Private equity investment, backing venture capital and management buy-outs, has been around a long time. Private-equity takeovers of public companies listed on the stock exchange are a more recent development; and the number and size of such transactions has increased dramatically. Since some identified individuals have made enormous fortunes, inevitably there has been a bit of an outcry.
Several forces have come together. Abundant liquidity has made banks ready to lend large amounts of money at interest rates which are still low by historical standards. Energetic entrepreneurs have spotted that they can exploit opportunities arising from the way the stock exchange values some companies. On top of this, tax changes have made the net returns seriously attractive, assuming all goes well.
The stock exchange arrives at market prices which suit buyers and sellers; but fund managers have to perform and are judged on a quarterly or half-yearly basis. Chief executives, under pressure to avoid disappointments, often judge that capital spending with long-term horizons and high levels of gearing is too risky.
There is nothing inappropriate about all this; but it’s easy to see the contrast between conventional public-company management constraints and a confident private owner who has a plan to grow the value of the business and is not distracted by burdensome governance rules, much of which are ‘box-ticking’ stuff. If the entire company can be acquired and the strategy for improvement looks sound, the bulk of the purchase cost, say 70 per cent, can be borrowed. Since interest payable to an independent bank is tax deductible, this is economical capital for someone willing to take the risk.
Backing the entrepreneur who promotes the deal is a group of investors formed as a limited partnership. They put up the required capital. They allocate to the promoter and executive management, either free or at a very low price, a ‘carried interest’ which yields perhaps 20 per cent of the profits after passing a hurdle which gives the other investors a basic return.
This is where the favourable tax rates come in. The rules are complicated, but roughly what happens is this: assuming the target is a trading company, it counts as a ‘business asset’ and the taxable capital gains of the managing individuals are reduced by ‘taper relief’ by 75 per cent after two years. This leaves 25 per cent to be taxed at 40 per cent, which comes out at 10 per cent. The attraction of paying capital gains tax at 10 per cent instead of 40 per cent is one of the reasons driving the private equity trend.
However, the buyers have to be relatively patient. There is no easy get-out if things go wrong. Unlike listed shares which can be sold on the market, the exit from these deals is either to sell the business to a trade buyer or to re-float it on the stock exchange. It takes time for the new management to produce improved results and achieve a sale price high enough to make a profit. Everything has to go right.
The idea that private equity purchases are usually short-term investments is wrong. There is plenty of risk — although few deals have gone wrong so far. Since the company’s management is totally aligned with its ownership, without distractions, and is highly incentivised, most transactions work out well.
But there are complaints that the tax relief is unfair and the whole process is too secret. Sir David Walker’s rather tentative report released last week (tax was outside his remit) comes out in favour of much more public disclosure. The private equity sector, he says, ‘has come to be seen as needlessly secretive, feeding suspicion and in some quarters [something] close to hostility’. But an important part of the very attraction of the activity is that management is free from the distractions of public reporting with pious statements about employment policy, corporate values and their role in the community.
Sir David knows this, but he equates reluctance to publicise with secrecy and thinks public reporting would be good for business. He may be right, but sceptics may think it will just provide more food for critics; moreover, it is more than other private companies have to do.
The Treasury select committee is also due to issue an interim report on private equity this week, with its full findings to come in the autumn and again likely to be critical. Labour MPs on the committee were very aggressive in their questioning of private equity chiefs — and it is true that a few cases of pure asset-stripping have damaged reputations. Sometimes the new management cuts the labour force for reasons of efficiency but, overall, the evidence is that private equity investment increases employment. One well-known provider of private equity, 3i, reckons that employment has increased by 11 per cent in companies it has backed. Trade unions (whose business is complaining about capitalist behaviour) are, as usual, barking up the wrong tree. More reporting might conceivably help show this up.
Under the new owners, with bank debt around their necks, life for the executive management is fundamentally changed. No longer is the chief executive the star attraction in the boardroom, with board members hanging on his words, generous compensation, including pension, and profiles in the press. The owning shareholders are no longer passive portfolio managers. The executive management has to be ready to face a single-minded new shareholder exercising constant surveillance, with demanding targets, frequent inquisitions and telephone calls at all hours. Obligations to the bank must, on no account, be missed. Life is very different. It was not surprising that Richard Baker, chief executive of Boots, decided he did not want to go on with Stefano Pessina, who was clearly going to be a highly executive chairman.
Is the tax treatment justified? It is well understood that tax incentives can be used to encourage desired economic results. Think of growing timber, or Lloyd’s of London, magnetising insurance business to London before greed and fraud temporarily damaged that institution 25 years ago.
Gordon Brown, having seen how business investment is nurtured in the US, and knowing how much the UK needs entrepreneurial energy, decided that private equity ownership must be encouraged to produce worthwhile private enterprise. So capital gains tax taper relief was introduced in 2000, and has been increased twice since. This does not lessen the risk; but it does enormously increase the rewards if all goes well.
It is true that wide rate differentials re-energise the tax avoidance industry, and some think taper relief for private equity managers is unfair. Some respected voices, including the Financial Times, think their gains should be taxed as income, though this would certainly deter some of them al-together. And, after all, fairness in tax is an elusive goal, and the UK’s rules are not far out of line with international standards. Often the whole operation could be done abroad anyway. So toughening up the rules might drive it all offshore.
Knee jerks should be avoided.
Sir Martin Jacomb was, among other senior City posts, chairman of Prudential and a director of the Bank of England; he is currently chairman of Canary Wharf Group. He writes here in a personal capacity.