Select Committee on Treasury Written Evidence

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 loan conditions.


  Private equity firms have long promoted the virtue of active ownership—the 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 company—in 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 companies—and the correlation of the results with cash-in/cash-out multiples2—identified 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 incentives—usually 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 the worst.

  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 deals—but only 33% of the worst—firms 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.

July 2007

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Prepared 22 August 2007