Private Equity/venture Capital Industry
January 30, 2008
Mark tabled a debate in Westminster Hall on the regulation and future of the private equity industry. He received a response from Angela Eagle MP, the Exchequer Secretary to the Treasury.
Mr. Mark Field (Cities of London and Westminster) (Con): Change is afoot in the world of private equity. Only a diehard few would now oppose the principle that there should be some tightening of the generous capital gains tax regime for private equity investment. The Government have made an utter mess of their capital gains tax reform, culminating in the need for clarification only last week. That confusion risks further anti-avoidance measures being required.
In fairness, it is worth looking at the issue in some perspective. A capital gains tax regime that is simplified is something to be welcomed, especially if it is simplified at a relatively low level, historically, of 18 per cent. It is fair to say that most business folk who operated during much of the period between 1945 and 2002 would have rejoiced at the prospect of a sale of business giving them some 82 per cent. of tax-free gains.
In relation to private equity, it is crucial that we do not undermine the future prosperity that will be generated by the industry, not least in invisible exports. It is an industry in which the UK has become a world player second only to the United States. Some 60 per cent. of Europe’s private equity industry comes from these shores. The political and fiscal decision makers must recognise the appeal for many players in the industry of working in what is now a truly cosmopolitan environment.
Barely 12 months ago, few people in the UK had heard of private equity. Indeed, even in the United States, it was only the listing last year of Blackstone, which is widely regarded as one of the three leading practitioners of the dark arts of private equity, that helped to create a culture of greater public scrutiny.
For a time last summer, thanks to people such as the Minister, who was perhaps playing a somewhat different role then, as a member of the trade union-loving Treasury Committee, from the one she might play today?we look forward to hearing her comments later?the newspapers, and not just the business pages, seemed to talk of little other than private equity matters. Although the catalogue of Government misfortunes, from Northern Rock to the credit crunch to domestic economic difficulties, has taken private equity out of the news today, I think that that situation will change.
The tax treatment of businesses bought up by private equity firms is likely to remain a hot political potato. For sure, that will largely be down to campaigns orchestrated by trade unions that are worried about job losses, but it will also be because the issue of private equity firms has been a backdrop to the recent contest for the deputy leadership of the Labour party. However, the real catalyst for public debate has been the concerns expressed, often by middle-class professionals outside the financial services industry, about the astronomical wealth earned by affluent private equity principals in the industry. In short, the controversy about private equity is, to my mind, a symbol of the increasingly nagging concern that the benefits of globalisation have not been spread either equally or fairly.
Much of that discussion belongs to a far broader debate; indeed, I suspect that it will be the backdrop to quite a lot of debates that will take place not just in this Chamber but more widely in this country and across the western world in the decades ahead, particularly with the emergence of China and India as great economic superpowers of the future. I think that we will return to that issue?the way the spoils of globalisation appear to be very unequally spread?during many of those debates and they will no doubt agitate public policy makers. However, the important issue, and it also applies to private equity, is not to take too much of a short-term view. There needs to be a sense of perspective, taking in both the past and the future, to determine what is in the broader interests of this country.
Over recent years there has been a relatively generous tax regime for private equity investment, about which I will say a little more later. That regime was designed in part to reflect the value that was added by innovative venture capitalists and the risks that they incurred. On balance, I believe that 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 considerably more jobs and generated vastly higher profits than the public companies from which they were originally spun off. Indeed, the evidence is plain: leading management in public companies display less motivation, innovation or flair than decision makers in companies where private equity involvement has restored value and undone the damage caused by 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, of course, a boost to broader employment.
Contrary to the views of some of its more vocal critics, private equity rarely brings with it job losses and asset stripping, except for those struggling businesses that otherwise would probably have gone under without the resurgence that often accompanies radical business restructuring. Indeed, for the financial year 2006-07, the last for which we have reliable and up-to-date statistics, it is estimated that private equity-backed companies generated total sales of some £310 billion, created exports of £60 billion and contributed some £35 billion in taxes to the UK economy. That is all very much a good news story, and one that perhaps has been somewhat lost in some of the negative publicity that venture capital and private equity have received.
It seems that the real problem is that, even after recent economic hiccups, the financial services sector is increasingly regarded by a sceptical and bemused general public as a one-way bet to untold riches. That perception is leading to enormous resentment, not least from the middle classes, 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 that fact. By contrast, the civil service, the senior rungs of the NHS and education, and indeed many respectable private sector professions fail to offer such astronomical rewards. As a result, the markets in housing and private education, to name just two, have spiralled out of control and out of the reach of those who, in a previous generation, might have expected to enjoy such returns from their often highly skilled qualifications.
The Labour Government have rightly encouraged the private equity industry to thrive on these shores, and they have to take a certain amount of credit where credit is due. The private equity industry here is a world trend-setter, which otherwise might have left these shores to operate somewhere else, for example, Switzerland. The UK is at the forefront of that global industry. The private equity industry here employs some 18,000 people in 1,500 firms and it helped to generate some £5.5 billion domestically last year in fees for legal, accounting and other professional service firms.
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. Unarguably, management in the public markets has been inspired to sharpen up its act in the face of the potential for radical restructuring by potential bidders.
Nevertheless, the generous tax regime, although it is justified for those entrepreneurs who take enormous risks, is less easy to justify for many of the operators in the private equity field. The taper relief arrangements, which from 2002 reduced corporation tax on holdings of two years or more to just 10 per cent., encouraged?perhaps over-encouraged?the structuring of corporate refinancing transactions to maximise the amount of debt. That has had the effect of allowing companies to benefit 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.
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 more like income, and therefore subject perhaps to higher tax rates, not least because so much of the debt created in the structuring of their transactions is rapidly syndicated out to other banks. Therefore, I firmly believe that the creation of a standard 18 per cent. simplified rate of capital gains tax is to be welcomed. I hope that that will be driven through properly by the Government in the months ahead, not least in view of the confusion that has reigned supreme recently.
Also controversial has been the treatment of "carried interest" on private equity funds, 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 in the past was intended to reward genuine entrepreneurs. In principle, that surely must mean 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 that a future Conservative Treasury would seek in time to reduce to 18 per cent. the basic rate of income tax in line with the level of CGT to apply from April.
Given the strangulating effect of ever more obtrusive regulation on public companies, it is of little surprise that many companies have chosen to go down the private equity route. They have not done so simply out of a desire for greater secrecy; it is a reflection on the level of transparency expected of public companies in the modern age.
Mr. Brooks Newmark (Braintree) (Con): For clarification, the reason that the UK is so successful in attracting private equity is our historically?in recent years?attractive tax regime. I hope that my hon. Friend is not suggesting that carried interest should be viewed as income, because all other major western countries view it is a capital gain. It is important that, in order to remain competitive, the UK maintains a competitive carried interest regime.
Mr. Field: I accept my hon. Friend’s point. He has a track record in private equity and has been a big supporter of it in various debates in the Treasury Committee. I want income to be treated as income, and capital as capital. There has been a muddying of the water, and if it were my job to look after such matters, as it is the Minister’s, I would take a slightly harder line than perhaps my hon. Friend would prefer. In considering carried interest, we should look beyond the benefits that perhaps have applied in recent years. In effect, some elements of carried interest constitute income, and should be taxed accordingly.
I shall return to the causes of so many of the problems in the public markets. A level of transparency is expected of public companies that is out of kilter with the desires of many who run them. The disequilibrium between public and private company requirements makes the latter route attractive.
The Exchequer Secretary to the Treasury (Angela Eagle): The hon. Gentleman is making some interesting points. If he thinks that there is a problem with transparency of public companies, does he think that the answer is to level the playing field on transparency by ratcheting up private equity to public company level, or by ratcheting the latter down to private equity level?
As I was saying, I think that the disequilibrium is such that there has been too much regulation and expectation, not just of transparency?we all want transparent markets?but of bureaucracy in the hands of public companies, which runs the risk of some businesses moving to different shores. We are living in a globalised world, for which we should rejoice.
Mr. Newmark: Although I might disagree with my hon. Friend on his tax analysis of the regime that we should have, he makes an excellent point about regulation. On transparency, which was a point brought up during Treasury Committee hearings, I hope that he supports the Walker review and its suggestions for the behaviour of private equity.
If public markets worked efficiently, there would be very little need for private equity. Hitherto, most companies subject to private equity have been ostensibly underperformers in the public market, and the alchemy of talented fresh management has helped to transform their fortunes, which is why the leading players in UK private equity and venture capital are comfortable adopting in full Sir David Walker’s guidelines on transparency and disclosure. The industry recognises the need to comply with effective self-regulation, with financial statements and annual reviews being the norm. That rather than Financial Services Authority or Government intervention is the right way forward.
As private equity becomes more popular, however, so too does the level of complexity in the debt instruments being created. There are even many in the financial services and banking industry who do not properly understand the operation of some of the debt obligations being created and sold off, as we have seen to our cost globally in recent months. The buoyant global economy and the wall of money available to financiers, given historically low interest rates, bring with it 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, once financially restructured, relatively few jobs would be lost. 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 might be used to paying higher rates of tax. The original private equity players are likely to be long gone.
The year ahead for private equity will, I suspect, be dominated by the emergence of sovereign wealth funds. The fear is that their investment in UK business will simply reopen the debate on transparency and disclosure, which the Walker report was designed to close. Indeed Delta 2, the Qatari sovereign wealth fund, whose bid for Sainsbury’s last autumn fell only at the final hurdle, had agreed to abide by the terms of the Walker report, which is to be supported. These SWFs, from India and the middle east in particular, but also from places such as Russia, I suspect, given the sustained high oil and gas prices, will look to invest aggressively especially where falling stock markets provide good value in public company shares. It has been estimated that those funds have anything up to $3 trillion at their disposal. Ideally they too should be subject to Walker-style self-regulation, as a matter of course.
In conclusion, traditionally in the UK we have an open approach to overseas investment. The City, and the UK as a whole, rightly welcome business from investors of all nationalities. If that culture is not to be threatened by public outcry, it is to be hoped that 2008’s new big thing?sovereign wealth funds?will recognise that the spirit of the age demands responsible investment with a code of conduct governing its behaviour.
The Exchequer Secretary to the Treasury (Angela Eagle): I congratulate the hon. Member for Cities of London and Westminster (Mr. Field) on securing today’s timely debate on one of the most interesting phenomena in our ever-evolving and changing dynamic marketplace. It is important and true to say that although private equity has been growing it remains a relatively small part of our overall economy. It is not a form of ownership that the Government particularly favour over other models.
With the hon. Gentleman’s expertise as secretary of the all-party group on private equity and venture capital, he made a positive case for private equity where it works well. I do not particularly disagree with any part of his analysis. However, we think that what matters for investors, companies, employees and the economy as a whole is not the form of ownership, but how effectively it is exercised in promoting the long-term creation of value, investment, growth and employment.
As the hon. Gentleman was gracious enough to hint, and possibly even state explicitly, over the past 10 years, the Government have made real progress in promoting long-term decision making on investment. We have taken important steps to make our economy more dynamic, to enhance competition and to deal with the challenges of globalisation. We could have a very interesting debate on how that might play out in popular belief, and on the fact that worries and insecurities are never the right basis for taking long-term decisions. However, both sides of the House will admit that we have to deal with those insecurities and worries if we are to continue to make the case for what has been the UK’s traditional approach to living and doing well in the world?an open and dynamic economy facing out to the world rather than turned in on itself.
We believe that the changes we have made have helped businesses to raise finance. The private equity sector is disparate; it ranges from private equity by-outs to the provision of venture capital and investment by business angels in small start-up companies, and includes everything in between. Evidence at the smaller end of the scale shows that most businesses are raising the finance they need?in fact, more than 85 per cent. obtain it at the first attempt. However, for the minority of businesses that are unable to do so, the Government have designed a range of measures to help; the enterprise capital funds, for example, are intended to address the equity gap that many small but potentially high-growth businesses face. The funds are run by private sector fund managers who make commercial investments, but they invest a mix of public and private money, with the Government providing up to £2 for every £1 of private money. The total Government commitment to those funds is more than £140 million, and it will continue at £50 million a year by 2010-11, providing the seed corn for a generation of new and potentially high-growth businesses. That is in our interest.
The Government have also reformed the tax system to encourage innovation and investment. I discerned from the hon. Gentleman’s comments a basic agreement with the approach to capital gains tax. Despite issues about the detail, he was gracious enough to point out that we now have one of the lowest and most competitive rates of capital gains tax?at least we will by April.
We have also reformed the tax system. For example, the enterprise investment scheme has raised about £6.1 billion, which has been invested in more than 14,000 small, higher-risk companies. Venture capital trusts have invested another £3.3 billion in more than 1,400 companies. Those schemes help to encourage the creation and growth of new firms, and they can also be a less focused-upon part of private equity. They ensure that anybody with the potential to succeed in business has the opportunity to do so if they can sell their ideas to the funds, and they have helped the number of small businesses in the UK to rise by 760,000 since 1997.
Mr. Field: The Minister has quite rightly given more details?as I did not in my additional comments?about seed-corn finance for smaller businesses, and the Government rightly place much importance on innovation and flair. One could not possibly disagree. Likewise, the simplified capital gains tax regime is an important element. However, my concerns were about when private equity clashes with public companies. Are the Government not concerned that the public markets seem to be so unattractive to companies of that size that they choose private equity as the route to run their businesses?
Angela Eagle: We must examine the trends of the different choices that business people can make, and the balance between them, and the different business models that can be adopted. I recognise the point that the hon. Gentleman makes, but at the same time, it is also important to recognise that transparency in public companies is to ensure that shareholders have appropriate access to the information they need to make business decisions. Some of the private equity issues that the Walker report dealt with were precisely about valuation and trying to assess what is going on in funds, to ensure that in the private equity model, investors are certain about what is being done in their name, and with their money.
There is a general case for transparency, and the hon. Gentleman made it when he talked about possible issues in the future with sovereign wealth funds and transparency. We must keep the issues under review, but the recent changes to company law got the balance about right. We note with approval the Walker report and its comments about transparency, annual reviews and the need to ensure that the private equity industry addresses the detail of valuation and activity, which the Myners review also pointed out.
On buy-outs, the hon. Gentleman is quite right: at their best, private equity companies can make changes to businesses through restructuring, efficiency to give the business a better future, a shorter management chain, clearer targets and accountabilities and stronger incentives. There are good and bad examples of how private equity works, as there are with all generic models. The hon. Gentleman can cite some good ones, but there have been some not so good examples, too. The Government want best practice in all areas, leading to fitter companies that can deal with change more effectively and, therefore, survive in good health to provide growth and investment opportunities. That is what we want to encourage, and I hope that there is no disagreement in the Chamber about that.
On executive remuneration, the hon. Gentleman’s view was disputed by his hon. Friend the Member for Braintree (Mr. Newmark), and I do not want to interfere in what is obviously an interesting debate on the Opposition Benches. However, I make it clear that we remain interested in all aspects of rewards to people involved in private equity. That includes application of the legislation on employment-related security, some of which touches on the issues that the hon. Member for Cities of London and Westminster raised, and the tax treatment of carried interest and management fees. We will continue to keep those issues under review. The hon. Gentleman has his own views, but his hon. Friend the Member for Braintree disagrees?at least on that point. We keep a close eye on what is going on to ensure that tax treatments and rules are properly followed, and that there is no attempt to reclassify debt as equity or income as capital gains outwith the existing rules.
Mr. Field: But is the heart of the matter not the concern that because tax treatment of income and capital is so disparate it generates a perverse incentive to behave in a particular way? The ideal scenario would be to return to the regime that Lord Lawson brought in about 20 years ago, when he moved towards looking on income and capital in the same light. That would render any minor disagreement that I may have with my hon. Friend the Member for Braintree (Mr. Newmark) entirely redundant.
Angela Eagle: Obviously?the ultimate simplification. I noted the spending commitment of the hon. Member for Cities of London and Westminster to bring income tax down over time from 22 per cent?possibly he was talking about 40 per cent.?to 18 per cent. I shall look with interest at his explanation of how it can be paid for.
Angela Eagle: A very long-term aspiration, I suspect. Should there be the calamity of a Conservative Government who wished to do that, I should like to see how they would fund even a tiny part of the public services such as schools, hospitals and so on, in which we have just spent the past 10 years re-investing. It is important both to remember that tax-take finances such services, as well as to examine what might?in an academic exercise?be welcome, such as the same taxes on capital and income across the piece. The idea has certain implications, as the hon. Gentleman knows.
I am sure that early in the Minister’s political career, about 20 years ago, she opposed tooth and nail Lord Lawson’s Budget, to which I referred. However, even the Labour Government will recognise that we are in a global economy and that, as a result, we need downward pressure on our tax rates because we must remain globally competitive. Surely, that is the lesson. The Treasury has learned it fairly well over the past 11 years; none the less, we must consider it a work in progress.
Angela Eagle: Of course, those points are true as far as they go, but as a Government we have other issues and other requirements, such as looking after the social development of our society. For that, one needs tax revenues and transfers, which must be balanced out. On the hon. Gentleman’s side of the political argument there is a slightly different way of doing things than on our side. Perhaps that is what general elections are about.
The transparency of the private equity industry is important. It is in the industry’s interest to provide information that will improve public understanding, so that it can demonstrate its contribution to the UK’s economy and employment. The Government therefore welcomed the announcement by the British Venture Capital Association and leading private equity houses of an independent working party chaired by Sir David Walker, which would draw up a comply-or-explain code to improve disclosure and transparency. We welcomed the report, and Sir David’s code has set a challenge for the private equity industry to improve transparency and disclosure. The Government will watch with keen interest to see how the industry responds.