Private Equity In The Uk
July 9, 2007
Change is afoot in the world of private equity. Few would disagree that there should now be some tightening of the generous tax regime for private equity investment. But it is crucial that we do not undermine the future prosperity generated by private equity, not least in invisible exports, in an ar…
Change is afoot in the world of private equity. Few would disagree that there should now be some tightening of the generous tax regime for private equity investment. But it is crucial that we do not undermine the future prosperity generated by private equity, not least in invisible exports, in an area where the UK has become a world leader. The political and fiscal decision-makers must recognise the appeal for many players in this industry of working in a truly cosmopolitan environment.
Barely six months ago few people had heard of private equity in the UK. Today newspapers, and not only in the business pages, seem to talk of little else. The tax treatment of businesses bought up by private equity firms has become a political hot potato. For sure, much of this is down to campaigns orchestrated by Trades Unions worried about job losses, and as a backdrop to the recent contest for the deputy leadership of the Labour Party. However, the real catalyst for this public debate has been the concerns expressed by middle class professionals outside the financial services industry as to the astronomical wealth earned by affluent private equity principals in the industry. In short, the controversy about private equity is a symbol of the increasingly nagging concern that the benefits of globalisation have not been spread equally or fairly.
Over the past few years there has been a generous tax regime for private equity (of which more later). This was designed to reflect the value added by innovative venture capitalists and the risks incurred. On balance, it is difficult to fly in the face of the evidence ? generally (although not exclusively) businesses owned by private equity concerns have grown considerably faster, created more jobs and generated vastly higher profits than the public companies from which they were spun off. Indeed, the evidence is plain ? many leading management figures in public companies display less motivation, innovation or flair than those in companies where private equity involvement has restored value and undone the damage of previous managerial deficiencies. More often than not, the transformed businesses are more profitable and grow faster. The positive effects of private equity result in enhanced corporation tax receipts and a boost to employment.
Contrary to the view of some of its more vocal critics, private equity rarely brings with it job losses and asset stripping – except for those struggling businesses that would otherwise most likely have gone under without the resurgence that comes with radical business restructuring.
No, the real problem is that the financial services sector is increasingly regarded by a sceptical and bemused general public as a one way bet to untold riches. This is leading to enormous resentment, not least from the middle class, whose material expectations particularly in London and the South East are becoming increasingly bleak. The fact is that London’s financial services industry is a leading global performer. The rewards that flow to its most talented players reflect this fact. By contrast the civil service, the senior rungs of the NHS and education and many respectable private sector professions fail to offer such astronomical rewards. As a result, the markets in housing and private education, to name but two, have spiralled out of reach of those who, in a previous generation, might have expected to enjoy such returns from their often highly skilled qualifications.
The Labour government has rightly encouraged the private equity industry. It is a world leader, which otherwise might have left these shores to operate out of somewhere like Switzerland. The UK is at the forefront of this global industry. It is also worth reflecting on the positive effects that the threat of private equity involvement has had on many of our leading public companies. Management has sharpened up its act in the face of the potential of radical change.
Nevertheless, the generous tax regime, whilst justified for those entrepreneurs taking enormous risks, is less easy to understand for many of the operators in the private equity field. The taper relief arrangements, which reduce corporation tax on holdings of two years or more to just ten percent, encourage the structuring of corporate refinancing transactions to maximise the amount of debt. This has the effect of benefiting from a more generous taxation treatment, not least in the creation of ‘shareholder debt’ which behaves in some ways like equity but is treated as debt for tax purposes. But many in the private equity field are in effect financiers rather than risk takers. As such, it is surely more equitable for their rewards to be treated as income (and subject to a forty percent tax rate) not least as so much of the debt created in the structuring of their transactions is rapidly syndicated out to other banks.
There is also the treatment of ‘carried interest’ on a private equity fund which is taxed as a capital gain rather than as income. No one is suggesting that anyone in the private equity world is doing anything wrong ? however, it is clear that the Treasury’s granting of a more favourable regime was intended to reward genuine entrepreneurs. In principle, this means that where ‘carried interest’ looks like income, it should be treated as such for taxation purposes. Incidentally, it also makes good sense to treat capital gains and income more evenly and I anticipate the Treasury might reduce minimum taper relief to twenty percent in line with the level from next April of basic rate income tax.
Given the strangulating effect of ever greater and more obtrusive regulation on public companies, it is perhaps of little surprise that many companies choose to go down the private equity route. It is not a desire for unnecessary secrecy, more a reflection on the transparency that is expected of public companies in the modern age. Hitherto most companies subject to private equity have been ostensibly underperformers in their field and where the alchemy of talented new management has helped transform their fortunes.
However, as private equity becomes ever more popular so too does the level of complication in the debt instruments that are being created. There are even many in the financial services and banking industry who do not properly understand the operation of the debt obligations that are being created and sold off. The buoyant global economy and the wall of money available to financiers given historically low interest rates bring the risk of a systemic collapse. Once more it is important to stress that relatively few jobs are at risk. If a private equity backed company bought out at a price representing the top of an economic cycle were to fail, then once financially restructured, relatively few jobs would be at risk. The real losers in the event of a high profile private equity failure would be banks ? and by extension, their shareholders and pension fundholders who are naturally the type of people who are used to paying forty percent tax. The original private equity players are likely to be long gone.
Whilst rightly praising the private equity industry as an innovative world beater, we should not blind ourselves to the depth of feeling over its favourable ? which many regard as over-favourable ? taxation treatment. Whilst the primary concern of the government must be to ensure that London remains a global champion of financial services prosperity, it may also need to persuade private equity players not to put at risk the goose that lays their golden egg.
9 July 2007