Memorandum from the Association of British
Insurers (ABI)
INTRODUCTION
1. This paper is the response of the Association
of British Insurers (ABI) to the Treasury Committee's invitation
to submit further evidence to its inquiry on private equity. ABI
members as institutional investors have around £1.3 trillion
of funds under management, which includes around 20% of UK-listed
equities, plus substantial other investments in UK financial assets
including fixed interest stocks and investments in unquoted companies.
As such they are concerned to see that private equity contributes
to the overall health of the investment markets. More specifically
they are themselves investors in private equity as well as investing
on behalf of third party clients.
EXECUTIVE SUMMARY
2. The final proposals from Sir David Walker
on transparency have been strengthened as regards the monitoring
role for their effectiveness but their scope has been narrowed
to exclude portfolio companies with less than half of their turnover
sourced from the UK. This reduces the all-purpose usefulness of
the guidelines though investors in private equity will be able
to fall back on existing disclosure which is largely adequate.
Disclosures proposed to be made at fund level have also been scaled
back.
3. Private equity should operate on a level
playing field. It is well-placed to take advantage of the imbalance
of tax treatment of debt and equity capital but the remedy for
this should be reform to achieve a sensible rebalancing, not penalisation
of private equity. Tax treatment of carried interest equally needs
to fairly reflect the nature of such earnings taken by general
partners. On the assumption it will continue to fall within the
CGT regime we do not believe there are cogent arguments for a
more favourable tax rate than the 18% designed to apply across
the board for capital gains.
4. The private equity and quoted plc models
are different. This reflects not just the needs of the businesses
owned but also the very different investor and capital bases.
This in turn produces different governance and financial structures.
Private equity is characterised by concentrated ownership giving
rise to shareholder representation on the Board, high debt levels
and a more defined investment time horizon. This contrasts with
quoted companies where shareholders look to the Board, including
its non-executive directors, to run the company on their behalf.
However, in doing so, Boards will need to be responsive to the
expectations of investors.
GENERAL COMMENT
5. We do wish to emphasise, at a general
level, that the private equity industry works well as regards
information flows to its investors. Appropriate levels of transparency
allow informed investment decisions to be made. Nevertheless,
there is scope to enhance further the flows of information about
private equity funds for the benefit of investors. We consider
that this focus on responding to the information needs of investors
is the appropriate organising principle around which greater transparency
in private equity can best be provided.
QUESTIONS FOR
CONSULTATION
TRANSPARENCY
Sir David Walker's proposals for improving the
transparency of the private equity industry; including;
The structure and effectiveness of the recently
established BVCA panel for monitoring, and encouraging compliance
with, the code of conduct
6. The changes that Sir David Walker has
proposed in his Final Report for a more explicit and independent
monitoring process of the Guidelines are a welcome strengthening
reflecting a clear consensus that the initial proposals did not
in this respect go far enough. It is essential that the proposed
"comply or explain" framework be made to work. This
is a framework that works well in the quoted equity sector where
shareholders make judgments as to the appropriateness of departures
from best practice benchmarks, and this informs their on-going
relationships with the companies in which they invest. Their enlightened
self-interest helps ensure that governance arrangements are made
to work but participants in private equity are in a somewhat different
position.
The appropriateness of the proposed level and
type of disclosure for the various stakeholders in private equity-owned
businesses
7. The concern as to transparency relating
to companies owned by private equity has been the withdrawal of
the disclosures that would be made in the normal course of events
by quoted companies to their shareholders and, by extension, other
investors and other interested parties (stakeholders). We consider
that the Report's recommendations to replicate this approach to
disclosure are correct. This approach is not, therefore, concerned
about reporting to but, rather, about stakeholders. This does
not, however, impair its value by extension as a reporting tool
to those stakeholders.
Proposals for a respected capability for providing
comprehensive, industry-wide data on the private equity industry
8. These proposals for industry-wide data
for private equity are appropriately pitched and we hope that
the BVCA will be able to take this forward in an effective fashion.
The private equity-owned companies to be covered
by the code
9. We consider that the final Guideline
formulation to be a step backwards from the original proposals
in Sir David Walker's Consultation Document.
10. As regards reporting by portfolio companies,
the trigger criteria for enhanced reporting have been changed
from a size of consideration or size of workforce formulation
to one that kicks in when size of consideration and size of UK
workforce exceed the previously suggested thresholds. However,
this is all subject to a new criterion that the proportion of
revenues generated in the UK exceeds 50% of the total.
11. We consider that the scope of reporting
obligations should be consistent, as far as possible, with the
scope of reporting by quoted companies. Many companies with their
principal stock market quotation in the UK have turnover of significantly
less than 50% in the UK but they are no less a constituent of
the UK corporate sector on account of this. It would have been
better for the Report to have used the opportunity presented by
consultation feedback suggesting that UK turnover should be a
relevant criterion by adding this whilst leaving the rest of its
original formulation unchanged.
12. As regards reporting by private equity
firms the obligations appear to have been scaled back. Disclosure
of philosophy of approach to employees, working environment and
corporate social responsibility are dropped; there is less visibility
on attribution analysis between operational performance and financial
engineering (where any data will now be cross-sector rather than
on a firm-by-firm basis); and other aspects of disclosure are
to be made UK-specific (eg it is how the FSA-authorised entity
within the firm on which disclosure of investment approach, identification
of senior management etc).
TAXATION
The tax treatment of debt and equity
13. Our earlier submission to the Committee
outlined our view that there are tax disadvantages of equity compared
to debt finance that are material and which have grown. This has
created an unlevel playing field which the private equity sector
has been well positioned to take advantage of. It has done so
through exploiting the consequent advantages of increased leverage
whilst investment through private equity has proved a particularly
tax-efficient route for tax-exempt institutional investment funds,
such as pension funds, to obtain investment exposure to the fruits
of business enterprise. We do not believe that private equity
should be penalised on this account but, rather, we see merit
in a more fundamental reappraisal of how the tax system can ensure
an appropriate balance in the treatment of debt and equity finance,
for the benefit of all investors.
14. There has been discussion about the
extent to which anti-avoidance arrangements should be used in
the tax system to prevent excessive use of debt where the reality
is that a corporate entity requires genuinely committed equity
capital. However, the more enlightened approach should be to consider
why debt finance should enjoy particular tax advantages compared
to equity, or vice versa, and to reassess whether some degree
of convergence should be sought. The introduction of the dividend
imputation system in the 1970s achieved much in this regard but
recent changes have lost some of the advances that were made then.
The Memorandum of Understanding between the BVCA
and HMRC
15. Arguments as to whether carried interest
should be treated as income or capital gains are relatively finely
balanced and we see no particular need to challenge the basis
of the memorandum of understanding in so far as it establishes
the treatment as capital gain. However, qualitatively, this type
of return is different and it does not involve genuine commitment
of capital over time by the private equity general partner. Its
specific characterisation as, for example, a long-term gain over
the life of the fund since inception, is somewhat more difficult
to sustain.
Options for further reforms of shareholder debt
and employment-related securities
16. We have no observations on treatment
of shareholder debt other than to emphasise that this would be
less of a difficulty if there were a more level playing field
as regards taxation of debt and equity capital.
17. As regards taxation of employment-related
securities our understanding is that for many recipients of such
securities as part of their remuneration and incentivisation benefits
a capital gains tax liability seldom eventuates as the tax free
annual allowance is sufficient to cover the gain. For high-paid
participants, the benefits of treatment as a CGT liability rather
than as liable to income tax at full marginal rate is significant
and it is difficult to conclude that withdrawal of taper relief
and bringing this within the new and generally applicable 18%
CGT rate is an unreasonable or injudicious change.
The appropriateness of the tax regime for private
equity, in the light of recent changes to capital gains tax
18. In the context of private equity, the
change to the CGT regime is of particular relevance to treatment
of general partners' carried interest. Consistent with our earlier
comments, we consider that liability to this tax at 18% but with
withdrawal of taper relief would be difficult to characterise
as constituting unfair treatment for carried interest recipients.
We recognise that comparative attractiveness of other tax jurisdictions
and the impact this has on decisions as to tax domicile is of
greater practical force in giving weight to arguments for maintaining
tax rate on carried interest at what may still be considered a
comparatively low level.
OTHER ISSUES
Why investors make different demands of public
companies compared with private equity-owned companies
19. The principle that companies and their
businesses are run in a manner that seeks to maximise value over
time applies equally to quoted and private equity investments.
20. Investors in quoted equities wish to
see growth in shareholder value usually marked by dividend income
which is sustained but with growth over time. This should reflect
underlying business performance and generation of cash flows whilst
providing sufficient balance sheet resilience so that the objective
of long-term shareholder value creation is not compromised by
short-term financial exigencies. Decisions as to the appropriate
capital structure of the corporate entity will be a function of
the views of the board in the context of their understanding of
the expectations of the company's investors. By contrast, the
business model of private equity will often involve a more closely
targeted objective that can create enhanced incentives and disciplines
to perform but which may provide less resilience and therefore
require a change in strategy for the business. The close involvement
of the shareholder, generally through representation on the Board
underpinned by a shareholder relationship agreement, will be therefore
be of key importance to the governance of the investee.
21. The managements of businesses in private
equity ownership which perform effectively may receive substantial
reward but, conversely, may be replaced at short notice with limited
contractual compensation for affected individuals when it fails
to do so. The members of plc boards are in a qualitatively different
position with major responsibilities to manage the company's business
including relationships with stakeholders and, in so doing, to
generate value and meet the expectations of shareholders and of
the investment markets. The governance structure, as provided
for under the Combined Code, will be much more principles-based
than for private equity. The status of quoted plc directors, their
powers, and their responsibilities and the best interests of the
company are all relevant in determining what tenure, remuneration
and incentive arrangements are appropriate.
22. The private equity model differs considerably
from the quoted plc model but it is one that will be appropriate
for some companies and businesses, either temporarily or on a
more permanent basis. As well as the circumstances of the businesses
owned, private equity's divergence from the norms of the quoted
equity sector also reflects the materially different nature of
its investor base and the pools of investment capital that it
taps. It is unsurprising that there are significant differences,
therefore, in the governance of businesses in private equity ownership
compared to those on the quoted market, and also in the manner
of their financing, and that investors, bearing in mind their
own objectives, will recognise the value of both approaches.
The implications of private equity-funded takeovers
for company pension funds
23. It is important that decisions to take
companies into private equity ownership are not motivated by plans
to gear up the investee company and thereby reduce the effective
value provided by the company's covenant as sponsoring employer
of its pension schemes. Equally it would be wrong for the existence
of pension schemes and the interests of their members to be used
to inhibit or prevent corporate transactions merited on other
grounds.
24. The powers of The Pension Regulator
to provide clearance and to impose conditions such as for injection
of additional funds into the scheme to raise the funding level
are appropriate and helpful. It is important, though, that they
are used in a proportionate manner to ensure that members are
not disadvantaged but without enhancing their position by more
than is necessary to offset the effects of the corporate transaction
for which clearance is being sought.
The operation of TUPE in private equity takeovers
25. Where a business undertaking and its
employees are transferred from one company to another, or into
or out of the public sector, the Transfer of Undertakings (Protection
of Employment) Regulations provide an appropriate framework for
treatment of the contractual position of employees. Where the
identity of the owners of the shares of a company changes, whether
slowly over time or more abruptly, there is no such change in
the contractual position of employees and TUPE is not applicable.
There is no reason why it should be made applicable; indeed it
would be wrong in principle to do so as well as very difficult
in practice.
Market abuse and conflicts of interest in private
transactions
26. These are primarily issues for the Financial
Services Authority (FSA) to address. They consulted last year
in "DP 06/6—Private Equity: A Discussion of Risk and
Regulatory Engagement", to which the ABI responded. We emphasised
our concern that leakage of information within the investment
banking sector, which is heavily involved in both public and private
equity markets, remains an obvious risk if their structures and
processes are inadequate or otherwise ineffective. Responding
to the requirements imposed under Markets in Financial Instruments
Directive (MiFID) will hopefully have helped firms to ensure that
their internal structures and processes are well specified and
robust and minimise these risks. We have argued that a more specific
focus by the FSA, given the challenges posed by private equity
conflicts, could be helpful.
December 2007
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