Select Committee on Treasury Written Evidence

Memorandum from the Association of British Insurers (ABI)


  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.


  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.


  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.



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).


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.


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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