Select Committee on Treasury Written Evidence


Memorandum submitted by the TUC

SUMMARY

  2.1  The role of private equity in the economy has grown rapidly in recent years. Following an increase in the size and number of private equity buyouts, around 1.2 million people, one in 12 private sector workers, are currently employed by private equity owned companies. Until recently, the sector was operating out of the public spotlight; however, given its major economic assets and significant economic and social impacts it is right that public scrutiny should be increased. The TUC welcomes the Treasury Committee Inquiry as an important part of this process of public scrutiny.

  2.2  The TUC's major concerns about private equity sector are summarised below.

    (i)  The regulatory environment has not kept pace with the rapid rise of private equity and is inappropriate given the sector's major economic assets and impacts.

    (ii)  The disclosure requirements for private companies are considerably weaker than those for quoted companies. This means that when a quoted company is bought by a private equity fund its disclosure obligations are significantly reduced.

    (iii)  The TUC believes that large private companies should be required to produce a full business review and to publish their full annual report on their website.

    (iv)  Employees and their representatives in companies bought by private equity companies face particular difficulties in terms of receiving information about company plans both before and after the buyout and recognition of and negotiations with trade unions post-buyout.

    (v)  The TUC believes that the Government needs to examine how the Information and Consultation Regulations operate in relation to a change in company ownership and make recommendations to ensure proper implementation and enforcement.

    (vi)  The TUC proposes that the Transfer of Undertakings (Protection of Employment Regulations) should be extended to cover changes of company ownership.

    (vii)  The TUC believes that a working group should be established by the Government to examine the impact of mergers and takeovers on employment rights and put forward proposals for reform.

    (viii)  The TUC is concerned about the risks associated with the very high levels of leverage now being used in private equity buyouts and is concerned that employees shoulder a disproportionate share of that risk.

    (ix)  The TUC urges the Treasury Committee to investigate the rise of corporate debt and its implications for economic stability.

    (x)  The TUC believes that there is a fundamental difference between debt used to fund organic growth through investment and debt used to buy up other companies. The TUC argues that reflecting this distinction in the tax rules so that tax-deductibility on debt would not apply to debt used to buy up other companies merits further investigation.

    (xi)  The TUC believes that the regulatory regime for limited partnerships is not appropriate for organisations that control increasing swathes of the UK's corporate sector. The TUC believes that private equity funds should be required to publish an annual report and accounts, and required to make this publicly available via their website.

    (xii)  The TUC is concerned about the potential for conflicts of interests, both between limited and general partners within private equity funds and between private equity fund managers and the long-term success of the companies they own.

    (xiii)  The TUC is concerned that directors' duties as set out in the Companies Act 2006 are not suited to the fixed time horizons of private equity owners, and urges the Government to look into this area as a matter of urgency.

    (xiv)  The TUC believes that it is essential that private equity partners pay income tax on their earnings.

    (xv)  The TUC is concerned that private equity buyouts are reducing the size of the stock market and that scaled up private equity buyouts would make the distribution of wealth generated by UK companies for more unequal than at present.

INTRODUCTION

  3.1  The TUC welcomes the Treasury Committee inquiry into private equity. Private equity has risen rapidly up the news agenda in recent months, and has not only dominated the financial pages of the broadsheets but been widely covered throughout the media as a whole. Widespread concern has been expressed about the impact of private equity on the companies they buy and on the wider economy. Trade union campaigns around particular companies have generated considerable publicity, but it is also clear that trade union concerns have struck a much wider chord, and a host of commentators have joined in the debate about the role of private equity in the UK economy.

  3.2  The TUC represents nearly 6.5 million workers in 63 unions and welcomes the opportunity to submit evidence to the Treasury Committee inquiry. One of the areas where both trade unions and other commentators, including Paul Myners[78] and John Plender of the Financial Times, have raised concerns is the employment impact of private equity buyouts. This issue is not directly referred to in the Treasury Committee inquiry's terms of reference, but the TUC believes that employment issues are central to public concern about private equity and merit proper consideration.

THE REGULATORY ENVIRONMENT

  4.1  A number of macroeconomic factors have facilitated the rise of private equity, including high levels of global liquidity, low interest rates and a drive from investors for ever-higher returns. However, the regulatory environment has not kept pace with the rapid rise of private equity, and in particular is not suited to the current situation where private equity funds are able to buy up increasingly large quoted companies.

Transparency

  4.2  There are two distinct issues with regard to "transparency on the activities, objectives and structure of private equity funds": the disclosure requirements for companies owned by private equity; and those for private equity funds themselves. The issue of transparency relating to private equity funds themselves will be dealt with below in the section on corporate status of private equity funds. This section will deal with transparency in relation to companies bought by private equity funds. This is significant because private equity companies are increasingly buying quoted companies and taking them private.

  4.3  The disclosure requirements for private companies are considerably weaker than those for quoted companies. A private company does not have to file its annual accounts until nine months after its year end and does not have to produce quarterly earnings or interim results. Crucially, it does not have to place its annual report on its website, greatly diminishing public access to the information contained therein. While the public can gain access to company reports via Companies House, this is not a free service and a charge is made for each download.

  4.4  Requirements for non-financial reporting, an area of particular interest to the TUC, have recently been strengthened for quoted companies by the Companies Act 2006. From October 2007, all quoted companies, even the smallest, will have to include in their business review the directors' view of "the main trends and factors likely to affect the future development, performance or position of the company's business". Information on the company's employees and suppliers, on environmental matters and on social and community issues must also be included, including information on company policies relating to these areas and their effectiveness. However, all private companies, even those employing tens of thousands of staff, are excluded from these requirements.

  4.5  Executive pay is another area where there is a stark contrast between the obligations on private and quoted companies. While the Directors' Remuneration Report Regulations 2002 require quoted companies to produce a report on directors' remuneration and put it to the vote at their AGM, private companies are not covered by this legislation and are subject only to the general Companies Act requirements, which are much weaker.

  4.6  The phenomenon of private equity companies taking large quoted companies private, overnight weakening the transparency of major UK businesses, throws a spotlight on this two-tier system of disclosure and illustrates the weaknesses of making ownership structure rather than economic and social impact the determinant of disclosure requirements. For example, on completion of its purchase by KKR, Boots, a company with 2,600 outlets, 1,500 pharmacies and 85,000 UK workers, will have its disclosure obligations significantly reduced, at the same time as there is heightened employee and public interest in the company's plans and activities[79].

  4.7  The social and economic impact of a large private company is no less than that of a quoted company, and there is a legitimate public interest in the plans and activities of companies, regardless of their ownership structure. The TUC believes that large private companies should be subject to the same non-financial reporting requirements as quoted companies. It is essential that the disparity between quoted and private companies with regard to reporting and the reduced transparency caused by the rise of private equity buyouts are addressed by regulatory reform, and not left to voluntary initiatives, which will inevitably result in patchy and uneven reporting.

  4.8  The TUC believes that:

    (i)  large private companies should be required to produce a full business review; and

    (ii)  large private companies should be required to publish their full annual report on their website.

THE REGULATORY ENVIRONMENTRESPECTING THE RIGHTS OF WORKERS AND THEIR REPRESENTATIVES

Informing and consulting employees

  5.1  The TUC is particularly concerned about the difficulty that employees and their representatives have had in obtaining basic information about company plans and strategy prior to and following private equity buyouts. The rights of employees and their representatives to be informed and consulted about important developments that may affect their interests have been recognised and set out in the Information and Consultation Regulations 2004, which have been in operation for organisations of 150 or more employees since 2005 and will apply to organisations with 50 or more employees by April 2008. These state that employers should consult employee representatives on matters that include:

    (i)  The recent and probable development of the undertaking's activities and economic situation;

    (ii)  The situation, structure and probable development of employment within the undertaking and any anticipatory measures envisaged, especially where there is a threat to employment within the undertaking.

  5.2  The general principles of the Takeover Code require a board to advise shareholders of "its views on the effects of implementation of the bid on employment, conditions of employment and the locations of the company's places of business". This requirement demonstrates the importance of the impact of mergers and takeovers on employment. However, the takeover rules also require that "all persons privy to confidential information, and particularly price-sensitive information, concerning an offer or contemplated offer must treat that information as secret and may only pass it to another person if it is necessary and if that person is made aware of the need for secrecy".

  5.3  This requirement of secrecy is interpreted by companies involved in takeovers as preventing any consultation taking place with employees about a potential takeover. Despite the fact that boards are required to inform shareholders of the employment impact of a bid, they feel constrained by the Takeover Code from even informing employees that a bid is taking place. This applies to all mergers and takeovers, not just private equity buyouts. Because of the concern about the impact of private equity buyouts on employment, newspaper speculation about private equity buyouts has created particular uncertainty and insecurity for staff in the companies concerned, but it is important to note that this stems from a general problem about how mergers and takeovers operate in the UK.

  5.4  The TUC understands the rationale behind the Takeover Code and its aim of ensuring that information that could affect share prices is not revealed prior to a concrete bid being made. Nonetheless, the TUC does not regard it as acceptable for employees to be kept in the dark about an issue as major as a takeover of their company. Employees should not be treated as pawns whose fate will be decided by others while they themselves are not even informed about key decisions affecting their future. The TUC believes that employees should be informed and consulted about mergers and takeovers prior to a bid being presented to shareholders. Issues of secrecy could be addressed as they are in countries with board level employee representation, where employee representatives undertake to respect the confidentiality of papers under discussion. The TUC believes that the injustice of the current situation must be addressed as a matter of urgency.

  5.5  Clearly, once a buyout has taken place the rights of employees to be informed and consulted over plans and future activities should be guaranteed by the Information and Consultation Directive. In practice, however, unions have informed the TUC of their difficulties in obtaining information from companies once they have been bought by private equity funds. The TUC believes that the Government needs to examine how the Information and Consultation Regulations operate in relation to a change in company ownership and make recommendations to ensure the proper implementation and enforcement of the Regulations.

Recognising the role of trade unions

  5.6  Trade unions both in the UK and internationally have highlighted experiences where a good relationship between the union and company management has been destroyed by a private equity buyout. In some instances, unions have found themselves in the position of trying to negotiate with a management that is no longer the prime decision making body in the company. Indeed, this experience fits with one of the arguments put forward in favour of private equity—that a much smaller number of highly-invested shareholders is able to exert far more influence and take a much more hands on approach to management than is the case with listed companies. Clearly, the traditional model of trade union representation and collective bargaining does not work if the real decision makers are not present at negotiations (and indeed at times are not even clearly identified).

  5.7  A study of private equity buyouts in the UK and the Netherlands found that the number of companies recognising trade unions fell after a buyout from 34%-29%, although over time it reverted to the original level. The study also showed high levels of hostility to trade unions among company managers in the buyout firms, with only one in ten managers having a positive attitude to trade unions and 40 per cent admitting to being hostile.[80]

  5.8  It is not only trade union rights that may be jeopardised when a company is bought by a private equity fund. There is a heated debate about whether overall private equity buyouts destroy or create jobs, but what is clear is that in some instances private equity buyouts have been followed by very large numbers of redundancies. It is particularly important in a situation where management is proposing major layoffs that workers and their representatives are fully consulted on plans and are given the opportunity to comment and put forward alternative proposals. These rights are enshrined under the Directive on Collective Redundancies, implemented in the UK by the Trade Union Labour Relations Act of 1992.

  5.9  There is some evidence that workers' terms and conditions may be weakened by private equity buyouts. As well as anecdotal evidence, a study carried out by Centre for Management Buy Out Research and Nottingham University Business School found that buy-out firms had significantly lower annual wage growth than non-buyout firms. The downward pressure on wages was particularly great in management buy-ins (as opposed to management buy-outs). The study also indicates that the larger the company, the greater the downward pressure on wages.[81] Given the high returns that private equity funds earn from the firms they buy, a key question is why employees are not sharing in these financial benefits.

  5.10  The Transfer of Undertakings (Protection of Employment Regulations) or TUPE preserves employees' terms and conditions when a business or undertaking, or part of one, is transferred to a new employer through, for example, an outsourcing arrangement. The TUC proposes that TUPE should be extended to cover changes of company ownership. It would be possible to explore variations of this model so that selected protections such as trade union recognition, maintenance of collective bargaining and some terms and conditions would be protected.

  5.11  The TUC believes that a working group should be established by the Government to examine the impact of mergers and takeovers on employment rights and put forward proposals for reform. The terms of reference should include:

    (i)  issues relating to consultation with, and the provision of information to, workers and their representatives prior to a bid;

    (ii)  how any proposed redundancies are dealt with;

    (iii)  recognition of trade unions after a takeover has taken place;

    (iv)  terms and conditions of workers after a takeover has taken place.

LEVERAGE AND DEBT

  6.1  Leverage in many private equity buyouts has been extremely high. Major purchases have been made using one part of equity to three or four parts of debt. The Financial Services Authority found that in the five largest leveraged buyouts involving bank lending in the 12 months up to June 2006, the average share of equity was just 21%.[82] This is in contrast to a typical takeover by a quoted company, which might be funded with roughly 70% equity and 30% debt.

  6.2  There has been much debate in the press about the pros and cons of such highly leveraged deals. Defenders of the private equity model have argued that debt provides an effective discipline on management. This seems to imply that managers in UK companies are only able to respond to immediate financial pressures rather than being able to make decisions in order to implement a strategy for long-term company success and growth. This is a very negative view, and if it is accurate, there is an urgent need to improve the quality of management in UK companies.

  6.3  It has been suggested by some commentators that most public companies do not make sufficient use of debt.[83] However, the TUC does not believe that it is possible to generalise about an optimum level of debt that applies to all companies; optimum levels of debt for a company will depend on that company's particular circumstance and crucially what the debt is to be used for. Marks and Spencer is an example of a company that fought off a bid to take the company private and has then successfully turned itself round while remaining a quoted company. In order to do this it has increased its levels of debt and this investment has clearly paid off. However, this is fundamentally different from using debt to buy another company. A highly indebted company may find it difficult to find the funds for the sort of long-term investment that Marks and Spencer was able to make.

  6.4  The TUC believes that there are clear risks associated with such high levels of debt. A significant rise in interest rates would have a major impact on the economic rationale of highly-leveraged buyouts and on the balance sheets of companies carrying significant levels of debt. Equally, companies carrying such high levels of debt have no buffer to protect them against a general economic slowdown. A rise in interest rates, particularly a sudden rise, or an economic slump would increase the risk of large-scale company closures and a sharp reduction in private equity returns.

  6.5  Standard and Poor's, the ratings agency, has said that the quality of debt backing private equity deals has fallen dramatically, and that there is now a one in five chance that companies that are taken private using leverage will fall into default. Its research shows that at the end of August 2006 the loans backing three-quarters of European private equity deals were rated in the single "B" range of junk debt. The quality of debt backing private equity deals has declined significantly since the end of 2002, when less than one third of debt was in the B range and 57% was in the BB range, which gives it a risk of default of one in 20. Currently only one in ten deals has a default rating of one in 20.

  6.6  The Financial Services Authority has talked about "excessive leverage", and has said: "The amount of credit that lenders are willing to extend on private equity transactions has risen substantially. This lending may not, in some circumstances, be entirely prudent. Given current leverage levels and recent developments in the economic/credit cycle, the default of a large private equity backed company or a cluster of smaller private equity backed companies seems inevitable".[84] Similarly, the Bank of England lists high and rising leverage in parts of the corporate sector as one of six key sources of vulnerability for the UK financial system. These assessments of risk from a major ratings agency, the UK's financial watchdog and the Bank of England are a serious cause for concern.

  6.7  This raises the very important issue of how that risk is distributed, both among investors and between investors and other stakeholders such as creditors and employees. The TUC is very concerned that employees carry disproportionate risk in private equity buyouts. It has been noted above that employees' wages appear to grow more slowly after private equity buyouts. And if things go wrong, the levels of debt are likely to mean that job losses are more rapid and more severe than in a company that could use its equity and other economic resources as a buffer to protect itself from external pressures.

  6.8  The impact of private equity buyouts on employees has been highlighted by Paul Myners and Financial Times journalist John Plender. Paul Myners has argued that "the one party who is not rewarded is the employees, who, generally speaking, suffer an erosion of job security and a loss of benefits".[85] Similarly, John Plender has written that "of the various stakeholders involved, employees stand to lose most from a change of ownership", highlighting the impact on jobs and arguing that debt to equity ratios create "potentially job-threatening vulnerability".[86]

  6.9  The FSA has described the ownership of risk in private equity deals as "unclear". It argues that the use of "opaque, complex and time consuming" risk transfer practices, combined with increased use of credit derivatives, makes it hard to know exactly who owns the risk in a leveraged buyout and how these owners will react to a crisis.

  6.10  As well as the risk of catastrophic failure caused by a rise in interest rates or economic slowdown, such high levels of leverage may create pressure for the company to become as profitable as possible in the shortest possible time. There is a danger that such pressures may lead to a "quick fix" approach that will leave the company vulnerable in the longer-term and unable to take advantage of opportunities for future growth and development. For example, the impact of private equity takeovers on levels of research and development investment within companies is an area of potential risk that merits further investigation.

  6.11  The TUC urges the Treasury Committee to investigate the implications of the rise of corporate debt for economic stability.

Leverage and tax

  6.12  One factor that has encouraged the high levels of leverage that are seen in private equity takeovers is the tax treatment of corporate debt. Interest payments on debt are tax deductible, meaning that companies can offset interest payments against their tax bill, thus reducing the costs of debt-financing. It is important to note that tax deductibility of interest is not limited to private equity and extends to all companies in the UK and indeed is a common international practice.

  6.13  However, there is a concern that the tax-deductibility of interest payments is influencing the economic rationale of takeovers, and favouring debt over equity as a means of financing buyouts. It has been widely suggested that the tax relief on debt is a significant factor in the profitability and returns generated by private equity takeovers. Julie Froud and Karel Williams from the University of Manchester have argued that if the debt leveraging is stripped out of the equation, the returns generated by private equity would be mediocre at best compared with the stock market as a whole.[87] Similarly, a study for Citigroup also came to the conclusion that the higher returns for private equity disappeared if the high degree of leverage was stripped out of the model.

  6.14  This raises two important issues of public policy. Firstly, if the tax regime is a significant factor in the economic rationale for highly-leveraged takeovers, the Government—and indeed all those with an interest in the area—would need to be assured that it believes that encouraging such highly-leveraged deals is in the public interest. The TUC is not convinced that this is the case.

  6.15  Secondly, if the tax regime favours debt-funded takeovers over equity funded-takeovers, this risks distorting the market for corporate control. The market for corporate control is widely regarded as an important discipline on company management that facilitates the efficient allocation of capital. A system that favours debt-funded takeovers over equity-funded takeovers risks damaging the ability of the market for corporate control to lead to improved company performance.

  6.16  The TUC believes that there is a fundamental difference between debt used to fund organic growth through investment in research and development, innovation and training and debt used to buy up other companies. The TUC believes that reflecting this distinction in the tax rules so that tax-deductibility on debt would not apply to debt used to buy up other companies is an approach that merits further investigation. The size of debt relative to company turnover could be used as a possible proxy to distinguish between debt to fund organic growth and debt to fund takeovers.

  6.17  The Governments of Denmark and Germany are in the process of discussing proposals to amend their tax laws to address concerns about tax-relief encouraging excessive leverage. In March, Financial Treasury to the Secretary Ed Balls announced a review into the "current rules that apply to shareholder debt where it replaces the equity element in highly leveraged deals". The TUC believes that this review should be widened to examine tax relief on debt more generally and in particular whether it is in the public interest for tax relief on debt used for takeovers to be treated in the same way as tax relief for debt that will be used to invest for long-term, organic growth.

CORPORATE STATUS OF PRIVATE EQUITY FUNDS

  7.1  Private equity firms are generally run as limited partnerships. As such they are treated as a collection of private interests, despite their major economic assets and impacts. Limited partnerships are subject to a very light regulatory regime. It is necessary to register a limited partnership at Companies House, but other than the registration form and any subsequent amendment (such as a change of partner) no other information has to be filed. Registration costs £2, and requires the following information:

    (i)  The firm's name;

    (ii)  The general nature of the business;

    (iii)  The address of the principal place of business;

    (iv)  The full name of each partner, listing general and limited partners separately;

    (v)  The term (if any) for which the partnership is entered into;

    (vi)  The date of its commencement;

    (vii)  A statement that the partnership is limited and the description of every partner as such; and

    (viii)  The sum contributed by each limited partner, and whether it is paid in cash or otherwise.

  7.2  It is not possible to view registration forms on the Companies House website, although copies will be sent out to members of the public on request.

  7.3  This is an extremely light regulatory regime for organisations that own such major economic assets and control increasing swathes of the UK's corporate sector. Given the role that private equity is currently playing in the UK economy, the TUC strongly believes that greater transparency from private equity funds about their operations, plans and impacts is in the public interest. The TUC believes that private equity buyout funds should be required to publish an annual report and accounts and required to make this publicly available via their website. These should include information on the distribution of investment, returns on each investment and distribution of these returns. In addition, the annual report should contain:

    (i)  The development and performance of the fund during the financial year;

    (ii)  A description of the principal risks and uncertainties facing the fund; and

    (iii)  The main trends and factors likely to affect the future development, performance and position of the fund.

  7.4  This would ensure that information about the activities of the private equity buyout fund over the past year were set out in the public domain, and would also require private equity funds to set out their future plans and strategies. All those affected by private equity buyouts, including the many employees working in companies that have been or will be bought by such funds, have a strong potential interest in greater information about the priorities, plans and activities of these funds. It would also be of benefit to investors and trustees.

Distribution of risks and reward and conflicts of interests

  7.5  The TUC is concerned about the balance of risks and rewards within the limited partnership model. The general partners who run the fund generally charge high fees, and gain a high percentage of any profits that are generated. While their control is extensive, it is not matched by their level of risk. Even in private equity deals that have been regarded as failures, like Little Chef, it would appear that the general partners have still been able to make money and protect their own interests. Returns to limited partners are generally significantly lower than those to general partners, who often receive around 20% of annual returns.

  7.6  Limited partners investing in private equity funds include pension funds and insurance companies with long-term commitments to beneficiaries. Paul Myners recently questioned whether pension fund trustees are looking sufficiently closely at the costs of investing in private equity against public stocks.[88] His recent intervention is significant because in his Review of Institutional Investment in 2001, he encouraged pension funds and other institutional investors to invest in alternative assets in order to diversify their investment portfolio.

  7.7  One of the issues for pension funds and other limited partners of private equity funds is that their investments are illiquid and cannot be retrieved outside the terms of the agreement. This means that trustees and other investors are exposing themselves to much greater risk in comparison to investing in the stock market, which allows risk to be diversified. Commentators have questioned whether the returns from private equity are sufficient to compensate for this illiquidity.

  7.8  The FSA has warned of the potential for conflicts of interest, both between general partners and limited partners and between the private equity fund managers and the companies they invest in. For example, general partners are often able to over or under commit to specific company investments through "co-financing" deals. This could enable them to cherry pick the best deals for extra investment, while capping their exposure to more risky deals. Or, a fund manager may be managing investment funds at different stages of the investment cycle, both of which are invested in the same company. The interests of the two investment funds may diverge (for example, in terms of whether the private equity fund should sell to realise profit now or wait until later), while the fund manager has responsibilities to both groups.[89]

  7.9  The potential for conflicts of interest between private equity fund managers and the long-term success of the companies they own is an area of great concern to the TUC. The potential for conflicts of interest starts as soon as a buyout is proposed, as often company directors are offered highly lucrative stakes in the company if the bid succeeds. This may create a conflict of interest between the company's board and its current shareholders. Once bought, fund managers' intention of selling the company after a specified time and the fact that a company is one among many of its investments may create a divergence between the interests of fund managers and the long-term success of the company. The FSA also highlights the potential for conflicts of interest between fund managers and the firms they buy as an issue of concern.[90]

  7.10  The Companies Act 2006 enshrined what the Government has called "enlightened shareholder value" as the basis of UK company law. The duties of directors as set out in the new Act require directors to serve shareholder interests, and require that in so doing they have regard, among other matters, to the interests of employees, relationships with suppliers and customers, social and environmental impacts and the likely consequences of their decisions in the long-term. The thinking behind enlightened shareholder value was that in the long-term, the interests of different company stakeholders converge, thus making it unnecessary to put responsibilities to employees and other stakeholders on an equal footing to responsibilities to shareholders.[91]

  7.11  These duties are not suited to a situation where shareholders have defined their interest as maximising a sale price for the company after two to five years. There is a risk that directors may be serving existing shareholders' interests at the expense of the interests of other stakeholders, future investors and the long-term success of the company. If the owners stated interest is to sell the company after a few years, having generated maximum profit along the way, this may not be compatible with the sort of business decisions needed to put the company on a sustainable long-term footing. An example of the kind of action in question is when company assets are sold to generate funds at the expense of future revenue streams. For example, the private equity owners of Debenhams sold the ownership of its stores in a refinancing deal, requiring the company to pay rent for stores it previously owned indefinitely.

  7.12  The motives of the private equity fund managers and their commitment to the long-term sustainability of the company have been questioned by the FSA: "The entrance of new types of market participant with business models that may not favour the survival of distressed companies adds further complexities ... which may create confusion which could damage the timeliness and effectiveness of work outs following credit events and could, in an extreme scenario, undermine an otherwise viable restructuring".[92]

  7.13  The TUC does not believe that it should be legal for private interests to buy a company and then run that company for their own benefit, at the expense of the company's long-term future. The TUC believes that it is necessary to address the issue of conflicts of interests between private equity fund managers and the companies they own, and urges to Government to look into this area as a matter of urgency.

Private equity fund managers and tax

  7.14  The rewards for general partners of private equity funds are inflated by the fact that their fees are taxed as capital gains tax rather than income tax. This enables them to pay tax at 10% (and commentators have argued that the effective rate may be as low as five per cent), rather than 40%, the rate of income tax for higher earners.

  7.15  The origins of this go back to 1987 when the Government allowed performance fees to be taxed as capital, rather than income, in an attempt to encourage more venture capital funding for small companies. However, the gains from this change were dramatically increased in 1998, when the Government reduced capital gains tax from 40% to just 10% for people owning shares in their own or unlisted companies, providing they had owned the asset for ten years. In 2002, however, the ownership requirement was reduced to only two years. This new "taper relief" encouraged many companies to set up share-based pay schemes to allow highly paid employees to take their income in the form of capital gains, and in 2003 the Government moved to address this by introducing new rules requiring employees to declare shares received as part of their pay package as income. However, the British Venture Capital Association negotiated a special deal with the Government, exempting private equity firms from the new rules.

  7.16  Whatever the arguments for encouraging venture capital investment in small firms, these do not apply to individuals making very large sums of money from buying and selling major British companies. The TUC believes that treating carried interest as capital gains rather than income for tax purposes is an anomaly that is extremely unfair to the very many people on far lower incomes who pay much higher levels of tax for the greater good of society. The TUC believes that it is essential that the exemption for private equity funds should be abolished, and that private equity general partners should pay income tax on their earnings.

IMPACT OF PRIVATE EQUITY ON INVESTMENTS IN THE LONG-TERM

  8.1  The number and scale of private equity buyouts has risen sharply in recent years, to the extent that private equity is now contributing to a reduction in the size of the stock market. Last year, UK buyout funds made up over a quarter of all British-based takeover deals; nine years earlier, the figure was under 7%.[93] At the same time, the UK equity market capitalisation shrank by £46.9 billion in the first half of last year, and has not grown since the last quarter of 2004. The FSA attributes this shrinkage to the impact of public to private transactions, share buy backs and special dividends (sometimes as part of a defence against a private equity bid) and reduced capital flows from the private sector.[94]

  8.2  This goes to the heart of the workings of the UK's capital markets. Reducing the size of the stock market directly reduces the liquidity of capital, which is seen as vital in ensuring the efficiency of capital investments. If an increasing proportion of investment monies, including those from institutional investors such as pension funds, are tied into particular private equity buyouts, such investors are increasingly dependent on high returns being generated in a much more limited number of companies, rather than across the stock market as a whole. This clearly increases their exposure to risk.

  8.3  This is linked to distributional impacts. Private equity buyouts reduce the number of investors benefiting from the returns generated by UK companies. Companies that were previously generating returns for millions of pension fund beneficiaries and others through the stock market are now generating returns for a narrow group of individuals, plus some wider beneficiaries in the form of the limited partners. However, the proportion of returns paid to limited partners is limited by the structure of private equity funds, with general partners frequently extracting a fifth of generated returns as "carried interest".

  8.4  Even when some of the investors in private equity funds are pension funds, this is a tiny proportion of those who would have previously benefited through the stock market. Scaled up, the TUC is concerned that private equity buyouts would create a situation where the wealth generated by UK companies would be distributed far more unequally than at present. The TUC believes that this would be both socially and economically damaging. Given the crucial role of the stock market in pensions provision, significantly reducing the size of the stock market could have a major impact on the incomes of millions of future retirees.

CONCLUSION

  9.1  At the heart of the debate about private equity is the question of whether it is fuelling short-termism within the economy through creating pressure within companies to take decisions based on short-term gains rather than long-term value creation. There is a danger that private equity buyouts are geared towards value extraction for the few rather than value creation for the many, and this is central to the economic and social concerns raised about the sector. A major issue facing the Government is whether the regulatory framework for private equity funds is appropriate for companies that are not just funding start-ups with venture capital but are now able to buy household names like Boots. This TUC submission has argued that given the major economic assets under the control of private equity, the current regulatory regime is inappropriate and should be strengthened to ensure that private equity funds and the companies they own operate in the public interest.

May 2007






















78   Author of Review of Institutional Investment, 2001. Back

79   These comments relate to what Boots will be required to report, and do not prejudge what information the company will decide voluntarily to put into the public domain. Back

80   Bruining H, Boselie P, Wright M and Bacon N, The impact of business ownership change on employee relations: buy-outs in the UK and The Netherlands, The International Journal of Human Resource Management, March 2005. Back

81   Ammess K and Wright M, The wage and employment effects of leveraged buyouts in the UK, International Journal of Economics and Business, forthcoming, in Phil Thornton, Inside the dark box: shedding light on private equity, The Work Foundation, March 2007. Back

82   FSA, Private equity: a discussion of risk and regulatory engagement, November 2006. Back

83   Eg, Weighing up the debt balancing act, Financial Times 12 March 2007. Back

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

85   Interview in the Financial Times, 21 February 2007. Back

86   Private equity cannot escape the public eye, The Guardian, 24 April 2007. Back

87   CRESC Working Paper Series No 31, Private equity and the culture of value extraction, February 2007. Back

88   Interview in Financial Times, 21 February 2007. Back

89   FSA, Private equity: a discussion of risk and regulatory engagement, November 2006. Back

90   ibid. Back

91   It should be noted that the TUC consistently argued for pluralist directors' duties, which would require directors to balance the interests of shareholder with those of employees and other stakeholders. Back

92   ibid. Back

93   Tom Burroughes, Private equity returns slow amid M&A boom, The Business, 7 March 2007. Back

94   FSA, Private equity: a discussion of risk and regulatory engagement, November 2006. Back


 
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