Memorandum submitted by the London Investment
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: www.liba.org.uk)
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
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 UKby
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 UKThe
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
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
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
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
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
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.