Select Committee on Treasury Written Evidence

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 investments.


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 in consequence?

  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.

May 2007

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