but their core holdings in companies may remain for
many years, often far longer than the time horizons of investment
decisions within the business and generally far longer than individual
directors serve on the boards of companies. However, the decisions
of institutional investors to buy, sell, hold or avoid will always
be made with reference to their assessment of long-term prospects
as compared to the assessment of other market participants. Private
equity funds, by contrast, will generally work to definite time
horizons with the intention that a business be restructured or
transformed creating value prior to exit by the private equity
fund. There is, however, a legitimate concern that risky financing
structures with high levels of debt make the ability to realise
cash through asset disposals more important creating a bias toward
inefficient economic decision-making for the longer term, but
which is made good by the tax benefits of high levels of debt
finance at the start.
Q7. To what factors, including the current
macroeconomic context and position in the economic cycle, is the
current rise of private equity attributable?
There is no simple explanation in economic conditions
for the rise in private equity ownership of UK businesses. Rising
stock market valuation levels during the middle part of this decade
have not deterred private equity from acquiring quoted companies,
indeed quite the reverse. Benign economic conditions coupled to
low costs of debt finance could be said to have made it possible
for private equity to grow in the way it has but does not fully
explain why it should have done so. A shift in the emphasis of
institutional investors, in particular pension funds, in response
to regulatory pressures for risk-averse investment in low yielding
matching assets whilst being encouraged at the margin to seek
high absolute returns from investments in alternative asset classes
such as private equity have probably had a significant impact.
Q8. What are the economic advantages and
disadvantages of a firm being owned by private equity funds as
opposed to being publicly listed?
For a business to exist in the quoted sector
brings both advantages and disadvantages. The balance of advantage
will vary according to the circumstances and across time. Valuation
levels in the listed market must, in practice, relate in some
fashion to the availability of investment capital from participants
in the listed equity market. If private equity funds have large
amounts of capital at their disposal whilst mainstream investors
have limited fresh funds available it is inevitable that some
migration of businesses from market investor to private equity
ownership will take place. This represents the healthy operation
of market forces. For most large scale businesses, listed equity
status would until recently have been regarded as mandatory with
the levels of transparency appropriate for the information needs
of the market and investor protection also suiting the level of
transparency appropriate to a large public interest business.
Large organisations that were privately owned were the exception
to the rule but in these cases, special circumstances would often
apply and employees and other `stakeholders' might feel they gained
as much if not more from the special culture of those entities
as they lost through lack of public transparency. We recognise
that there will always be merit for some corporate business entities
in existing outside the more closely regulated listed sector.
It is important that the private equity sector can play to its
strengths in helping to facilitate this.