Select Committee on Treasury Written Evidence


Memorandum submitted by 3i Group plc

EXECUTIVE SUMMARY

  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.

CURRENT MARKET AND REGULATORY ENVIRONMENT

    "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.

ECONOMIC ADVANTAGES OF PRIVATE EQUITY OWNERSHIP

    "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 market investors.

  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.
BuyoutsGrowth Capital
200754%48%
200629%26%
200520%23%
200424%23%


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.

TRANSPARENCY IN PRIVATE EQUITY

  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 partnerships.

  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 equity investments.

  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 Corporate Responsibility.

LEVERAGE AND THE POSSIBILTY OF SYSTEMIC RISK

  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 Source—S&P LCD

  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 Source—S&P LCD

  Figure 5 below illustrates that the amount of leverage that is being raised to support these leveraged transactions has also increased.


Figure 5:  European leverage multiples Source—S&P LCD

  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 Source—S&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 to quantify.

CURRENT TAXATION REGIME

  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.

SUMMARY

  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 years;

    —  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 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.

May 2007





 
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