Further memorandum submitted by Dr Tony
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 equityor "venture capital" as it preferred
to be calledconducted 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 territoryas when buyout firms were tempted
into dot.com investment at the height of the internet bubbleit
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 leveragedcompanies
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 jargonby 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 companiesthey 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 "BVCAThe British Private Equity and Venture
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 million8%
of UK private sector employees. Despite this, the myth persists
that one-fifth of private sector employees work for private equity-owned
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 bidswhich they do.
To an extent that few realise, commercial banksthe
familiar high street names among themalso 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 leveragethe 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".