Select Committee on Treasury Written Evidence

Memorandum submitted by CBI


  1.  The CBI welcomes the inquiry undertaken by the Treasury Committee into Private Equity, and the opportunity to provide representations.

  2.  As the UK's leading business organisation, the CBI speaks for some 240,000 businesses that together employ around a third of the private sector workforce, covering the full spectrum of business interests both by sector and by size.


  3.  Private equity has existed in the UK for more than 20 years and has invested over £75 billion world-wide in 22,000 businesses during this time, according to the Treasury. The British Venture Capital Association (BVCA) puts the figures at nearer £80 billion and 29,000 businesses since 1984.[44] The UK now stands second only to the US in the size and scope of its private equity sector.

  4.  Around one-fifth of the private sector workforce in the UK is currently employed by a PE-owned business. A survey by the Financial Times[45] revealed the 30 biggest PE deals in 2003 and 2004 created 36,000 more jobs than they cut. Three-quarters of the new jobs have been created by organic growth of companies and PE-owned firms have outpaced plcs in employment growth. Over the past five years jobs in PE-owned companies grew by 9% per annum compared to 1% in the FTSE 100.[46]

  5.  PE firms have come a long way since the early 1980s. Today they directly employ around 5,000 people in the UK, helping generate £3.3 billion in fees for supporting organisations in 2005 which equates to more than 7% of the total annual turnover of the UK financial services industry.[47] PE-owned businesses generated sales of £424 billion and paid the Treasury £26 billion in tax revenues last year.[48]

  6.  Whilst private equity firms have been active for many years, the sector has only been thrust into the spotlight of public attention in recent months. This is because the scale of transactions has increased dramatically: in particular, PE houses have been linked with some of the biggest and best-known names on the high street. But despite its proven success as a business model over the long term, much of the public comment has been negative.

  7.  Among other things, PE firms have been accused of being ruthless asset-strippers which practice "casino capitalism" to make huge amounts of money for their partners and their investors, while ruining the lives of the ordinary worker.

  8.  These charges are ill founded, and based on misunderstandings about how this form of corporate ownership actually operates. Private equity makes a dynamic contribution to the economy, and can bring a new sense of direction to long-established businesses. Successful transactions lead to new investment and more jobs, and businesses which come back to the public market after a period of private equity management have often created above average returns for their new shareholders.

  9.  Private equity owned businesses and publicly listed companies both have a valid part to play in a successful modern economy.

  10.  The success of private equity has been built on three central factors. The first is detailed scrutiny and due diligence of potential acquisitions to identify latent value in the business, before working closely with management to capitalise on the value. The interests of owners and managers in private equity owned businesses tend to be much more closely aligned than is the case with publicly listed companies.

  11.  Second, a favourable tax and regulatory regime towards private equity has helped attract money and talent from all over the world to the financial services industry in the UK. This must be preserved. Whereas publicly listed companies have been burdened with a growing accumulation of governance codes and reporting rules, private equity owners do not require such formalised systems since they are much more closely involved in the operations of the business.

  12.  The third crucial factor has been the long period of macroeconomic stability in the UK. Very low long-term interest rates, low and stable inflation, and ample liquidity in the financial markets have provided an ideal background for the growth of PE investment.

  13.  Until recently private equity firms felt able to go about their business with little attempt to engage beyond their immediate investment partners. Although this latter engagement goes far beyond the level of disclosure and involvement that shareholders in publicly listed companies enjoy, the critics of PE have been free to step into the wider vacuum of information.

  14.  Now, with private equity emerging into the limelight with bids for the likes of Alliance Boots and Sainsbury's, there is an increasing need for the sector to engage its critics, and the wider public.

  15.  PE firms must do more to win the hearts and minds of all its stakeholders, as shareholders, employees, suppliers and customers all have a legitimate interest in the health of such major business concerns.

  16.  This is starting to be understood by private equity. The BVCA has a working group producing a voluntary code of practice to improve transparency and disclosure, which firms appear very happy to support. KKR, one of the leading firms, has been reported saying it will appoint independent non-executive directors to the board once its purchase of Alliance Boots is complete. It has also pledged to produce detailed jargon-free financial reports to keep the 100,000 staff informed.[49]

  17.  As Wol Kolade, chairman of the BVCA, recently told the Financial Times[50]: "Private equity has to get out and change the agenda ... we have not caught up with the need and willingness to engage with a wider stakeholder group. If private equity is tackling things where there is a legitimate public interest, it is important to talk to a wider group about its plans."

  18.  In the context of wider public engagement, it is also important that the financial authorities should have sufficient oversight of the activities of the sector, given the high degree of leverage involved in most transactions and the importance of PE as a revenue generator for many financial intermediaries.

  19.  It is critically important that the private equity sector addresses this communication problem. And it is just as important that in the meantime there is no knee-jerk reaction to the industry which damages its ability to compete, or drives it offshore.


Is the current regulatory regime for private equity funds suitable?

  20.  The Financial Services Authority's existing regulatory regime for private equity funds is suitable, and we support the FSA's recent assessment that its "long-standing regulation of the private equity market is both proportionate and effective."[51]

  21.  There have been no significant market failings in private equity under the existing regime, and the sector has grown significantly in the UK. The City of London is second only to the USA as a private equity market and the number of PE houses has increased three-fold in the past two decades. The industry is attracting huge capital investment from around the world—an annual average of £8 billion flowing into UK funds over the past six years, representing over 70% of the total capital raised by the UK industry over that period.[52]

  22.  Private equity houses are fully regulated by the Financial Services Authority. Senior executives must be individually registered with the regulator, which is also responsible for approving any changes in the ownership of authorised private equity firms. Such firms must comply with rules covering systems, controls and regulatory reporting.

  23.  While the regulatory regime is by no means the only reason for the PE industry's success, it is a contributory factor. Ed Balls, the City Minister, recently cited the FSA's risk-based regulatory approach to the UK's financial services industry, as a boost to private equity. "It is not often that Government ministers are able to talk about regulation as a `competitive advantage' for our economy",[53] he said.

  24.  It is important that the FSA maintains this measured and proportionate approach. In its consultation paper, it identified several areas where a regulatory response may be warranted: the level of leverage in private equity; the ownership of economic risk and levels of outstanding debt; and the risks around capital market efficiency. It is sensible that the FSA should seek to understand and monitor these risks in discharging its regulatory oversight. But a balance needs to be maintained, since successful investment cannot be risk free.

  25.  As Harvard professor and private equity specialist Josh Lerner has said: "Private equity is a dynamic industry whose heart is the taking of calculated risks ... the many benefits private equity provides by facilitating economic growth are unlikely to be sustained if the heavy hand of government intrudes."[54]

  26.  The FSA, which has established an internationally respected regulatory approach to financial services in the UK, acknowledged this in its report: "Any disproportionate regulatory requirements could damage the competitive position of capital markets and should therefore be avoided ... too much regulation could ... cause the private equity industry to move to more lightly regulated jurisdictions."[55]

  27.  We would urge the government to heed the advice of the regulator and be wary of any regulatory creep which could have adverse consequences for the UK's strong position as a global financial centre.

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

  28.  Private equity fund investors are far better informed about the performance of their businesses than are their counterparts in the publicly listed sector. They can access relevant company information and data whenever they want to, and often have a seat at the boardroom table. By contrast, investors in publicly listed companies receive only occasional snapshots of the underlying performance of their assets.

  29.  Well-managed companies, whether in public or private ownership, also make sure that their employees, suppliers and other key stakeholders are fully informed about how the business is doing, how its strategy is developing and how it is performing against plan.

  30.  But perceptions do matter and until recently private equity has been operating below the radar of public interest and awareness. Now the industry has reached a size where it is emerging into public consciousness, and is feeling the full glare of public scrutiny.

  31.  To its credit, the industry has acknowledged that its approach needs to change and that more openness and disclosure would be beneficial, especially for the largest transactions.

  32.  One example of this new awareness is the creation by the BVCA of an independent working group, chaired by Sir David Walker, to establish a voluntary code on transparency which aims to address any concerns of the relevant stakeholders in the large private equity backed companies.

  33.  And PE can win over its doubters. Damon Buffini, head of Permira, commented: "We do believe we have to be more open, that we have to communicate more about what we do, that we have to encourage our companies to disclose more about what they are doing but that's OK because I think we have a very good story to tell."[56]

  34.  When some of the industry's critics make the case for increased transparency, it is clear that what they would really like to see are details of the compensation of senior PE executives. But there is no public interest argument for such information to be published, any more than there is in other forms of private ownership.

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

  35.  There has been an increase in the debt leverage used by PE firms to support investments in recent years as they seek ever bigger deals and returns. But there is no evidence that this is creating broad risks to the financial system, as opposed to individual firms. Today's capital markets allow debt to be sliced and repackaged, and risks are widely dispersed among a broad range of investors.

  36.  The growth in leverage has been highlighted in several recent studies. A European Central Bank survey[57] of 41 banks, that provide the bulk PE debt funding, found leverage has increased materially in the past two years, with the average purchase multiple (purchase price as a multiple of EBITDA[58]) of leveraged buy-outs in Europe reaching 8.4 times in 2006. An FSA report discovered the average debt / EBITDA ratio on banks' five largest transactions in the 12 months to June 2006 was 6.41. This was high both in terms of historic large transactions and levels observed today in smaller deals.

  37.  The FSA summed it up: "The amount of credit that lenders are willing to extend on private equity transactions has risen substantially. Lending limits are increasing, multiples are rising, transaction structures are being extended and covenants are weakening."[59]

  38.  But while more debt attached to a business inevitably means more risk, it does not automatically imply excessive leverage. This depends greatly on the financial circumstances of the business and the economic backdrop. It is inevitable that there will be some company casualties if the UK, and the wider economy, move from an era of low and steady interest rates into a more volatile stage of the business cycle. But this would impact on business in general. A badly-run company which cannot generate sufficient cash-flow would be at risk of failure irrespective of its ownership model.

  39.  The ECB found little evidence that corporate leveraged-buyouts by private equity groups could create serious difficulties for the financial system. It concluded: "The likelihood of LBO activity posing systemic risks for the banking sector appears remote at EU level ... although many of the risks identified could have a potential adverse impact on banks' profitability ... few of them are likely to be severe enough to pose a broader threat to financial stability."[60]

  40.  The International Monetary Fund reviewed leverage in its latest Global Financial Stability Report. While it noted the higher risks posed by highly leveraged transactions, it fell short of concluding that leveraged deals posed a systemic risk. Instead, it pointed to the more likely risk of reduced returns for private equity in a less favourable economic landscape: "deals that looked promising in a benign environment could suddenly appear much less attractive. It is therefore likely that some private equity deals will fail to live up to expectations."[61]

  41.  Private equity has also built risk-management into its business model and there are often contractual constraints on funds limiting the amount of capital they can invest into a single company to 10 or 20% of the total available. This means funds hold a diverse range of investments, thereby spreading the impact of a company failure.[62]

  42.  The link between these shared conclusions is the ability of banks to spread their exposures across the financial system through the ability to slice up and sell on debt. In these circumstances, there is uncertainty about where the risks ultimately lie. As John Kay suggested in the FT "perhaps there is a miasma of complexity and confusion in which everyone persuades themselves that the uncertainties of business have been landed on someone else."[63]

  43.  But at the moment there is agreement that there is no systemic risk.

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

  44.  The most positive effect of the current arrangements is that the UK, and London in particular, has become the European centre for the private equity industry, second only in scale to the US.

  45.  According to BVCA research[64], the consequences of this concentration of private equity houses in the UK for jobs and investment are significant:

    —  PE firms tend to outsource most aspects of their work to other financial services providers. This supports thousands of very high skilled jobs.

    —  For every private equity executive investing directly in UK companies, there are 2.3 full-time equivalent advisors or executives providing specialist advice or services;

    —  Including the financial, professional and business services, there are over 10,000 highly-skilled professionals across over 1,000 firms engaged either directly or indirectly in private equity related activities.

    —  This generates revenues of approximately £3.3 billion a year for the financial services sector and the wider UK economy.

  46.  These successes have been built on the strength of the UK's global financial services, which is underpinned by the broadly welcoming regime, fiscally and in terms of company law.

  47.  However there are potential concerns. Technological advances and globalisation mean capital and talent are increasingly mobile and attempts to tinker with the current tax and regulatory regime could pose a significant threat to London's pre-eminence.

  48.  In other words, if local business conditions change, financial service providers including private equity houses can easily move to more favourable locations. It is therefore imperative that the business conditions that have enabled the UK to have a comparative edge in private equity are kept under review and remain competitive.


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

  49.  Our overall view is that the current arrangements are generally regarded as appropriate, subject to some concerns about tax competitiveness. This is an important factor that has contributed to the concentration of private equity houses in the UK but our competitive position is being eroded.

  50.  A benchmarking study from the EVCA[65] published in December 2006 compared the tax and legal environments across 25 European countries and the extent they affect the development of private equity and venture capital and encourage entrepreneurial activity. In 2003 and 2004 the UK was found to have the most supportive tax and legal environment. But by 2006 it had slipped to third place behind Ireland and France. And worryingly, the UK's relative competitiveness score had markedly deteriorated as the majority of competitor countries in the EU noticeably improved.

  51.  So while the UK taxation regime is still relatively attractive compared to other EU countries, it is clear the situation is changing. For the sake of private equity and the wider business community, the UK's tax competitiveness needs to be kept under close review—particularly, as noted above, because the financial services industry is highly mobile and can easily relocate to more competitive locations.

  52.  The specifics of the current taxation arrangements vary significantly in structure and complexity in each individual case. But broadly, and irrespective of the fund structure, investors are taxed in the countries where they are based, and fund management entities and company executives are taxed in the country where the investment activity is undertaken. Operating companies are taxed like any other private business in the UK.

  53.  There are individual issues that have caused some controversy—most notably on the tax deductibility of interest. With higher levels of borrowing by PE houses, there is often an initial reduction in the tax take by government as interest is tax deductible.

  54.  Some European countries have responded, namely Denmark and Germany, by proposing limits to this practice in exchange for reductions in the overall corporation tax rate. We would warn against government taking similar action as any change to this balance in the UK could seriously damage long-term investment by UK companies both large and small.

  55.  A key point to note is that tax deductibility is available to all companies as an incentive to invest. It is not a "loophole" being exploited by private equity.

  56.  We welcomed Ed Balls' comments in a recent speech that: "There is, of course, nothing specific to private equity in the tax deductibility of interest. Any kind of company can claim it and most quoted companies do. It is also the international norm that interest is in general treated as a business expense and deductible from taxable profits for companies in any form of ownership. We have no plans to review this principle."[66]

  57.  Mr Balls though noted that there have been concerns about shareholder debt replacing equity in some PE arrangements. He has announced a review of the current rules surrounding shareholder debt to ensure they are working as intended. We will want to see the outcome of this review before commenting further.

  58.  Another particular area of controversy is around carried interest and its tax treatment as a capital gain rather than income. The purpose of this arrangement is to align the interests of PE executives with those of institutional investors, both of whom commit funds so that they share a growth in value but also suffer financial loss if the fund loses value. These investments by private equity executives are subject to capital gains tax to reflect the risks in the transaction.

  59.  Attempts to make any significant change to this arrangement, in a bid to extract more tax from high-earning private equity executives, must be seen in the wider context of UK competitiveness. PE firms and executives base themselves in London because of the favourable regime but would have no qualms or difficulties about moving elsewhere if the mood turned sour. Thousands of jobs and billions of pounds of investment and tax revenues would follow suit. Both the Treasury and the UK economy as a whole would suffer.


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

  60.  We have seen no evidence that the environment and structure of private equity is affecting investments in the long term. The business model of private equity closely aligns the interests of the investor and management in adding value to the business. Economic returns are generated by enhancing the performance of the company.

  61.  Allegations that private equity firms are simply short-term asset strippers are unfounded. Typically the time horizons of PE firms' investment in a business tend to be three to five years. This is actually longer than the holding period of many listed company investors, which tend to turn over their portfolios at a more rapid pace.

  62.  Since the whole aim of private equity investment is to sell the asset on at a profit, managers have a real interest in the long-term health of their business. If they strip out assets and close down factories, as critics allege, they won't have a viable business to sell on at the end of their holding period. It is highly unlikely that anyone would pay much for a company that has been stripped of its assets and its ability to grow in the future, whether the exit is to the public markets or another private owner.

  63.  As ERC Commissioner Charlie McCreevy, has observed: "One investor's sale is another investor's asset purchase, and the potential of the asset does not disappear with its sale. Rather the purchaser sees opportunities to generate better returns from the asset than the vendor. That's what creates a market. That's what risk taking is about and it is risk taking that drives innovation, employment and growth."[67]

  64.  Other evidence points to a positive impact by private equity. According to data published by the BVCA[68], private equity-backed companies have created more new jobs in recent years than their publicly listed counterparts. The Work Foundation, which is no great fan of private equity, accepts independent research showing that "overall PE ownership does result in an expansion of employment."[69]

  65.  Overall business investment has risen at a brisk pace over the past year, which does not suggest that the presence of private equity investors has made companies less willing to buy assets for the long term. Research published by the Financial Times shows that PE owned businesses are also willing to spend money to support their brands. "Far from suggesting that private equity firms were reluctant or short-term spenders on brand marketing, the data suggests they were as good—if not better—at it than publicly listed groups."[70]

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

  66.  The success of private equity in recent years has attracted many billions of pounds of capital into firms' investment funds which, when the borrowing they can generate is added in, means all but the very largest businesses are potential targets.

  67.  Four main reasons have contributed to this success: the benign macroeconomic conditions of the past five years, the relative under-performance of UK equity markets, the ability of the private equity business model to create value, and the restraints on publicly-listed companies created by burdensome regulatory and corporate governance regime.

  68.  The European Central Bank acknowledged the value of stable economic conditions on private equity in its report into leverage and risk. It commented: "the combination of benign macroeconomic and financial conditions that took hold after the correction of the global stock markets in 2000-01 has been conducive to the rapid expansion of the LBO sector."[71]

  69.  The influx of money to PE is also a result of the very high returns that have been made on private equity assets in contrast with the sometimes lacklustre performance of the bond and equity markets in recent years.

  70.  Part of this under-performance has been caused by a retreat of pension funds and other investors from the equity markets. Following the global stock market correction at the beginning of the decade, pension fund trustees are far more conservative with portfolios and have been selling off equities and investing in bonds instead. The introduction of new regulatory requirements and various tax changes has also further discouraged equity investment.

  71.  One effect of this has been to keep the prices of potential PE targets down, allowing acquisitions to be made more cheaply and comparative value added more rapidly.

  72.  However, investors in private equity funds on average take more risks than those in publicly listed companies, in the shape of higher leverage. And their holdings are by definition less easily tradeable than are shares in publicly listed companies. Both these reasons make it necessary for them to secure higher returns on their investments in this sector.

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

  73.  The private equity business model is also very successful at attracting the best talent. There are two reasons for this: one, PE firms are prepared to reward success more lucratively than are publicly listed companies; two, managers in PE-owned businesses can concentrate on the job in hand without the distractions which occupy their publicly-owned counterparts.

  74.  Senior management in PE-owned firms often have a significant equity interest in their business. This has the effect of closely aligning their interests with that of the business owners and encourages an approach to creating value that is more open to taking risks and seeking innovation. Successful managers are handsomely rewarded, unsuccessful ones are unceremoniously dumped.

  75.  Managers are also able to focus on the job rather than having to spend days talking to investment analysts or journalists, as their publicly-owned equivalents have to. They can also take tough strategic decisions without having to worry about the short-term impact on earnings or the comments of analysts.

  76.  In the short term, this can sometimes lead to a "shake-out" of labour and capital. The private equity house will, if necessary, strip a company to its core and contract out the rest of its services, allowing it to focus on the remaining area where it has competitive advantage.

  77.  At the same time the contracted-out services will be handled by people with appropriate expertise. The outcome of this specialisation leaves both the outsourcer and the outsourcee better off, more efficient, more competitive, and more able to offer sustainable employment.

  78.  In the long-term this practice helps improve the efficient allocation of labour and capital across the economy. As Charlie McCreevy has said, private equity "has been among the main drivers of the major restructuring that some of Europe's most significant businesses have needed in order to remain competitive in increasingly globalised markets."[72]

  79.  Another burden on publicly listed companies is the hidden costs of corporate governance compliance and regulation. While private equity managers focus on creating value their equivalents in publicly-owned companies spend a great deal of time managing bureaucracy.

  80.  Corporate governance requirements have increased year on year to such an extent that they have almost driven the ability to take a risk or adopt a new idea out of publicly listed companies. The fact that HSBC has to produce a 456 page annual report shows that the regulatory pendulum has swung too far. A more balanced approach would provide a competitive boost for the UK economy.

  81.  In short, as Philip Purcell argued in the FT: "Taking companies private spurs innovation. This may seem paradoxical, given private equity's reputation for `flipping', or sale for short-term profit. It is true that private equity firms have a near obsession with trimming costs and tidying up balance sheets of portfolio companies so that they can eventually be sold. But that can take five years or so, which provides breathing room to consider promising innovations. Public companies, on the other hand, face relentless pressure to meet quarterly earnings estimates. The halcyon days for private equity will eventually end. The constraints on the public model will ease. The returns in private equity and those in the public markets will begin to converge. Increased regulation of private equity or a radical turn in the credit cycle could also affect the current dynamic. Until then, private equity firms will continue to offer a classic capitalist response to a public market that is failing to allocate capital efficiently."[73]

May 2007

44   The Economic Impact of Private Equity on the UK, 2006, BVCA, page 18. Back

45   Financial Times, 2 April 2007. Back

46   The Economic Impact of Private Equity on the UK, 2006, BVCA, page 9. Back

47   The Economic Impact of Private Equity on the UK, 2006, BVCA, page 18. Back

48   The Economic Impact of Private Equity on the UK, 2006, BVCA, page 6. Back

49   Article by Zoe Wood, The Observer, 29 April 2007. Back

50   Financial Times, 30 April 2007. Back

51   Financial Services Authority Discussion Paper 06/6: Private equity: a discussion of risk and regulatory engagement (November 2006). Back

52   BVCA-Private Equity's Impact as a UK Financial Service (January 2007) Back

53   Speech by the Economic Secretary to the Treasury, Ed Balls MP, at the FSA Principles-based Regulation Conference, 23 April 2007. Back

54   Josh Lerner, Government's Misguided Probe of Private Equity, Harvard Business School, 14 March 2007. Back

55   FSA Discussion paper, page 5. Back

56   BBC interview, source, Friday 23 February 2007. Back

57   European Central Bank-Large banks and private equity-sponsored leveraged buyouts in the EU (April 2007). Back

58   Earnings before interest, taxation, depreciation and amortisation. Back

59   FSA Discussion paper, page 59. Back

60   ECB report, page 5. Back

61   IMF Global Financial Stability Report, April 2007, page 15. Back

62   EVCA comments to FSA discussion paper on private equity, p5. March 2007. Back

63   Financial Times, 13 March 2007. Back

64   BVCA, Private Equity's Impact as a UK Financial Service, January 2007. Back

65   European Venture Capital Association, Benchmarking European Tax and Legal Environments: Indicators of Tax and Legal Environments Favouring the Development of Private Equity and Venture Capital and Entrepreneurship in Europe, December 2006. Back

66   Speech by the Economic Secretary to the Treasury, Ed Balls MP, to the London Business School on 8 March 2007. Back

67   Charlie McCreevy, European Commissioner for Internal Market and Services, Private Equity: Getting it right, speech to the House of Commons-All Party Parliamentary Group Breakfast Meeting, 22 March 2007. Back

68   BVCA, The Economic Impact of Private Equity in the UK, page 3. Back

69   The Work Foundation report "Inside the dark box: shedding light on private equity", p.4, March 2007. Back

70   Financial Times, 7 May 2007. Back

71   ECB report, page13. Back

72   Charlie McCreevy, European Commissioner for Internal Market and Services, Private Equity: Getting it right, speech to the House of Commons-All Party Parliamentary Group Breakfast Meeting, 22 March 2007. Back

73   Philip Purcell, president of Continental Investors, a former chairman and CEO of Morgan Stanley, Financial Times, 8 March 2007, page17. Back

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