Supplementary memorandum submitted by
The Carlyle Group
During the hearing, the panel members asked
Dr. Easton to tell the committee how much Capital Gains Tax (CGT)
was paid by our firm. Dr. Easton did not provide an answer to
this question and it is important to clarify the reason for this.
CGT is not paid from the private equity fund
or by a Carlyle corporate entity. It is paid individually by the
investors who have provided capital to the private equity fund,
which is invested by the fund manager in underlying portfolio
companies. The investors include the limited partners and the
general partners of the fund, which include charities and pension
funds, high net worth individuals, corporations, financial institutions
and Carlyle employees.
All of these institutions and individuals are
subject to their own individual tax arrangements depending on
their status, and thus CGT will apply to each them in a way that
reflects that status. It is not therefore possible for Carlyle
to provide a figure on the CGT paid by the firm because CGT is
in fact paid by our individual investors, and this information
is unique to them.
The committee expressed an interest in receiving
further information about "covenant lite" loans, described
by the Bank of England's Quarterly Review (Q2 2007) as loans without
maintenance covenants (which place restrictions on the borrower
to be met on an on-going basis) but including "incurrence-only
covenants", which impose restrictions only in circumstances
where a specific event occurs, or have fewer maintenance covenants.
Covenant lite loan structures give companies
flexibility to navigate through periods when they may face difficult
economic pressures, pronounced cyclical downturns or external
shocks. Banks will not intervene as early as they otherwise might
if, for example, certain maintenance covenants were breached.
Therefore, where a covenant lite loan is deployed companies and
their management teams will have more ability to work through
their problems, which they would not necessarily have been able
to, had banks intervened and dictated the strategy of the company.
For example, if there was a temporary drop in profitability, a
business may be able to continue investing in growth, where, but
for the "covenant lite" loan, it might have been forced
to focus only on taking out costs, making redundancies or breaking
up the business and selling off assets.
Covenant lite loans have been arranged in Europe
for four companies (VNU World Media, Trader Media, Jupiter Asset
Management and Gartmore) which represent strong credit due to
their stable cash-flow generation. Covenant packages are negotiated
between arranging banks and companies owned by private equity
firms on an arms-length basis, and subsequently syndicated to
a variety of market participants, including traditional banks,
CDOs and hedge funds.
We believe that the Bank of the England correctly
identifies this emerging trend in Europe, the risks that it poses
and some of the ways in which those risks should be addressed.
We also concur with Paul Tucker of the Monetary Policy Committee
in his speech in the Quarterly Review, where he states that "covenant
lite" loans should not be seen plainly as a "bad thing".
He observes that while there are qualifications, "it would
seem that there is a good deal to welcome in the greater dispersion
of risk made possible by modern instruments, markets and institutions."
We agree with Mr Tucker's observation that banks should stress-test
their systems to ensure adequate capital and liquidity to absorb
stresses that may be caused by credit risk and hedging instruments.
In this regard, we would encourage the committee to receive guidance
from the banking community on this topic, as the lenders will
be able to give their own perspective on the reasons for changing
Private equity firms have long promoted the
virtue of active ownershipthe hands-on style that distinguishes
them from traditional portfolio investors. But what does active
ownership mean, and does it really lead to superior performance?
Recent McKinsey research reveals a strong correlation
between five steps that private equity firms can take to direct
a company in which they invest and out-performance by that companyin
other words, performance better than that of its industry peers.
Many private equity firms have embraced these steps and execute
them well, yet surprisingly few do so in the consistent and systematic
way that would increase the returns from an active-ownership approach.
Eleven leading private equity firms, all boasting
better-than-average track records, made up our sample. Each of
them submitted five or six deals from which they had exited. The
deals represented a range of returns from average to very good.
To calculate the value generated by active ownership, we built
a model to isolate the source of each deal's value: overall stock
market appreciation, sector appreciation, the effect of extra
financial leverage on those market or sector gains, arbitrage
(a below-market purchase price), or company out-performance.
The main source of value in nearly two-thirds
of the deals in our sample was company out-performance. Market
or sector increases accounted for the rest. Out-performance, which
generated a risk-adjusted return twice that of market or sector
growth, was the least variable source of value.
These results show that out-performance by companies
is clearly the heart of the way private equity firms create value.
How do top investors make this happen? Interviews with deal partners
and with the CEOs of target companiesand the correlation
of the results with cash-in/cash-out multiples2identified
five common features that could constitute a code of leading-edge
practice. The first two concern traditional private equity competencies,
the other three a more engaged form of corporate governance that
we describe as true active ownership.
First, successful deal partners seek out expertise
before committing themselves. In 83% of the best deals, the initial
step for investors was to secure privileged knowledge: insights
from the board, management, or a trusted external source. In the
worst third of deals, expertise was sought less than half of the
time. Second, successful deal partners institute substantial and
focused performance incentivesusually a system of rewards
equaling 15-20% of the total equity. Such incentives heavily target
a company's leading officers as well as a handful of others who
report directly to the chief executive. In addition, best-practice
deal partners require CEOs to invest personally in these ventures.
There is no standard formula, but the most successful arrangements
call for a significant commitment by CEOs while ensuring that
the potential rewards don't make them too risk averse. Formulas
that failed to account for the individual circumstances of a company's
officers or that spread incentives too widely proved less effective.
Next, successful deal partners craft better
value creation plans and execute them more effectively. Naturally,
management's plan is a part of the process, but the best new owners
view it skeptically and develop their own well-researched viewpoint
that they use to challenge it. Once developed, the plan is subject
to nearly continual review and revision, and an appropriate set
of key performance indicators is developed to ensure that it remains
on track. Firms implemented such a performance-management system
in 92% of the best-performing deals and only half as often in
Fourth, the most effective deal partners simply
devote more hours to the initial stages of deals. In the best-performing
ones, the partners spent more than half of their time on the company
during the first 100 days and met almost daily with top executives.
These meetings are critical in helping key players reach a consensus
on the company's strategic priorities: relationships are built
and personal responsibilities detailed. A deal partner may use
the meetings to challenge management's assumptions and to unearth
the company's real sources of value. By contrast, lower-performing
deals typically took up only 20% of the investors' time during
this crucial period.
Last, if leading deal partners want to change
a company's management, they do so early in the investment. In
83% of the best dealsbut only 33% of the worstfirms
strengthened the management team before the closing. Later in
the deal's life, the more successful deal partners are likelier
to use external support to complement management than are the
less successful deal partners.
These research findings pinpoint the practices
that distinguish great deals from good ones. The five steps are,
in the main, uncontroversial. They are applied inconsistently,
however, and their implementation seems to depend on the individual
partner's beliefs and skills. A standard active-ownership process
that applies and develops best practices is the next step for
the private equity industry.