Select Committee on Treasury Written Evidence


Memorandum submitted by T&G

  The T&G welcomes the Treasury Select Committee inquiry and the opportunity to submit evidence. The T&G represents 800,000 members employed throughout all sectors of the economy, including the food and drink industry, manufacturing, transport, commercial and contract services as well as the public and voluntary sectors. The T&G has recently merged with Amicus to form the UK's largest trade union of over two million members.

  The T&G responded to the FSA's discussion paper Private Equity: a Discussion of Risk and Regulatory Engagement as well as to the European Commission Internal Market & Services DGs "Report of the Alternative Investment Expert Group" in 2006.

1.  EXECUTIVE SUMMARY

  1.1  The T&G believes regulation and rights are needed in three broad areas to ameliorate the negative effects of private equity. These are employment rights, transparency and taxation.

  1.2  Workers and their representative should be informed and consulted on the business and financing plan of any takeover prior to the acquisition. Through their trade unions, workers should have the right, equivalent to that of pension fund trustees, to seek fair compensation and protection should substantially greater levels of leverage be part of a private equity (or any other) takeover. In private equity transactions, banks are able to charge risk adjusted rates of interest, pension trustees exercise the right to demand greater up-front funding to compensate for added risk, but presently workers are not consulted let alone protected or compensated. The T&G proposes that regulation should include extending the Transfer of Undertakings (Protection of Employment Regulations) or TUPE to cover transfer through share purchase as well as strengthening of Information and Consultation regulations.

  1.3  The information rights of employees in private equity companies should be strengthened by regulation, so that audited information at least equivalent to Companies House accounts is made available to all stakeholders including employees, their unions, suppliers, the local community and investors. This should include an obligation to transparency by provision of the information online and an annual CEO report.

  1.4  Changes to tax should include abolition of tax relief for interest on debt and taper relief must be withdrawn from "carry" in private equity investments.

  1.5  These recommendations arise from a number of concerns about the impact of private equity on our members and the enterprises the work for.

  1.6  First, we do not believe the industry's claims of job creation; our experience of redundancies, and the consequent cost to families and communities, tells us otherwise. The T&G commissioned a preliminary analysis[76] of the private equity industry's assertions and the surveys on which they are based. The main findings, presented here, are:

  1.6.1  The major surveys conducted for the UK, EU, and USA private equity associations suffer from a number of flaws, both in sampling and in data quality.

  1.6.2  Problems of self-selection and the difficulty of verifying data on employment arise from the information opacity that is a systematic feature of private equity buyouts.

  1.6.3  There is no overall effect on employment compared with other forms of ownership;

  1.6.4  An indication that buyouts generally depress wages.

  1.6.5  Claims about returns to investors in PE funds are susceptible to confusion and exaggeration because of the same problems of information asymmetry.

  1.7  The T&G believes that the Government should commission independent research on the impact of Private equity on jobs as well as wages and conditions.

  1.8  Second, the high leverage crucial to the private equity buyout model shifts risk, often dramatically so onto other stakeholders, primarily the workforce, who have no compensation or protection. In the unprecedented stable economic climate that has existed during the last 10 years in the UK, private equity leveraged buyouts have had a negative impact on the wages, terms and conditions and job security of workers. Less favourable economic circumstances would further increase the risk and whole swathes of the UK business could face financial distress, which would further damage the interests of workers in those companies.

  1.9  The overall UK economy could be seriously damaged by the high-risk nature of private equity leveraged buyouts of what is now a very substantial part of the economy. In less favourable economic circumstances, this could generate a high rate of failures of private equity owned companies, a calamity for enterprise that could in turn damage the banking system of the UK.

  1.10  Third, a significant source of the "value" created by buyouts simply comes from radically reducing tax as a result of interest tax shelters from high leverage. As such private equity activity undermines public revenues which must ultimately be recovered elsewhere in the form of higher taxes on those who cannot avoid tax. It is completely unacceptable that general partners in private equity firms may face effective tax rates of 5%-10% in incomes of £ million whereas employees pay far higher on modest income.

  1.11  Fourth, the T&G is concerned that private equity does not invest in the companies to the same degree as publicly quoted firms. Private equity firms impose higher hurdle rates on a company which directly lowers investment. The limited term nature of private equity ownership has a further negative effect. Intangible asset investment, in for example R&D and employee training, appears to be particularly affected.

2.  INTRODUCTION

  2.1  The impact of private equity in the UK and globally is growing. Private equity raised globally has reached $400 billion, equivalent with leverage to around $2 trillion in potential buying power. The size of the funds has grown with $10 billion funds now common, and mention of funds of up to of even $100 billion in the future. With funds collaborating together in club or "cartel" deals to bid, no company is immune from potential take over as well as risks being bigger. Private equity leveraged buyouts means that private control over businesses is being achieved by the provision of a significantly reduced level of equity. A key distinguishing feature of private equity acquisitions from traditional acquisitions and mergers is their reliance on heavily leveraged debt.

3.  IMPACT ON JOBS

  3.1  The T&G does not believe the industry's claims of job creation; experience of redundancies, and the consequent cost to families and communities, tells us otherwise. The T&G does not accept what is essentially a money making endeavour for a privileged few being spun as being a job creation scheme. Given that the industry has operated outside the realms of public scrutiny, it is important to look at the facts behind the figures claimed.

  3.2  The T&G therefore commissioned a preliminary analysis of the private equity industry's assertions and the surveys on which they are based. The main findings are:

  3.2.1  That major surveys conducted for the UK, EU, and USA private equity associations suffer from a number of flaws, both in sampling and in data quality. Recent surveys in the UK by academics and journalists avoid many of these problems.

  3.2.2  That most of the assertions made by commentators, and some made by the reports themselves, cannot be justified on the basis of the evidence from existing surveys. The most reliable results suggest that buyouts generally depress wages but there is no overall effect on employment compared with other forms of ownership, and certainly not a positive effect.

  3.2.3  Problems of self-selection and the difficulty of verifying data on employment arise from the information opacity that is a systematic feature of private equity buyouts. Claims about returns to investors in private equity funds are susceptible to confusion and exaggeration because of the same problems of information asymmetry.

  3.2.4  That there is a need for detailed research on the actual impact on employment, pay and industrial relations in each buyout in recent years and much stronger information rights for employees and investors both before and after buyouts.

  3.3  The T&G believes that the Government should commission independent research on the impact of private equity on jobs including on pay and conditions.

4.  LEVERAGE

  4.1  The T&G concern is with the leveraged buyout model of private equity, where up to 90% of the cost of acquisition is funded by debt and 10% by equity, which reverses the usual financial structure of typical public firms.

  4.2  The T&G believes that inherent in highly leveraged buyouts is an unbalanced risk/return reality—where workers have to take undue risk in order that private equity funds and managers may make undue returns—that needs to be rectified by regulation and rights. While Pension Funds and debt providers get compensation for the additional risk resulting, workers have no such protection or compensation.

  4.3  With a private equity leveraged buyout, debt used to finance the buyout is loaded onto the accounts of the target company, not the private equity fund, and the bought-out firm has to meet the interest payments. This means that the financial structure of the company has been radically transformed.

  4.4  Private equity's first step on acquisition is to "recapitalize" the firm, that is, to increase the firm's borrowing and, correspondingly, reduce the amount of equity finance. This leads to a dramatic increase in leverage, with a number of consequences:

Leverage explains the spectacular returns

  4.5  Firstly, it is leverage that explains the spectacular returns: Leverage minimizes the amount of equity capital the private equity investors need to commit. If private equity targets a firm worth 10 and thinks they can turn it into a firm worth 12, then that is a 20% return. But if they can persuade banks to provide nine of the 10, then their return becomes 200%.

The effect of leverage on jobs

  4.6  Secondly, the burden of debt service—interest payments and scheduled debt repayments—is used by private equity as an instrument to force management to focus on costs and cash flow. Management is driven to cut costs because increasing EBIT (earnings before interest and tax) is the only way they can relax the shackles of the interest cover covenant. Private equity likes to describe this as a tool for enhancing efficiency. In well-managed firms it means managers have to cut muscle, not fat.

  4.7  The T&G believes that there are two very serious negative incentive effects of high leverage. Employees are the stakeholder group whose claim is most vulnerable to private equity. Labour's contract with the firm tends to be "incomplete", in the language of contract economics. It typically involves high levels of trust, and performance cannot usually be fully specified in advance. Employees frequently build significant employer -specific capital, and family ties, amongst other factors, can make their mobility costly and often not possible. In our experience these factors make workers most vulnerable to private equity that feels unconstrained by pre-existent loyalties and agreements and which is unconstrained by the discipline of public accountability. The result may be in job losses and in pay restraint, and a negative the impact on job quality. The mega rewards of the few are partially funded by the job, pay and condition sacrifices of the many.

  4.8  One of the most insidious effects of private equity is to increase the demands upon workers, and levels of stress and job uncertainty. Anecdotal evidence also reports dismay amongst human resource managers expected to "stretch human assets" to meet new financial performance requirements.

  4.9  Standard & Poors has stated that the greater the quantity of debt a company held on its balance sheet, the greater the chance of redundancy, erosion of pay and conditions as the business struggled to repay its interest burden. Higher debt leads to much harder work and more stress, not just for employees, but also for stakeholders such as suppliers, who are less likely to get paid. Even if the company doesn't default, workers have less job security and are looking over their shoulders a lot more, worrying what will happen if the company misses the projections its debt is based on and struggles to make its repayments.

  4.10   Furthermore, the cost cutting culture of private equity is likely to reduce investment in intangible assets, such as R&D and employee training, that are key to success in the modern economy. Such spending usually directly reduces EBIT and thus is an obvious target for cost-focused managers.

  4.11  Private equity engages with workers on a "heads we win, tails you lose" basis. If a highly leveraged buyout goes well, private equity principals and senior managers receive huge returns. Even in cases that turn out positively, the most workers can expect is that a few extra jobs are created. Certainly there is no sharing of the rewards with workers whose livelihoods have been put in jeopardy by the high leverage.

Leverage and tax

  4.12  Private equity maximises the tax benefits of gearing. Debt finance is tax privileged in most countries; generally speaking, interest is tax deductible whereas dividends to equity are not. As a result firms significantly reduce or even entirely eliminate their tax liabilities.

  4.13  Tax economists have long been aware of the asymmetry between the treatment of debt and equity and many solutions have been discussed, and some attempted. The issue could be ignored when firms were relatively conservative in their gearing practices. But if a significant source of the value created by buyouts simply comes from interest tax shelters from high leverage, government should urgently consider limiting that shelter, both on incentive grounds and to protect revenues.

Leverage and financial risk

  4.14  The final effect of leverage is to increase the financial risk of the firm, and thus the risk of default, thus shifting risk, often dramatically so, to other stakeholders.

  4.15  Inevitably, given the very high levels of gearing, the associated debt frequently has a lower credit rating, implying a higher perceived risk of default. Traditionally, we understood that a firm's ability to service debt is a function of the volatility of its EBIT, which reflects its business risk—the vulnerability of sales to changes in economic conditions, and its operating leverage—which describes the extent to which its costs remain fixed as sales change. These factors differ significantly, business-to-business and sector-to-sector, which is why we traditionally observed a wide range of gearing ratios in practice. This conventional wisdom remains relevant to judgements today about private equity leverage.

  4.16  The UK FSA report "Private Equity: a Discussion of Risk and Regulatory Engagement", states that "the risks inherent in the private equity market are not confined to the private equity fund managers/advisers. Rather, they affect all types of participant in varying proportions including, in particular, fund managers/advisers, leveraged finance providers, transaction advisers and investors in the relevant equity, debt and related derivatives products." There is no mention of other stakeholders, including labour, there.

  4.17  Given that the growth of private equity has taken place in the context of an unprecedented stable economic environment, in less favourable economic circumstances the negative impact on pay and jobs would be greatly magnified as a result of Private Equity buyouts because whole swathes of the UK economy could face significant financial distress, if not administration.

  4.18  High and rising leverage in parts of the corporate sector is identified as one of six sources of vulnerability for the UK financial system according to the Bank of England's Stability Report; the IMF has also expressed its concerns. The growth of sub investment grade corporate bonds and high-risk debt poses further risk.

  4.19  Additional debt being added to acquired firms as a result of so called dividend recapitalisations and secondary buyouts adds to all these concerns.

Dividend recapitalisations

  4.20  After acquisition additional debt may be used to fund dividend recapitalisations whereby the owners of the firm are paid a bonus based on borrowing even more debt, not based on growth on earnings. When Hertz was taken over by Private Equity they took out £1 billion in dividends within six months after acquisition. Some $30 billion (£16 billion) of debt was issued globally by private equity-owned companies to fund dividend payments for investors in the first six months of 2006, according to Standard & Poors, who also considered that rises in dividend recaps could increase defaults.

Secondary Buyouts

  4.21  The increase in secondary buyouts (when an acquired company is sold on to another private equity firm) exacerbates all these problems and raises additional concerns. How does private equity make returns, and the returns that they claim, from a business that was previously owned by private equity, without adding further to risks above, particularly in relation to jobs? Why, if a business has longer-term prospects for growth (and is hence attractive to another private equity firm) is it sold on? If another fund can generate further returns why does the original pprivate equity owner not retain it?

  4.22  The T&G urges the Treasury Committee to regularly report on the rise and quality of corporate debt and the implications for economic stability.

Fees

  4.23  Other charges associated with the private equity leveraged buyout, such as fees for completing the deal and annual management fees, are also loaded onto the acquired company's accounts, not the private equity fund. For example had a private equity firm been successful in a £10 billion bid for Sainsbury's, it is estimated the firm would have received from Sainsbury's an immediate fee of £50 million (a 0.5% fee of £10 billion) simply for completing the acquisition, as well £30 million a year in management fees. It appears to the T&G that such fees are excessive and reward the general partner even if an investment turns out badly.

  4.24  Given the cartel like nature of the private equity industry, the T&G urges that the fees charged by the general partners are investigated by the Competition Commission.

  4.25  In the following sections we address elements of public company law and employment rights that we believe should be equally applicable when ownership is transferred to Private Equity enterprises. The case we make is for consistency, equity, protection and fairness, and the issues we address are those of consultation, recognition and representation rights, transparency, taxation and investment.

5.  CONSULTATION, EMPLOYMENT PROTECTION AND COMPENSATION

  5.1  Workers and their representative should be informed and consulted on the business and financing plan of any takeover prior to acquisition, and "exit". Through their trade unions workers should have the right, equivalent to that of pension fund trustees, to seek fair compensation and protection should substantially greater levels of leverage be part of the financing plan. Our members, bear a number of uncompensated costs, in addition to the risk of default itself, but receive no premium to compensate for the increased financial risk for example downward pressure on wages. Banks charge risk adjusted rates of interest, pension trustees have the right to demand greater up-front funding to compensate for this added risk, but presently workers are not consulted, let alone compensated.

  5.2  Before a leveraged buyout has taken place workers need to have proper information and consultation about the financing and business plans and full recognition and negotiation rights at all levels. Workers and their trade unions need be informed and consulted regarding the business and financing plan of any takeover prior to it happening. This should include the right to adequate protection should substantially greater levels of leverage be part of the financing plan similar to the negotiating leverage available to pension trustees—ie, the right to insist upon fair compensation for the extra risk to them due to any substantial increase in the leverage of a company as a consequence of a takeover. It is not acceptable to for workers to be kept in the dark about as important an issue as the potential acquisition of their enterprise by a private equity buyout with all the implications for their future that might result.

  5.3  Trade unions and workers employed by firms owned by private equity should be informed and consulted to the same degree as workers employed in public companies. This is particularly so given the financing of the buyout and the massive changes to the financial structure of the firm and Information and Consultation rights should apply. Rights are essential to ensure that workers are not merely seen as liquid assets in a short term ownership cycle of acquisition, restructurings and disposal.

  5.4  The TUPE regulations exist to protect workers in the event of a transfer of undertakings. Information and consultation rights are critical in circumstances of a change of ownership. The T&G believes that the TUPE regulations need to be amended to cover circumstances where a change in ownership arises through share purchase. The T&G learned that Gate Gourmet was no longer owned by Texas Pacific Group from the following press report: "A day after Texas Pacific Group joined other powerful private equity houses in a call for more transparency, the firm's mystery sell-off of Gate Gourmet reveals just how much work the industry has ahead of it. Texas Pacific Group, which bought the airline catering firm in late 2002 from Swissair, has quietly reduced its stake in the business over the past year without any disclosure, selling the last piece to Merrill Lynch on Thursday." (Source: Reuters 2 March 2007).

  5.5  Private equity has a hands on approach to the acquired firm. The Financial Services Authority says "The Private Equity business model is not constrained to capital provision, rather it extends to the application of expertise and strategic vision to the privately owned companies". Unions should not end up trying to negotiate with a management that is no longer the prime decision making body. Real decision makers need to be present for negotiation and representation to be meaningful and effective. The decision makers need to be clearly identified.

  5.6  In summary trade unions need the right to be informed and consulted on the financing and business plan prior to a bid, and have the right equivalent to that of pension fund trustees to seek fair compensation and protection, proper recognition of trade unions is needed after the acquisition and terms and conditions need protection.

6.  TRANSPARENCY

  6.1  Public companies are subject to a range of reporting requirements, and information is typically publicly available through published accounts, media scrutiny and published research.

  6.2  Private equity firms, on the other hand, do not have the same obligations to transparency. One effect of a private equity buyout is to create an "information monopoly", in which the beneficial owner determines what, if any information is divulged. If Sainsbury's, responsible for the sale of a significant proportion of food consumed in the UK, had been taken over its disclosure obligations would have been drastically reduced. This information monopoly creates asymmetries that are problematic not only for employees and unions but also for investors and policy makers. The barriers between workers in the acquired firms and fund managers are massive.

  6.3  The T&G therefore believes the information rights of employees, their unions in private equity acquisitions and investors should be strengthened by regulation, so that audited information at least equivalent to Companies House accounts is made available to unions, suppliers, the local community and investors and that this should be made publicly available on the Internet to facilitate independent research and that reports from CEOs on company strategy should be made available to all stakeholders at least annually.

7.  TAXATION

  7.1  Private equity transactions are structured to radically reduce, or entirely eliminate, taxation. The key T&G areas of concern are as follows:

  7.2  The tax deductibility of debt interest, associated with very high private equity leverage, means that investee firms pay much reduced corporate taxes.

  7.3  The practice of equity investors contributing part of their capital as shareholder debt exacerbates this problem.

  7.4  The T&G believes that tax relief on debt should be abolished. The Danish model, whereby tax relief of interest payments is eliminated in conjunction with off sets elsewhere merits consideration.

  7.5  Private equity firms are usually structured as limited liability partnerships. This enables the general partners to be taxed as individuals. In consequence, and in the UK, they have been able to have their gains subject to the highly favourable "taper relief" rules. These rules enable individuals holding unquoted business assets to reduce the tax rate on a capital gain by three quarters after a two-year holding period.

  7.6  The taper relief rules were introduced with fractional ownership of smaller entities in mind, to encourage business investment. They were not introduced with private equity investors in mind and the T&G suggests that taper relief be withdrawn from "carry" in private equity investments.

  7.7  It is sometimes suggested that private equity is "tax motivated" and thus would, in part or in whole, cease to exist if the tax system were changed to eliminate the tax treatments and tax loopholes that private equity exploits. The T&G does not share this view. Private equity investors can realise very large amounts of cash from the purchase, restructuring, and subsequent resale of investee firms. These gains can provide enormous returns to general partners in private equity funds, whether or not they are beneficially taxed.

  7.8  Therefore in our view, it is essential that private equity be fully taxed for reasons both of public acceptability and revenue protection. It is completely unacceptable that general partners in private equity firms may face effective tax rates of 5%-10% on incomes of £ millions, when employees bear marginal tax rates, including social security taxes, that approach 50%, on quite modest incomes. Deeply regressive and highly visible inequalities such as these are highly corrosive in a modern democracy.

  7.9  It is often pointed out that the tax-free status achieved by much private equity activity threatens public revenues. This is its immediate impact but, given the level of public finances, the lost revenue from private equity must ultimately be recovered elsewhere, by higher taxes on those citizens who cannot avoid tax.

8.  INVESTMENT

  8.1  The T&G is especially concerned that the private equity leveraged buyouts have negative effects on investment. We are especially concerned about lack of investment of short-termist Private Equity ownership of a firm, with exit planned for a few years after acquisition. We have anecdotal evidence to support this but believe that the Select Committee should commission an independent and thorough study on the matter.

  8.2  Our anecdotal evidence for specific companies is bolstered by the following observations:

  8.2.1  Private equity appears to shun businesses requiring high levels of capital investment going forward. Providing funds to support very significant investments has, to date, not appeared to be their modus operandi which seems focused on taking over firms that can generate high and stable cashflows to extract either in the form of interest payments or dividend recapitalisations.

  8.2.2  Private equity imposes a very high rate of equity return on the businesses it acquires—on the order of 30+% after-tax per annum. This compares with returns on equity in the publicly quoted sector of something on the order of 10-20%. Combined with the much higher costs of debt for private equity companies versus publicly quoted companies the effect is to raise their weighted average cost of capital which effectively becomes the hurdle rate for new investment decisions. On a theoretical basis, this would have a substantial negative impact on the investment level of companies owned by private equity firms.

  8.2.3  The negative impact on investment is further impacted by the short-term horizon of private equity firms. Unlike public companies which view the future horizon as unlimited, private equity firms are looking to exit their investment in companies in three or five years. They are therefore seeking to raise the profits of the companies they own as much as possible as fast as possible (effectively looking to increase EBITDA to a high level and then sell). This has two effects on investment:

  8.2.3.1  As companies near the end of their shelf life in a private equity portfolio, the hurdle rate for making investments is raised even further. The T&G has had it stated to it by managers of private equity firms on multiple occasions that, "Unless the payback is within the year, we are not allowed to make any investment." This extremely negative attitude towards investment appears to be directly correlated to the length of time a company has been owned within a particular private equity limited liability partnership. Sure enough, once this attitude is stated by management, the company is sold on, sometimes to another private equity firm within a short period of time. Accordingly, the T&G believe that the limited life nature of the LLP's utilised by private equity, the maximum three to five year time horizon for ownership, combined with the obvious incentive of private equity general partners to sell a company in order to collect their "20% carry", has a negative effect on investment.

  8.2.3.2  Investment in intangible assets, eg, R&D, brands and employee training—also is likely to be low as the return on these investments is more uncertain and also likely to be beyond the expected holding period of the private equity firm. Moreover, with this spending usually hitting the profit and loss statement of the company immediately, it is an obvious target for cutting for managers struggling to hit the often very ambitious EBITDA targets agreed with their private equity owners. The T&G has seen cases where investment in employee training is cut markedly after a private equity takeover.

  8.3  The T&G is concerned there is a knock-on effect on publicly listed corporations though a similar squeezing of investment and long-term planning. Private equity leveraged buyouts puts huge pressure on other companies, who wish to avoid being taken over, to sell off or cut productive facilities while at the same time spending money on buying back its own shares or issuing dividends. Thus, private equity may well be reducing not only investment of companies they own but of the entire UK economy. The International Union of Foodworkers describes this as the imposition of "a levy on the real economy of goods and services"[77].

May 2007







76   Hall, David (2007) Secrets and selectivity-obscuring how private equity buyouts affect employment PSIRU University of Greenwich www.psiru.org Back

77   Rossman, Peter (207) Presentation to trade union sponsored MPs on private equity, International Union of Food, Agricultural, Hotel, Restaurant, Catering, Tobacco and Allied Workers Associations Back


 
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