Select Committee on Treasury Written Evidence


Memorandum submitted by the Institute of Chartered Accountants in England and Wales

INTRODUCTION

  1.  The Institute of Chartered Accountants in England and Wales (the "Institute") welcomes the opportunity to submit evidence to the inquiry into private equity published by the House of Commons' Treasury Committee.

WHO WE ARE

  2.  The Institute operates under a Royal Charter, working in the public interest. Its regulation of its members, in particular its responsibilities in respect of auditors, is overseen by the Financial Reporting Council. As a world leading professional accountancy body, the Institute provides leadership and practical support to over 128,000 members in more than 140 countries, working with governments, regulators and industry in order to ensure the highest standards are maintained. The Institute is a founding member of the Global Accounting Alliance with over 700,000 members worldwide.

  3.  Our members provide financial knowledge and guidance based on the highest technical and ethical standards. They are trained to challenge people and organisations to think and act differently, to provide clarity and rigour, and so help create and sustain prosperity. The ICAEW ensures these skills are constantly developed, recognised and valued.

  4.  The Institute's Corporate Finance Faculty is a network of some 6,000 professionals engaged in a wide range of functions and roles in the corporate finance field. The Faculty provides technical and professional development support to over 70 member firms, of which 14 are private equity houses, mostly in the middle market sector. As well as being engaged in all aspects of the private equity industry, Faculty members have a vital role to play in ensuring that appropriate due diligence is performed by investors to help ensure that risks are appropriately understood and managed. This response also draws on the expertise of the Institute in corporate reporting, tax, corporate governance, regulation and financial services.

SUPPORT FOR THE INITIATIVE

  5.  We welcome the Treasury Committee's inquiry into private equity funds at the height of a debate about the role of private equity in the UK economy. Investors' commitments to private equity funds continue to increase. We have also recently seen record-size deals involving higher purchase multiples and higher leverage in sectors previously the domain of publicly listed companies.

  6.  These deals have created uncertainty in some minds as to what has contributed to the success of private equity. Uncertainty can manifest itself in misdirected concerns and has resulted in calls, from some, for new regulation and changes to the tax regime. Changes in either of these areas are complex issues and it is important to consider the potential unintended consequences of such measures.

  7.  The Institute, through the Corporate Finance Faculty, is committed to ensuring that markets and the public are well informed about the risks and benefits associated with the growth in private equity. Insofar as the Treasury Committee identifies areas for further research and discussion, the Institute would welcome the opportunity to host and facilitate such activities.

EXECUTIVE SUMMARY

The regulatory environment

  8.  The call from some for further regulation does not, in our view, give adequate consideration to the principles-based regulation and the risk-based monitoring which are in place nor to the regulatory mechanisms for assessing and managing systemic risk. Furthermore, we are concerned that rules specifically introduced to address private equity would result in regulatory complexities for a wide range of businesses. (paragraphs 15-20)

  9.  While we support industry initiatives such as the Walker review of transparency and disclosure, it is important to appreciate that complete transparency for all relevant interested parties is very difficult to achieve. (paragraphs 21-25)

  10.  In our view, tackling systemic risk associated with private equity needs to be distinguished from taking regulatory action in relation to individual funds. We believe that those responsible for monitoring systemic risk are right to consider the actions they need to take where there is a suggestion of increasing leverage. There is evidence that the Financial Services Authority (FSA) is doing this, though we recognise that adequate transparency of the ultimate ownership of economic risk is critical to the FSA's ability to monitor systemic risk. (paragraphs 26-32)

  11.  The current corporate status of private equity funds has had a favourable impact on the UK as a place of choice to do business. The concentration of investors and skilled investment and support professionals together with attractive regulatory and tax regimes have contributed to the UK becoming the second largest private equity market in the world. Consequently, any measures taken on transparency or taxation may influence the preferred domicile of funds and related investment professionals and so should not be introduced without a proper impact assessment. (paragraphs 33-38)

Taxation

  12.  The taxation regime is a competitive advantage of the UK's private equity market. In our view any review of the taxation regime for private equity funds and investee firms should take account of other major changes that may be made to the current UK tax regime. We are concerned that attempts to introduce a different tax treatment for private equity borrowers and investees will risk further complicating the UK tax system and may result in more barriers to smaller companies raising funds. (paragraphs 39-43)

The economic context

  13.  We believe that further research would be useful in relation to whether private equity makes a positive contribution to long-term business investment and the extent to which private equity markets have developed on the basis of well-informed risk-taking. (paragraphs 44-46)

  14.  In our view the continuation of favourable economic conditions that have encouraged private equity to flourish and the possible impact of their discontinuance, are matters to be taken into account by those responsible for managing systemic risk. (paragraphs 47-51)

RESPONSES TO SPECIFIC QUESTIONS

The regulatory environment

Q1:   Is the current regulatory regime for private equity funds suitable?

  15.  Private equity managers (fund managers) establish private equity funds for which they raise capital from investors, in the main, professional investors and institutions. Funds usually take the form of limited liability partnerships, set up under the Limited Partnership Act 1907 and are not, as such, regulated. However:

    —  fund managers are regulated by the Financial Services Authority (FSA);

    —  institutional investors such as pension schemes, banks and insurance companies are separately regulated;

    —  the activity of promotion to professional investors is regulated; and

    —  the FSA monitors exposures of the institutions that lend to private equity funds.

  16.  In addition to the FSA's regulatory regime, investee companies are subject to reporting requirements and obligations in Companies Act legislation. Also, insofar as there is concern about investee companies' work-based pension schemes, it should be noted that these are regulated by the Pensions Regulator.

  17.  The overall principles-based regulatory regime is one of several competitive advantages of UK markets and, as such, influences private equity firms' decision to operate in the UK. Private equity funds are mainly raised from institutional and professional investors. Except for smaller venture capital trusts (VCTs), private equity is not aimed at retail consumers and it is appropriate that the regulatory regime should be lighter-touch than that for activities aimed at such consumers.

  18.  The FSA's risk-based framework is the regulatory regime for private equity firms carrying on activities in or from the UK. In its 2006 discussion paper, DP 06/6, Private equity: risk and regulatory engagement, the FSA discussed enhancements it is making to its organisational structure and framework to enable it to respond more effectively to private equity market developments. In our response to the discussion paper we supported these efforts.

  19.  The principles of risk-based regulation require that regulators remain vigilant to risks, including systemic risks. Evidence of this awareness is available in the FSA's discussion paper DP 06/6, which sets out the FSA's proposed responses to evidence of higher leverage (see also paragraph 30 below). In its subsequent Financial Risk Outlook 2007, the FSA summarises the risks inherent in the private equity sector, such as ownership of economic risk and market abuse.

  20.  The call from some for further regulation does not, in our view, give adequate consideration to the principles-based regulation and the risk-based monitoring which are already in place in the UK nor to the regulatory mechanisms for assessing and managing systemic risk. Furthermore, we are concerned that rules specifically introduced to address private equity would result in regulatory complexities for the wider market. For example, imposing a limit on leverage in private equity-backed deals would be fraught with difficulty not only in setting a maximum ratio of debt to equity, but also in imposing additional compliance costs on a wide range of businesses.

Q2:   Is there sufficient transparency on the activities, objectives and structure of private equity funds for all relevant interested parties?

  21.  We believe there is adequate accountability between private equity fund managers and their investors, and we are not aware of evidence to suggest institutional investors are unhappy with current levels of disclosure in private equity funds. Indeed, the 2006 Annual Survey from the National Association of Pension Funds highlighted the fact that 7% of defined benefit schemes had increased their investment in private equity, including venture capital. Moreover, capital commitments to private equity funds are increasing, according to the most recent Bank of England financial stability report.

  22.  There is a good flow of information on investee companies, ie the underlying invstments, between private equity fund managers and investors as full disclosure to these investors is not constrained, as in the case of publicly listed companies.

  23.  There have been increasing demands for accountability from interested parties other than investors, particularly in the light of recent "club"" deals involving consortia of private equity firms, and large public-to-private transactions. While it is important to maintain a level playing field for different forms of private ownership, market confidence and public trust are critical to the sustainability and success of the private equity industry and such demands need to be addressed.

  24.  There is positive evidence that the private equity industry acknowledges the need to meet the transparency expectations of investors and to be seen to doing so by other interested parties. For example the British Venture Capital Association (BVCA) has established a high-level working group under the chairmanship of Sir David Walker, to review transparency and disclosure with a view to establishing a voluntary code of compliance.

  25.  While we support such initiatives and are keen to contribute, it is important to appreciate that complete transparency in the investment chain is very difficult to achieve. We believe that a code should facilitate proportionate disclosure and should recognise, for example, that what is appropriate for a public-turned-private company may not be appropriate for a mid-market deal involving a small high-growth company. In this respect we note that the Walker review "will recognise the very different types of investment and issues relating to different segments of the industry from small start-up financing to large buyouts. It will also take account of the size of the portfolio companies concerned."

Q3:   Has there been evidence of excessive leverage in recent transactions and what systemic risks arise in consequence?

  26.  Excessive leverage occurs if a company borrows beyond what can be serviced in terms of interest and capital repayments, bearing in mind its cash generation and the quality of its earnings, irrespective of its specific debt to equity ratio. What is excessive gearing for one company will not be excessive for another and a single yardstick cannot be applied to an entire investment class.

  27.  What is relatively uncontentious is that leverage is high and, consequently, the percentage of equity required by lenders in leveraged buyouts is lower than it was a few years ago. The International Monetary Fund (IMF) and the Bank of England both report rising corporate leverage in their respective most recent financial stability reports and attribute this in part to private equity buyouts. The IMF suggests this may be down to weakening credit discipline and urges the maintenance of lending standards.

  28.  Anecdotal evidence in KPMG's European Mid-Market M&A Outlook of January 2007, a survey of mid-market executives and private equity funds targeting mid-market companies, suggests that there is a degree of high leverage in that market. High leverage appears to be a direct consequence of the low interest rates and more favourable debt terms that have resulted from low market volatility and increased risk appetite. The same survey indicates that the failure of a mid-market investment is not expected to precipitate systemic failure and the market is expected to be able to absorb related losses.

  29.  An issue arises with some private equity deals when they are being funded by syndicated leveraged loans with weak covenants. In general, credit standards on private equity deal terms have slipped, reflected by weaker, fewer, or dropped loan covenants. According to the Bank of England, issuance of so-called "covenant-lite" loans, which do not contain any maintenance covenants, is growing strongly in the United States and they have recently appeared in Europe for the first time (Financial Stability Report, April 2007, Issue No. 21, Bank of England).

  30.  Moreover, in its 2006 discussion paper, following an analysis of the exposures of UK banks within the leveraged lending market, the FSA observed that some lending on private equity transactions "may not be entirely prudent" and provisionally assessed the risk of excessive leverage as medium high. Consequently, under its risk-based approach, the FSA has begun proactive market surveillance of the credit markets. We support this approach firstly, as increased leverage has not yet been tested by decreased liquidity or economic shocks and secondly, because the leveraged investments of institutional investors and pension schemes ultimately expose the insured and the pensioner to the risk of default.

  31.  In our view, tackling systemic risk associated with private equity needs to be distinguished from taking regulatory action in relation to individual funds. The call from some for the private equity market to be further regulated because of increasing leverage is not, in our view, supported with appropriate evidence of excessive leverage across the whole private equity sector. Individual highly-leveraged deals (and the associated increase in the size of funds) do not indicate, on their own, a need for increased regulation.

  32.  Those responsible for monitoring systemic risk are right to be concerned where there is a suggestion of increasing leverage and to consider the actions they need to take. There is evidence that this has been happening through the FSA, though we recognise that adequate transparency of the ulitmate ownership of economic risk is a critical factor to the FSA's ability to monitor systemic risk.

Q4:   What are the effects of the current corporate status of private equity funds, including both their domicile and ownership structure?

  33.  It is usual for private equity funds to raise capital from investors through the flexible structure of an English limited liability partnership (LLP). This requires a General Partner (GP) with unlimited liability and investors known as Limited Partners (LPs). LPs include institutional investors, mainly banks and insurance companies, UK and overseas pension schemes, fund of funds investors and individual high net worth and professional investors.

  34.  The GP is often set up as a limited company or LLP and appoints an entity to act as the fund manager or operator of the private equity fund, under terms set out in a management agreement with the fund. If located in the UK, the entity is regulated by the FSA as a manager. If located offshore, the entity is regulated by the FSA as an adviser.

  35.  GPs are rewarded, in the main, through fees for managing capital and through "carried interest", which is the share of profits after LPs' funds and a hurdle rate of return on those funds have been repaid. The share of profits is usually 80 per cent to LPs and 20 per cent to the GP. GPs may also charge monitoring and transaction fees.

  36.  The domicile of the private equity fund is influenced by a host of factors. Onshore domicile is often chosen because of:

    —  the well-developed jurisdiction and light-touch regulatory regime;

    —  the concentration of skills and professional support services;

    —  access to investors in the City; and

    —  the taxation regime for investors.

  37.  Domicile in the Channel Islands or Isle of Man can also be attractive due to the availability of high quality administration professionals and more modern legislation.

  38.  The current corporate status of private equity funds has had a favourable impact on the UK as a place of choice to do business. The concentration of investors and skilled investment and support professionals together with attractive regulatory and tax regimes have contributed to the UK becoming the second largest private equity market in the world. Consequently, any measures taken on transparency or taxation may influence the preferred domicile of funds and related investment professionals and so should not be introduced without a proper impact assessment.

Taxation

Q5:   Is the current taxation regime for private equity funds and investee firms appropriate?

  39.  There are two main areas of the UK tax system where some people perceive that private equity finance has an advantage over more traditional forms of finance: the tax-deductibility of interest both at the company and shareholder level and the tax rates on income returns as compared to capital returns, particularly where the underlying capital is classified as a business asset. Government policy is, broadly, to ensure that tax considerations do not distort business investment decisions. If these areas are perceived to be a problem and distorting investment decisions, then we would expect the Government to undertake research into the issues so as to ensure that any policy decisions taken are evidence-based.

  40.  The UK tax system is currently subject to very considerable review. In the 2007 Budget Book the Government announced the forthcoming publication of a consultation document:

    "The Government will issue a consultation document later in the spring, which will consider in particular the taxation of foreign dividends received by UK companies and the Controlled Foreign Companies (CFC) rules. This is an area where business has expressed a preference for reform and where options that will be considered include European-style exemption for foreign dividends and income-based CFC rules. The document will also consider the implications of any such reform for other aspects of the UK tax regime, such as interest relief." [paragraph 3.39 Budget Book 2007]

  41.  There are also considerable non-governmental reviews of the UK tax system being undertaken by the Institute for Fiscal Studies Mirrlees Review, the work of the Oxford Centre for Business Taxation and by the European Tax Policy Forum. The objective of the IFS Mirrlees Review, which will report in 2008, is:

    "to identify the characteristics of a good tax system for any open developed economy in the 21st century, to assess the extent to which the UK tax system conforms to these ideals, and to recommend how it might realistically be reformed in that direction."

  42.  We are also concerned that the changes announced in response to the new EU State Aid rules for risk capital which impact investments qualifying under the VCT scheme, run the risk of overriding the Government's intention to reduce the equity gap faced by smaller companies with high growth potential. We are aware of and support the Government's request that the European Commission reviews the way in which it applies the State Aid guidelines.

  43.  The taxation regime is another competitive advantage of the UK's private equity market and, again, influences private equity firms' preference to operate in the UK. This further strengthens our view that any review of the taxation regime for private equity funds and investee firms should take account of other major changes that may be made to the current UK tax regime. Moreover, we are concerned that attempts to introduce a different tax treatment for private equity borrowers and investees will risk further complicating the UK tax system and may result in more barriers to smaller companies raising funds.

The economic context

Q6:   Are developments in the environment and structure of private equity affecting investments in the long-term?

  44.  Private equity firms tend to invest for the medium term and seek to exit from investee companies in three to five years. Anecdotal evidence suggests that fundraising takes place more frequently—every 24-36 months compared to every five years or so—and that capital raised is deployed more quickly. This also reflects a general trend favouring buyout funds rather than VCTs.

  45.  Focus on investment horizons has led to the perception that private equity investments are short-termist and bad for business. On the other hand, the findings of a recent study by the Centre for Management Buy-out Research (CMBOR) at the Nottingham University Business School, which are summarised in The Impact of Private Equity: Setting the Record Straight (www.nottingham.ac.uk/business/cmbor), indicate that private equity deals do make a positive contribution, on average, in financial, economic and human resource management terms. There is certainly scope for further research on the impact of developments in private equity on long-term business investment, for example, in R&D and training.

  46.  In acting upon research findings, regulators should nevertheless be wary of trying to second-guess markets. The private equity market has developed due to willing buyers and willing sellers investing in line with their risk appetite. As in other markets, the efficiency of private equity investment depends on the awareness of the risk-return trade-off and that should not be unnecessarily constrained. The extent to which private equity markets have developed on the basis of well-informed risk-taking would be another area where further research would be useful.

Q7:   To what factors, including the current macroeconomic context and position in the economic cycle, is the current rise of private equity attributable?

  47.  The macroeconomic context and position in the economic cycle are factors that influence the way regulators and governments approach systemic risk. In recent years, the substantial growth in capital flowing into private equity funds has been driven by low interest rates, high availability of credit, benign economic conditions, strong corporate balance sheets with high profitability and strong cash positions. Low interest rates and macroeconomic stability and strong corporate balance sheets have caused historically low financial market volatility and have contributed to very low global corporate default rates.

  48.  This greater economic and financial asset price stability combined with low volatility has encouraged increased risk-taking based on the assumption that this stability will continue and these conditions have created a considerable appetite for leveraged finance products offered in leveraged buyouts (LBOs).

  49.  These developments have increased the amount of leverage in corporate balance sheets, partly as a result of private equity buyouts. Global LBO loan issuance increased by 60% in 2006 and the stock of, as yet, undrawn commitments in private equity firms has grown to around $600 billion (Financial Stability Report, April 2007, Issue No. 21, Bank of England). These private equity deals are affecting the behaviour of other companies as well, with reports of public companies releveraging as a defence against LBOs.

  50.  The demand for the private equity asset class has also risen. Commitment, or funds committed by investors to private equity funds, is increasing, both as a result of new investors entering the market and existing investors increasing their allocations. This is partly attributable to poor equity returns in quoted markets driving institutional investors to higher-yielding alternative investments.

  51.  In our view, the continuation of favourable economic conditions that have encouraged private equity to flourish and the possible impact of their discontinuance are matters to be taken into account by those responsible for managing systemic risk.

Q8:   What are the economic advantages and disadvantages of a firm being owned by private equity funds as opposed to being publicly listed?

  52.  A generally cited economic advantage of private equity ownership as opposed to being publicly listed is that it is relatively easy to align the interests of management and owners. A publicly listed company with a diffuse shareholder base needs to address potential agency conflicts through adherence to corporate governance norms and will invest significant time and money in communicating with shareholders investor relations and periodic reporting. By contrast, management of a private equity-backed company has more opportunity to focus on stategy.

  53.  Privately owned companies can also more easily use leverage to achieve shareholder value and make use of the taxation rules on interest relief. Cheaper debt capital can also lower the weighted average cost of capital of investee companies.

  54.  Nevertheless, the access to liquidity in well developed public markets can be an important advantage of being publicly listed as can the ability to raise capital and use publicly-traded securities to fund acquisitions.

May 2007





 
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