Select Committee on Treasury Written Evidence

Memorandum submitted by the London Investment Banking Association

  We are writing in response to the invitation of the Treasury Committee to submit written evidence in respect of the Committee's inquiry into Private Equity Funds. You may know that LIBA is the trade association for investment banks with operations in London. Its objective is to ensure that London continues to be an attractive location for the conduct of international investment banking business. A list of our members is attached (and is also available on our website:

  The private equity sector has attracted very substantial public interest recently due to the sector's marked growth over the last few years. The usage of significant leverage to acquire public companies has occurred at a time when the pace of globalisation is perceived as accelerating and the outsourcing of jobs internationally is causing concern. Huge sums of cash and large numbers of high profile business leaders and advisors are being attracted into the private equity sector. There is concern regarding the relative opacity of the inner workings of private equity funds and private equity investor companies when compared to public companies.

  The FSA's Discussion Paper 06/06 on Private Equity did a very thorough job of identifying and describing the risks inherent in the private equity sector. The DP did not quantify the individual risks but did conclude that there is not now any crisis posed by the increased level of high leverage financing or any other risks discussed in the DP. The cited risks are present in every investment sector. They are not unique to private equity funds.

  The FSA concluded that the regulatory framework in the UK facing the private equity sector is effective, proportionate and adequately resourced. We strongly agree with this conclusion and with the proposed future actions by the FSA to periodically obtain information concerning the sector. As we understand their proposal, the FSA will maintain its regulatory posture but will monitor developments in the sector and assess their regulatory posture from time to time, if it is deemed necessary.

  While the FSA DP added much to the public understanding of private equity, it may also have inadvertently added to public concerns. A less informed reader of the DP could form the view that the private equity sector is ensconced in a regulatory vacuum. This would be a very inaccurate and unduly alarmist view. In fact, the most important activities of private equity funds and investee companies are regulated ie IPOs, secondary offerings, takeovers, schemes of arrangement, public company board decisions and duties, and decisions by private companies affecting employment and the situs of business.


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

  At present the important activities of private equity funds are regulated and governed by the same regulators and statutes which regulate other financial sectors in the UK—by the FSA, the Takeover Panel, the Takeover Code, FSMA, and the Statutory Instrument 2004 No 3426 (Informing Consulting Employees Regulation) to name the most important. While there is no regulatory structure which has been established specifically to regulate private equity funds, it would be misleading and grossly inaccurate to say that the sector finds itself in a regulatory vacuum.

  A brief reference to the more important activities of the sector will reflect the regulation facing the sector:

    1.  Takeovers/mergers in the UK—The takeover process in the UK is governed by the Takeover Code and is overseen by the Takeover Panel which is now authorised by statute and which has enforcement powers. Very importantly the Takeover Code aims at identifying and avoiding conflicts of interests and at comprehensive disclosure; and its principle goal is to protect the rights of the shareholders of target companies.

    2.  It is important to note that the Takeover Code requires the board of a target (offeree) company to obtain the advice of an independent advisor on the merits of any offers which must be communicated to shareholders along with the target company's board view of the offer (its recommendation to shareholders).

    3.  Under Takeover Code Rule 24.1 the offeror must issue an offer document which inter alia discloses its intentions regarding the future business of the company, its strategic plans for the offeree company and their likely repercussions on employment and the locations of its places of business, and its intentions with regard to the continued employment of its employees and management, including any material change in the conditions of employment.

    4.  The board of the offeree company (the target) must circulate to shareholders its recommendation on inter alia the effects of implementation of the offer on all the company's interests as well as its views of the likely repercussions of the offeror's strategic plans on employment and the location of the offeree's business. This opinion must be made available to the representatives of employees or to employees, if the target has more than 100 employees (more than 50 from April 08) and if the employees and the company have so arranged under applicable regulations giving effect to the EU Directive on Informing/Consulting Employees. Thus, the public concern about surreptitious actions damaging employment has been addressed, especially since any failure to meet the Takeover Code's rules re the offer documentation may be subject to criminal action in the UK by reason of new provisions introduced by the Company Law Act 2006 (which exists in no other EU Member State).

    5.  Rule 25.1 of the Takeover Code also requires the offeree company to disclose and explain any conflicts of interest of its directors in the offeree's circular to shareholders in response to an offer. This should clarify whether any director will have a continuing role in the proposed structure. Rule 25.4 requires an offeree's board to disclose directors' service contracts.

    6.  Once a public company has been taken private, it will be required under the Informing Consulting Employees Regulation to deal appropriately with the employees or their representatives concerning matters and events which are or may impact on employment or the nature of employee contracts, including relevant sales of subsidiaries, businesses, or premises and including material changes in trading results, provided that the necessary structure has been established by the employees or the company.

    7.  When a company is the subject of a public offering, the prospectus rules will apply including extensive disclosure requirements.

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

  In our view, there is very adequate transparency with respect to the activities of private equity funds as is detailed in the discussion above. This is quite important, since it is the activities of funds which should be the most important focus of regulation as is the case in every other sector of the economy. Generally, it is not the role of the regulator to pass judgement on the objectives of an enterprise so long as they are lawful. The lawfulness of the objectives of an enterprise soon becomes apparent from its activities. There is no suggestion that the objectives of any private equity fund are in any way unlawful.

  With respect to the objectives and structure of the private equity funds, however, there is a common perception that there is a need for regulators and market participants to have more information to enable the regulators and market in general to understand market developments. The regulators would use the additional information to anticipate increasing prudential risks which might develop, and market participants would use the additional information to better understand how and why markets are developing in particular ways over time. The FSA's proposal to expand its Alternative Investment Centre to cover the private equity sector and to periodically survey activities with the cooperation of the sector thus makes sense. Likewise, the market-led effort under Sir David Walker to find useful ways to improve information available to market participants in a way which will not inhibit unnecessarily the activities of the sector participants or their flexibility is a very positive development which will likely maximise the over-all benefit the market in general.

  Lenders to a fund or to an investee company of a fund should now be in a position to obtain necessary information concerning the objectives and structure of a borrower where that is required to assess creditworthiness. To the extent that such risks are securitised and passed to the market in the form of leveraged debt instruments, the holders of the debt instruments must have fair access to information concerning the ultimate debtor's financial posture eg financial or trading events affecting solvency. The FSA has identified the opacity of ownership of default risk as a potential problem, and we have proposed that means be found to encourage the timely flow of information from the issuer to the holders especially where there is no privity between the borrower and the holder of the debt instrument.

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

  We agree with the FSA's findings that there has been an increase in leveraged transactions and in their respective ratios of loan to equity which is notable but not problematic at this point ie there is not a systemic overhang which needs an external solution. The FSA found that there may be a higher level of risk of a default by an investee company due to the higher leverage employed in the sector, but that risk has been largely dispersed away from the financial institutions to investors which are able to assess risks as institutional investors. Thus, there is limited risk of a systemic failure or crisis.

  Financial institutions do have means to hedge their risks such as those inherent in leveraged debt. They may use credit derivatives which may or may not require the delivery of an underlying debt instrument at settlement. However, there have been backlogs and other difficulties in the clearing and settlement of transactions in these markets which have been the subject of regulatory notice and actions. It has been underscored that in the case of a default involving leveraged debt, the problems of backlog in credit derivative transactions will be exacerbated and will complicate creditor work-outs. Market participants and the FSA have already significantly reduced delinquency in clearing/settlement of credit derivatives and are working together to establish a market-led initiative to address clearing and settlement issues in the context of a default.

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

  We offer no comment at this time.


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

  The private equity sector does not enjoy any tax concessions which are not available to other corporate entities in other sectors and routinely used by them. Since there is no unfair advantage enjoyed by the private equity sector, we are not aware of any compelling argument to change the tax treatment of interest for that sector or any other. Of course, there are differences in the tax treatment of dividends paid by a company as compared to interest paid by a company. But the same financing options are available to all corporate entities.


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

  Private equity makes an important contribution to increased market efficiency, liquidity, and to the restructuring of underperforming companies in the long term. Private equity players are generally long term holders of companies and align their interests closely with the managements of their investee companies. They have fostered innovation which has resulted in improved products and services, and their restructuring efforts have frequently created sustainable jobs. Their enhanced returns over the long term benefit their investors which in the UK include pension and insurance funds.

  We do not believe that the expansion of the private equity sector will undermine the public company sector as an investment market because investors will not find it suitable or comfortable to place all or most investible funds in the sector. Moreover other macroeconomic factors will come into play over time which will challenge the current model eg a rise in interest rates.

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

  The abundance of capital at very reasonable cost coupled with investors' need for higher returns through alternative investment strategies are strong contributors to the growth in the private equity sector.

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


    1.  Private equity firms are professional shareholders who ensure that corporate assets are being used in the most efficient manner through their stewardship.

    2.  Private equity firms have a longer term perspective than institutional investors in the public markets with an average holding period of 3-6 years for private equity funds as compared to 12-18 months.

    3.  Private equity funds are able to align corporate strategy more closely with shareholder objectives and interests because they are clearer and more defined.

    4.  Private equity firms invest heavily in due diligence before acquiring a company and, after acquisition, invest heavily in training and development consistent with their strategic objectives which have been honed during the pre-acquisition stage.

    5.  Private equity funds will often inject very accomplished senior managers and director into their investee companies to propel success.

    6.  Decision making by investee companies will likely be simpler and more flexible without the need to achieve buy-in by a diverse shareholder base.

    7.  Administrative burdens will also be diminished by virtue of private company status.


    1.  There may be difficulties in changing/merging personnel and cultures.

    2.  Important suppliers and customers/clients may find reasons to change or cease relationships.

    3.  Key employees may become unavailable.

    4.  Highly leveraged debt may eventually threaten successful exit.

  In concluding, we take the view that the private equity sector is a very healthy factor in our market system which should be allowed to prosper as market forces may determine. Certainly there is a need for the sector to provide further public transparency consistent with a balanced assessment of the public need and the sector's business model. That effort should be market-led as is now the case. Regulators should continue their proportionate approach to the sector.

  We have attached our response to the FSA Discussion Paper 06/06 which you may find useful.

  Thank you very much for affording our members an opportunity to contribute to your review.

May 2007

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