Memorandum submitted by 3i Group plc
1. 3i Group plc ("3i") is pleased
to have the opportunity to submit a written response to the Treasury
Select Committee's inquiry into private equity. Under the terms
of reference announced for its inquiry published on 20 March,
the Committee is looking for evidence on:
whether the current market and regulatory
environment for private equity funds is appropriate;
the economic advantages and disadvantages
of a company being owned by a private equity firm (as opposed
to being publicly listed);
whether the private equity industry
is sufficiently transparent about its activities and objectives;
developments in private equity affecting
investments in the long term and to what factors, including the
current macroeconomic environment, the current rise in private
equity is attributable;
whether the current market environment
and levels of leverage being placed in private equity transactions
pose possible systemic risks for the financial markets; and
is the current taxation regime appropriate?
2. 3i's submission will address each of
these issues in turn. In summary, we believe the following conclusions
can be drawn from the evidence presented in this submission:
the current regulatory environment
for private equity in the UK is well suited to this effective
model and there does not appear to be any evidence of failure;
this appears to be witnessed by the success of the industry over
the past several years;
private equity is broader than management
or leveraged buyouts; less than 35% of 3i's own assets are in
buyouts as 3i invests across the full spectrum of private investment
opportunities including early and late stage venture, infrastructure,
and small and mid-cap public and privately owned companies.
the principal economic advantages
of private equity ownership arise from the ability, through active
shareholder involvement in critical decisions, to align the interests
of the private equity investor with the management team it supports
and the clear focus that private equity places on value creation
and shareholder value; such direct alignment of interest is not
easily replicated in the public markets;
the stable macroeconomic and low
interest rate environment have created favourable financing markets
and have contributed to the growth and strong performance of the
private equity industry over the past several years;
the private equity industry is not
necessarily well understood and there is an opportunity for the
industry to make itself more transparent to the wider community;
although there has been a considerable
increase in the amount of leverage going into certain private
equity transactions over the past few years, the risks of the
potential failure of individual investments appear to be isolated,
rather than there being a risk of systemic failure in the financial
markets; this view seems to be supported by research conducted
by the Financial Services Authority; and
the taxation environment for private
equity is generally appropriate, although when looking at the
tax legislation in detail the UK appears to have lost some of
its competitive advantage in recent years and is no longer the
most attractive location in the EU for private equity funds.
"We recognise the highly mobile and international
nature of the private equity sector and are conscious that it
would not be beneficial if regulatory action caused the private
equity industry to move to more lightly regulated jurisdications.
Consequently, we are giving due care to proportionality requirements
and the need to have regard to the competitiveness of the UK."
Source: FSA November 2006.
3. HM Government has been supportive of
the private equity industry and the role that it plays in building
a dynamic and competitive economy, able to meet the challenges
of an increasingly competitive European and global economic environment.
The market remains favourable for private equity
investing given the stable macroeconomic environment, low interest
rates and the favourable financing markets. Institutional investor
appetite to access the strong returns that have been generated
by private equity (relative to gilts and public equities) means
that an unprecedented amount of capital has been raised by private
equity firms in the past three years. This has been a significant
advantage to businesses seeking to attract capital for growth.
Leading private equity investors are also becoming
truly international as their business models have evolved from
being "boutique" partnerships (predominantly domestically
based funds) to institutional investors operating on an international
scale. For example, 3i now operates an international network across
14 countries and it is expected that over two-thirds of its investment
will be outside of the UK, in markets such as continental Europe,
China and India, during the current financial year.
"We believe that the private equity market
is an increasingly important component of a dynamic and efficient
capital market. Private equity offers a compelling business model
with significant potential to enhance the efficiency of companies
both in terms of their operation and their financial structure.
This has the potential to deliver substantial rewards both for
the companies' owners and for the economy as a whole."
Source: FSA November 2006.
4. The most important economic advantage
of private equity ownership is the clear alignment of interests
between the private equity investor, as a knowledgeable shareholder,
and the management teams that it is backing. Private equity achieves
a level of engagement between the investor and management that
is not normally possible for either lending institutions or public
Private equity investors will typically agree
a value creation strategy with a management team prior to investment
and will strengthen the financial, strategic and governance processes
to increase its probability of delivery. They are normally represented
on the board of the investee company and so have immediate access
to management and financial performance data (as opposed to the
quarterly or half-yearly access available to investors in quoted
businesses). Their focus is on setting management strategy, agreeing
budgets and key performance measures, and building of management
capabilities. In short, given the degree of engagement at Board
level as described above, private equity is in a position to support
management teams at all points in the performance cycle.
Private equity investors will also put in place
an efficient capital structure for a business. The amount of leverage
that an investor may use is predicated on the perceived risk and
security (ie, underlying assets) within a business.
However, as figure 1 below illustrates, our
experience is that private equity is much more about earnings
growth than leverage. Of the 28 fully divested assets that were
in 3i's European mid-market leveraged buyout business up to 30
June 2006, 63% of the returns that were generated were the result
of the earnings growth achieved during 3i's stewardship.
5. Whilst this represents a very strong
performance from the underlying assets in 3i's European buyout
portfolio, we believe that the best firms in the industry have
been able to generate returns similarly built on value creation
rather than just leverage.
It should also be noted that of this portfolio,
10 realised investments were in the UK. These show an overall
11% growth in employment during the duration of 3i's investment.
6. Figure 2 below sets out the performance
of 3i's Growth Capital business relative to the Buyout business.
Many who comment on the industry consider only buyouts when they
refer to private equity. But, at 3i, Growth Capital, which typically
involves an investment in 20-30% of the equity of a company in
order to help finance expansion, is an even larger part of our
business. Its approach involves injecting capital, management
expertise and capabilities into a company as it seeks to enter
new markets, make acquisitions or launch new products.
Figure 2 demonstrates that private equity does
not necessarily rely on leverage, and that good returns can be
generated even where the investor can only influence, rather than
determine, the financial structure of an investee company.
Figure 2: Gross Portfolio Return to the financial
year ended 31 March
7. In short, although balance sheet management may be
used to enhance underlying returns, 3i's private equity model
is predicated much more on enhancing underlying performance than
on financial restructuring.
8. The traditional funding model for private equity funds
was founded on a partnership agreement between the general partner
(as manager of a private equity fund) and its limited partners
(the investors in the fund). This relationship is typically confidential
and any specific investment or performance-related information
has been subject to the confidentiality agreements made by these
9. Pressure to increase financial disclosure to other
parties has been led, in the United States, by those who have
used the Freedom of Information Act to require certain major institutional
investors, such as Calpers (California Pensions) and UTIMCO (University
of Texas Pension Plan), to disclose the performance of their private
10. As the market matures and the profile of the industry
increases, private equity is likely to continue improving disclosure
and ensuring engagement with a broader set of stakeholders. The
high level working group, chaired by Sir David Walker, which is
considering a voluntary code on transparency, will address a number
of these issues, and its creation is a signal that the industry
understands and is responding to these challenges.
11. A recent development in the private equity industry
has been the emergence of publicly-listed private equity firms.
3i has, of course, been listed since 1994, and therefore has long
experience of meeting the standards of reporting and disclosure
required of a public company. We invest for our own balance sheet,
and also raise both quoted and unquoted funds, so we have a perhaps
unique perspective on the different models. In 3i's view, these
financial and governance reporting disciplines required of listed
companies can sit positively alongside our activities as a private
equity investor. 3i is proud of its membership of the Dow Jones
Sustainability Index and membership of the Business in the Community's
"Top 100 Companies". This year, 3i also won the Investor
Relations Society Best Practice Award for Annual Report: Best
12. As figure 3 below illustrates, there has been a dramatic
increase in the past two to three years in the volume of European
loans into leveraged buyout transactions ("LBO"). There
are several reasons for the dramatic increase: the increase in
the overall market for LBO transactions (over 240 LBOs were completed
in 2006 compared with fewer than 50 in 1999), the increase in
the average size of LBO transactions, the increased institutional
investor demand for debt and the emergence of non-amortising debt
structures (ie, structures where interest is not repaid over the
duration of the loan but as a single bullet payment at maturity).
The latter point has also been a driver of the refinancing markets
for LBO transactions.
Figure 3: European LBO loan volume SourceS&P
A significant driver of the growth in the LBO market has
been the capacity of private equity funds to raise ever larger
investment funds and hence the availability of capital. Increased
funding has also resulted in greater competition for deals which
has resulted in a considerable increase in entry price multiples
to acquire assets supported by increased leverage multiples.
Figure 4 illustrates the increase in purchase or entry price
multiples which have risen significantly, particularly since 2003.
Figure 4: European LBO price purchase multiples
Figure 5 below illustrates that the amount of leverage that
is being raised to support these leveraged transactions has also
Figure 5: European leverage multiples SourceS&P
As Figure 6 illustrates, another driver of potential risk
is that debt structures have changed considerably over the past
few years with the emergence of various layers of subordinated
debt, which carry greater risk than senior debt.
Figure 6: Growth in subordinated debt as % of total
transaction value SourceS&P LCD
Leverage multiples are likely to remain high for so long
as banks continue to distribute debt to institutional clients.
As banks minimise their direct exposure through this distribution
process, this also implies that the banks are prepared to arrange
financing at multiples higher than if they were not distributing
these loans to others.
13. The FSA (as well as the ECB) has conducted research
on the risks associated with the private equity industry and,
in particular, the risks of excessive leverage being placed into
private equity investments. They also considered market risk specific
to private equity.
Their preliminary view was that the industry did not appear
to present systemic risk to the broader financial markets, although
they noted potential risks that might arise from excessive leverage,
market abuse, market opacity or conflicts of interest.
It would not appear that that these risks amount to systemic
risk and would probably only impact a specific target investment
or a specific private equity fund.
14. Our Buyout business, which is the one that has the
most direct exposure to leveraged transactions, is very focused
on deal specific risk. Rigorous processes are in place to assess
financing risk, management risk, corporate responsibility risks
and market risk.
The most significant issue of concern to the 3i team that
negotiates the debt packages placed in individual investments
is the potential impact of the banks distributing their debt packages
to their institutional clients. The concern is that if an investee
company underperforms and breaches its covenants (loan agreement
between the company and lending bank) it may make it difficult
to know who holds the debt and may make any renegotiation of the
covenants difficult. The risk that this presents is difficult
15. The tax regime in the UK for private equity funds
is generally appropriate. The manager is taxed on the income it
receives and the investors in the funds are only generally taxable
in the UK if they are resident here, apart from normal withholding
taxes. But a recent EVCA survey comparing the attractiveness of
various jurisdictions for private equity indicated that the UK
has lost some of its competitive advantage relative to some other
EU jurisdictions (eg, Ireland, France).
16. Recent commentary has focused on the ability of private
equity backed companies to deduct interest on borrowings. This
tax treatment is not preferential to private equity backed companies
compared to other public or privately backed companies to which
the same rules apply. Any further restriction on interest distribution
will result in an increase in the cost of capital which may adversely
impact investment and productivity. This could also make the UK
a less attractive environment for private equity investment.
17. In summary, the following conclusions can be drawn
from the evidence presented in this submission:
the current regulatory environment for private
equity in the UK is well suited to this effective model and there
does not appear to be any evidence of failure; this appears to
be witnessed by the success of the industry over the past several
private equity is broader than LBOs and encompasses
early stage, late stage as well as growth capital investment opportunities;
the principal economic advantages of private equity
ownership arise from the ability, through active shareholder involvement
in critical decisions, to align the interests of the private equity
investor with the management team it supports and the clear focus
that private equity places on value creation and shareholder value;
such direct alignment of interest is not easily replicated in
the public markets;
the stable macroeconomic and low interest rate
environment have created favourable financing markets and have
contributed to the growth and strong performance of the private
equity industry over the past several years;
the private equity industry is not necessarily
well understood and there is an opportunity for the industry to
make itself more transparent to the wider community;
although there has been a considerable increase
in the amount of leverage going into certain private equity transactions
over the past few years, the risks to the potential failure of
individual investments appear to be isolated rather than there
being a risk of systemic failure in the financial markets; this
seems to be supported by research conducted by the Financial Services
the taxation environment for private equity is
generally appropriate, although when looking at the tax legislation
in detail the UK appears to have lost some of its competitive
advantage in recent years and is no longer the most attractive
location in the EU for private equity funds.