Select Committee on Treasury Written Evidence

Further memorandum submitted by Dr Tony Golding


  From nowhere a year ago, private equity has become the subject of an active public debate. Is it good or bad for the UK economy? What is the impact on jobs? These are important questions. A financial activity that not long ago was an obscure part of the City is now full frontal in terms of the attention paid to it by business, unions and politicians. For twenty years, private equity—or "venture capital" as it preferred to be called—conducted its business out of public view, buying private firms or subsidiaries of large listed companies. To smooth the way, the industry's representative body, the British Venture Capital Association (BVCA), quietly but effectively persuaded government of the need for tax concessions if "enterprise" was to flourish in the UK. Then, several years ago, came a trickle of bids for quoted companies, mostly small. Some sectors, health clubs for example, were entirely absorbed by private equity via what came to be called "buyouts". As the profitability of this specialised form of acquisition activity became fully established, institutional investors, particularly pension funds, happily supplied a small group of ambitious buyout firms with ever larger funds.

  But recent moves to acquire FTSE 100 quoted companies, such as the successful takeover of Alliance Boots, have taken the private equity industry into uncharted territory and, whether they like it or not (and the answer is "not"), the firms making these bids have been thrust blinking into the limelight. Remarkably for such sophisticated operators, the firms behind these buyouts naively imagined they could scale the heights of British business without attracting more than a flurry of interest from anyone outside the normal circle of fund managers, investment bankers and the financial press. The recent hearings of the Treasury Select Committee into the industry demonstrated how wrong they were. For the interested observer, as so often happens when some new and complex City transaction structure suddenly hits the headlines, it is difficult to separate myth from reality. Amid the fog of debate, the following points are worth keeping in mind.

  "Venture capital" and "buyout" firms are engaged in very different processes. About the only thing they have in common is that they both invest in unquoted companies. Genuine venture capital (invariably abbreviated to "VC") is a highly risky business. New firms pursuing innovative and untested technologies and business models frequently fail. In its strictest sense, "private equity" covers both these activities but, as investing in established companies rather than start-up businesses has come to dominate the unquoted terrain, the term "private equity" is frequently equated with buyouts. In the USA, where the whole business originated, there is no confusion between venture capital and buyouts. There is no suggestion, as there has been in the UK, that firms buying existing businesses merit a "venture capitalist" tag. VC firms do VC deals and buyout firms do buyout deals. By its very nature, VC is a much smaller business than buyouts. The truth is that they are totally different types of activities requiring quite distinct skill sets. When firms specialising in one sector move into alien territory—as when buyout firms were tempted into investment at the height of the internet bubble—it invariably ends in tears.

  The British Venture Capital Association may be so named but venture capital is not the business that attracts the majority of its members. Their interest lies in acquiring relatively low-risk existing companies, often in stable, mature industries, that are capable of being leveraged—companies possessing sufficient assets and, more especially the necessary cash flow, to support large amounts of debt. When they first hit the scene, buyouts were called "leveraged buyouts", or more usually "LBOs", but today the concept of loading up a firm with debt is so integral that the "L" is superfluous. For the buyout backers, the object of the exercise is paying off (or at least servicing) the debt with cash flow until, a few years down the line, the company can be "exited"—to use the industry's jargon—by selling out at a price that will generate several times the modest amount originally invested as equity. In the environment of cheap and easy credit that has prevailed since 2003 this has been an astonishingly good business to be in.

  For the past decade at least, the British Venture Capital Association has firmly resisted reality, choosing to retain its name even though the vast majority of its membership long ago lost interest in financing new and early-stage companies. The reason surely is that "venture" plays well with ministers and MPs. It conjures up an image of techie types toiling away in cramped units in business parks rather than the hard-nosed financial engineering that is the essence of the buyout model. Politicians love small companies—they present no threat to anyone and have the potential to create wealth and employment. As an experienced lobbying organisation, the value of associating itself with the venture agenda can hardly have escaped the BVCA's notice. Then, in March this year, in a belated concession to the changed composition of its membership, it came up with a distinctly odd solution. The name was retained but the strapline changed to read "BVCA—The British Private Equity and Venture Capital Association".

  As criticism of high-profile private equity bids mounted earlier this year, the industry countered by stressing the link between the returns earned by private equity firms and the pension funds that are their largest single group of investors. Certainly, the funds raised by private equity firms to pursue large-scale buyouts do rely on pension fund and other institutional money. Profits flow back to the pension funds invested in successful transactions and, by extension, to the members of those funds. However, it is a little-publicised fact that most of this investment is from overseas. Figures from the BVCA, quoted in a report last November by the Financial Services Authority, the City's regulator, showed that, in 2005, 80% of the investment that flowed into UK private equity firms came from abroad. American institutions, principally pension funds, contributed nearly half this total. British pension funds were responsible for just 5%. Rather surprisingly for a country that prides itself on "small government", some of the biggest and most influential American pension funds are state-based and have many billions of dollars to invest, reflecting the contributions of millions of public employees, such as teachers. In February this year, Permira, Europe's largest private equity group, told the Financial Times that "six million teachers were invested in Permira's funds and were direct beneficiaries of its success". They failed to mention that none of these teachers reside in the UK. The British Teachers Pension Scheme, with 1.4 million members, is unfunded, which means that it has no assets to invest in private equity or anything else.

  Research by Financial News, the City's own weekly journal, suggests that less than 5% of UK pension funds have made any commitment to private equity, though some of the larger funds, such as BT Pension Scheme and Barclays Bank Pension Fund, have made significant allocations to private equity and intend to increase them. However, those that do invest in private equity allocate a much smaller percentage of their assets to it than the typical American public fund. Generally, British pension funds, with the exception of those with more than £10 billion in assets, have adopted a conservative stance on investing in "alternatives", the category that covers private equity and everything else outside the tried and tested mainstream of equities and bonds. The truth is that a link does exist between private equity returns and UK pension fund membership but it is a weak one.

  How many UK jobs are controlled by private equity firms? The figure from a BVCA survey, which has been quoted widely in the media, is 19% of private sector employees, equivalent to 2.8 million people. Again, this requires careful scrutiny. The 19% figure refers to every company that has ever received private equity funding, including those where private equity is no longer involved because it has exited. A much more useful figure is the number currently employed by private equity-backed companies. Last year, for the first time ever, the BVCA estimated this figure. The difference is huge. The actual number is 1.2 million—8% of UK private sector employees. Despite this, the myth persists that one-fifth of private sector employees work for private equity-owned companies.

  Investment banks love private equity deals for the simple reason that they are more profitable than corporate deals. Private equity transactions have played a key role in driving the current merger and acquisition boom in the City. In the last three years, buyouts have been responsible for over 20% of all M & A activity in London. No wonder that, within the investment banks, the executives heading the "financial sponsors" division are the heroes of the moment. Debt lies at the centre of any buyout, specifically loans and high-yield bonds. The rewards for arranging and participating in "leveraged finance" (the term used to describe funding a company with levels of borrowing above that considered normal) are substantial, markedly more than the relatively paltry fees charged for M & A advice. Some banks are also active in private equity on their own account, even though this can bring them into conflict with their customers, the buyout community. The truth is that it is too lucrative an opportunity to ignore. Investment bankers are not responsible for private equity tilts at public companies but the potential for money-making means that they have every incentive to encourage their clients to make such bids—which they do.

  To an extent that few realise, commercial banks—the familiar high street names among them—also occupy an important place in the private equity process. Barclays, Royal Bank of Scotland and HBOS (the parent company of the Halifax) are all active in the leveraged finance market, as are many others. However, unlike the situation a decade ago, these loans are not held by a handful of major banks but distributed around many institutions, including hedge funds. The result is lots of small exposures rather than a few big ones. At the end of last year, the Financial Services Authority warned that the terms on offer from banks to buyout firms "appear to approach the limits of prudence". Banks assess deals on the degree of leverage—the ratio of debt to equity. If they felt that debt levels were too rich, the banks could, if they so wished, call a halt and refuse to lend, so stopping the more extreme financing structures in their tracks. In that sense, the banks have the ability to "police" this market. They have not done so. Presumably the lure of superior margins on leveraged deals versus the thin returns from bread-and-butter corporate lending is a consideration. Equally, the limited exposure each bank has to a single buyout must serve to reduce the incentive to make waves and say "This structure is too risky and we will not lend". And so the boom goes on. Until something gives, as it assuredly will. In the unequivocal words of the regulator last November: "Given current leverage levels and recent developments in the economic/credit cycle, the default of a large private equity backed or a cluster of smaller private equity backed companies seems inevitable".

July 2007

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