breakingviews.com Is private equity in the public interest?

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Contents

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Introduction The case against private equity, part one The case against private equity, part two The case for private equity An imbalance of greed and fear Of debt and taxes The real UK private equity tax loophole Private to public Missing the point Angels or Demons?

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Introduction
The rise of private equity over the last decade has been nothing less than a revolution. And like all revolutions, it has provoked furious debate as to what it all means. A few facts everybody can agree on: that over the last few years, the top private equity funds have delivered spectacular returns to investors, that these returns have enabled buyout firms to raise ever-larger funds, and that these huge funds have allowed buyout groups to chase even larger targets. As a result, private equity now employs a quarter of UK private sector workers. And this year has seen private equity bids for two FTSE 100 companies, J. Sainsbury and Boots, with plenty of others cited as potential targets. But then the questions begin. How has this success been achieved? How much is due to asset-stripping? How much to cutting jobs and slashing employee pay and benefits? How much to piling onto companies reckless quantities of debt? Or indeed, to clever tax loopholes? And how much is due to lucky timing, thanks to the huge rise in the stock market following the stock market crash? And how much is due to skill, to spotting undervalued and underperforming companies, to success in turning around struggling companies around and providing a structure that allows companies to grow? Will private equity’s success prove a flash in the pan? Or are we witnessing a permanent revolution? Should policymakers be worried? These arguments aren’t just taking place between trade unions and bosses, between regulators and bankers, between academics and practitioners. They rage within the City and on Wall Street too. Nobody knows for sure where this revolution will lead. Perhaps, like the French revolution, it is still too soon to tell. But breakingviews.com aims to be at the forefront of the debate, analysing deals, examining company and fund performance, probing the sources of the industry’s returns and investigating the claims of private equity’s opponents. This selection of recent articles, covers a range of different topics and contains a variety of points of view. We don’t claim to have all the answers, but we hope they will help you make up your own mind.

By Simon Nixon, Executive Editor

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The case against private equity, part one
By Edward Chancellor
The leveraged buyout industry has never been bigger or bolder. Over the last year, private equity has both raised and spent record amounts. It plays an increasingly prominent role in the markets for mergers and acquisitions and for IPOs. Fees generated from buyouts have enriched commercial and investment bankers alike, not to mention the employees of private equity firms themselves. And let's not forget the investors in buyout funds, who have enjoyed staggering returns over recent years. Nevertheless, the private equity industry feels unloved. The buyout barons are irked by those who cavil at their fees and warn of the dangers that come from piling too much debt onto companies. In the US they've responded by setting up a trade association, the Private Equity Council. And because returns apparently don't speak for themselves, the top industry figures are taking time off from their deal-making to argue the case for private equity. As we shall see, their arguments don't stack up. No amount of propaganda can conceal the truth that the buyout industry is a fee-devouring, asset-gathering operation which generates returns primarily from leveraging assets. This is not just a matter of concern for over-expectant buyout investors, known as limited partners. The industry has become so large and borrowed so much that it poses a threat to the financial system and the economy at large. The case for private equity begins with returns, large and mouth-watering returns. In the year to June 2006, the average return after fees for buyout investors was nearly 26%, according to Cambridge Associates, roughly three times as much as the S&P 500. Furthermore, over the past two decades there have been only a couple of years of negative returns for private equity investors. Institutional investors looking for high returns away from the volatile stock market are naturally excited by these figures. According to research firm Private Equity Intelligence, some $700bn has been invested by private equity (including venture capital) with a further $700bn committed and awaiting investment. The majority of buyout investors plan to increase their stake in the coming year, says Mark O'Hare of Private Equity Intelligence. Where do these returns come from? Well, says the buyout apologist, they're the premium investors receive for illiquidity, that is, for locking up their money for years at a time. Private equity managers know a thing or two about adding value. By taking control of the whole company, they claim to have got rid of the longstanding "agency problem." This refers to the numerous issues that arise when the management and ownership of public companies are separated. Furthermore, it's claimed that private equity has a longer time horizon than stock market investors. Hedge funds, for instance, force management of public companies to focus on their quarterly earnings figures. Private equity is not only more far-sighted, it is prepared to take hard decisions, such as radical restructurings and large leverage, which the managers of listed firms often eschew. Corporate turnarounds are therefore more effective when undertaken by private equity owners. -2-

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After a buyout, senior management is provided with huge financial incentives to maximise returns for investors. Besides, bosses prefer working for private equity since this frees them from onerous reporting duties, such as those entailed by Sarbanes-Oxley. Private equity also uses capital more efficiently. For a start, high levels of leverage enable buyouts to take advantage of the tax deductibility of interest payments. This lowers their cost of capital. Private equity employs sophisticated financial engineering to mine further gains. For example, when car-rental firm Hertz was acquired by a buyout consortium in late 2005, the securitisation of its fleet raised some $4.5bn, reducing interest payments by $80m a year. The larger private equity firms, such as Carlyle, boast that their global network of portfolio companies allows them to extract synergies by cross-marketing, joint-ventures and expansion into new geographic regions. These claims are not just special pleading by private equity insiders. Institutional investors, including the largest public pension funds, make the same argument. Even Britain's Financial Services Authority concluded in a recent report on the industry that "private equity offers a compelling business model with significant potential to enhance the efficiency of companies. This has the potential to deliver substantial rewards both for the companies' owners and for the economy as a whole." Or not. The case against private equity begins with investment returns. These are both exaggerated and misleading. For a start, it's mistaken to focus on average returns since the gains from private equity are very unevenly distributed. That means there's a very wide distribution of returns between the best and the worst managers. Unless investors have money in the bestperforming buyout funds, they're likely to do far worse than average. Then, there's a problem of survivorship bias in the data - the returns of the most successful private equity firms are recorded in the performance data while poor funds are discontinued and drop out. Furthermore, these returns aren't riskadjusted to account for the large levels of debt employed in LBOs. What's more, buyout firms have developed tricks, such as paying themselves a large dividend shortly after an acquisition, in order to boost their reported returns. Although some private equity deals undoubtedly add value with turnarounds and mergers ("roll-ups" in industry parlance) of their companies, there is no evidence that this holds true in aggregate. On the contrary, academic research has repeatedly demonstrated that the high returns from buyouts derive solely from their use of leverage. A report by Citigroup analyst Darren Brooks points out that private equity returns also need to be adjusted for investment style and company size. Buyouts typically occur among mid-size companies with 'value' characteristics, such as low price-tobook ratios. Over the past 10 years, investors could have beaten the returns of the best private equity funds simply by applying private equity-style leverage to a portfolio of quoted mid-cap value stocks, says Brooks. The other arguments put forward for private equity don't bear close examination. Senior executives at public US companies already have huge -3-

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incentives, through grants of stock options and deferred stock, to maximise shareholder value. And if they're not prepared to take difficult decisions, then directors can always fire them and find other people to run the company. The reason that chief executives like working for private equity owners has little to do with the short time horizons of stock market investors or the reporting requirements of Sarbox. On this score, the buyouts provide only a brief respite since the exit route is often back into the public markets. The real attraction for senior managers is the huge compensation that private equity is prepared to offer. Last August, General Electric executive David Calhoun joined the recently privatised Dutch media firm VNU with a package reportedly worth up to $100m. The claim that private equity is overhauling management is overdone. Many of today's largest deals involve management buyouts, such as the $32bn acquisition of HCA last summer - which don't involve any change at the top. Many private equity deals nowadays involve buying companies from other buyout firms. These so-called "sponsor-to-sponsor deals" offer little obvious scope for operational improvement. Besides it's wrong to suggest that equity investors in general are too myopic to allow management to pursue long-term strategies. Several hundred years of stock market history and industrial development suggest otherwise. For instance, the biotech industry, whose eventual profitability lies somewhere in the long-distant future, is largely funded in the stock market. Hedge fund managers may have an interest in boosting short-term returns but they're also locked in a symbiotic relationship with private equity. Activist hedge funds put public companies in play, while other hedge funds provide equity and debt financing for buyout deals. And although it's true that leveraged companies with large interest payments enjoy a lower cost of capital, private equity firms throw all this advantage away and a great deal more when they pay an average premium of nearly 20% to acquire firms in the public market. In fact, the largest buyout announced in 2006 - Blackstone's $36bn acquisition of Equity Office Properties , provided no tax benefits whatsoever since the company concerned was a tax exempt REIT. In the second part of this essay, I will examine the conflict of interest that exists between buyout shops and their limited partners.

Published 10 January 2007

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The case against private equity, part two
By Edward Chancellor
Although private equity disposes of the ancient division of ownership and management of public companies, it brings a host of new agency problems. Private equity firms have interests which are distinct from the investors in their funds. This leads them to engage in activities to maximise their own profits at the expense of their limited partners. Private equity firms charge large fees for executing deals. These vary between firms but are believed to average around 1%. They also extract annual management fees, also of around 1.25%, for managing companies and take a profit share, normally 20% above a hurdle rate, when a company is sold. Given these facts, we might expect that a profit-maximising private equity firm to do the following: grow assets under management as quickly as possible, invest that money speedily, and look for the first opportunity to exit the investment. The recent behaviour of the major private equity firms conforms to this pattern. They have recently been engaged in an unparalleled spurt of asset-gathering. Buyout firms raised nearly $240bn last year, according to Private Equity Intelligence. Fund envy dominates the industry and several leading firms now manage funds in excess of $10bn, Blackstone even has a $20bn fund on tap. You might think that with the stock market at record highs and profits bloated by a long period of expansion, private equity firms would resist spending all this money at once. Not so. Buyout funds used to invest their funds over an average six-year period. Yet over the last year, several of the mega funds, including those run by Blackstone and Bain Capital, have spent their more than half their cash piles within months of raising them. This frenzied deal-making belies the claim that private equity acts like a value investor waiting patiently to invest in the right companies at the right time. Because buyout firms are investing over such a short period, their limited partners are now more exposed than before to the danger of buying in at a cyclical top. As private equity rushes to put money to work, they've engaged in some questionable deals. For instance, last April Blackstone spent E2.7bn for shares in the listed German telecoms firm, Deutsche Telekom. This stake gave Blackstone board representation but no management control. Private equity is also entering into volatile sectors traditionally considered too risky to carry large amounts of debt. Of the $17.6bn acquisition of Freescale Semiconductor last September, Fred Hickey, editor of the High Tech Strategist, observed: "hugely cyclical, often money-losing, and usually cash-burning semis have all the attributes that should make LBO funds steer clear." Furthermore, rising competition among private equity firms has pushed up valuation multiples for buyouts. That spells lower returns for their investors in the future. Then, there's the unseemly dash to the exit. An early sale or large dividend payments (or 'recap') allows private equity firms to boost their reported returns. This helps them raise more money when they launch new funds. Private equity -5-

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has come to resemble a game of hot potato in which companies are handed from one private equity firm to another, sometimes as often as three or four times in succession. Buyout shops also look to float their companies as soon as possible on the stock exchange. The IPO of Hertz, for instance, occurred less than a year after the buyout. Speedy disposals suggest that private equity is not relying so much on its vaunted turnaround skills to generate returns and that its investment horizon is shorter than is claimed. There's a catch, however. As private equity firms engage in ever larger deals, Carlyle's David Rubenstein recently suggested that the first $100bn buyout may not be far away , there's a problem of how to exit the deal. Multibillion dollar companies, such HCA, are unlikely to find a trade buyer and are too large to flog to other private equity concerns. So the most likely exit is through an IPO. Yet private equity firms could clog up the world's stock markets as they prepare to float upwards of a trillion dollars worth of companies in the years to come. That may not be good news for limited partners, but the private equity firms will still harvest tens of millions of dollars in deal and management fees. All this suggests that the buyout industry is a confidence trick played at the expense of investors. Companies are taken from the public market, where the investment risk is evident in the daily fluctuation of share prices, and transferred to opaque buyout funds, where the risk is enhanced by leverage but concealed from public view. Hiding the true risk in buyout funds serves private equity because it makes their returns appear less volatile. It's no wonder that the industry has been fighting a change in accounting rules which forces them to mark the value of their investments to the market. Since large institutional investors have interests in the stock markets as well as private equity funds, the investor base may not change dramatically after a buyout. Yet private equity firms, investment and commercial banks and numerous others on Wall Street receive enormous fees for this public-to-private "repackaging" service. As we have seen, many private equity deals amount to little more than piling on debt. Yet sophisticated investors should be acquainted with the Modigliani-Miller theorem which teaches that adding debt to a company doesn't add value (leaving taxes aside). Therefore all those private equity fees represent a net loss to the investment world. Institutional investors, who are rushing to increase their buyout exposure, suffer from a private equity illusion. In truth, buyout funds aren't really much different than the heavily indebted conglomerates of the 1960s, such as LTV and ITT. In their heyday, the conglomerates also boasted that they added value with their lower cost of capital and superior financial skills. Private equity firms, such as Carlyle and Blackstone, which spread their tentacles across many industries, have come to resemble the highflying Japanese keiretsu of the 1980s. It should be remembered that both conglomerates and the keiretsu came unstuck when booming market conditions changed. Buyouts have generated large returns in recent years. But this has been due to favourable market circumstances - a combination of the very strong profits growth in recent years and a rise in corporate valuations since the stock market bottomed out in 2002. Extraordinarily loose credit conditions have also played -6-

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an important role. Private equity firms have been able to finance risky deals at very low interest rates. The credit markets have facilitated the private equity's daisy chain, as firms are handed from one sponsor to another, and have enabled dividend recaps. Easy money has also supported rising debt levels (relative to operating cash flow) and higher purchase prices for buyouts. Unfortunately, when the buyout boom ends it won't be just private equity investors who suffer. The industry has become so large that too many people and institutions will be involved in the debacle. The banking system has a large and increasing exposure to leveraged buyouts. While the great majority of these loans are parceled out in a matter of months, if the buyout party stops abruptly some banks will surely be caught on the hook. Then there's the legacy of excessive corporate debt to consider. This could cripple hundreds of companies in years to come. Jon Moulton of British private equity firm Alchemy Partners has recently warned of the prospect of rising defaults and a corporate world filled with "headless chickens." Institutions, whether insurers and pension funds, which have invested in buyout debt or in private equity funds are also at risk if investment returns fall far short of expectations. In fact, the only major financial players who stand to profit from a buyout bust are the private equity firms themselves. Senior industry figures acknowledge that corporate valuations are currently unattractive. Some admit, in private, to looking forward to a downturn, which might allow them to acquire companies at more affordable prices. Several firms, including industry titans Blackstone, Carlyle, KKR and Texas Pacific have anticipated such an outcome by raising distressed debt funds. Today's private equity boom is shaping up to add yet another chapter to Wall Street's long history of cynicism and arrogance.

Published 10 January 2007

The case for private equity
By Simon Nixon
Private equity is on the receiving end of a ferocious global backlash. But then it has never exactly been popular. It has lived with the "Barbarians at the Gate" tag for nearly 20 years. Now it faces a new barrage. To trade unionists protesting outside an industry gathering in Germany, buyout groups are "amoral asset strippers" and "casino capitalists". To many politicians, they are "locusts" and their salaries "obscene". In the UK and France, there has been talk of new taxes targeting private equity. In the US, there have been calls for an investigation into alleged collusion. And in South Korea, an executive from Warburg Pincus has been sentenced to jail. Much of this backlash is not really about private equity at all. The industry is the latest whipping boy for opponents of globalisation. For all the talk of assetstripping, UK private equity-backed firms have a better record of creating new jobs than public companies, having increased their employees by an average

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9% in the year to June 2006, compared to a 1% rise in jobs among the FTSE All-Share according to the British Venture Capital Association. And while private equity has certainly taken advantage of cheap debt over the last few years, it is hardly alone in that. So too, have UK and US consumers. And why do critics complain that private equity salaries fuel social inequalities, but not those of footballers? Do critics believe the way to ease social tensions is for private equity to promise to be less successful? But some criticism cannot be dismissed so easily. The most damaging charge one often heard even in the City - is that private equity fails its own investors. This view has been most pungently expressed by breakingviews.com columnist Edward Chancellor, who recently dismissed private equity as "a confidence trick". His argument boiled down to three criticisms. First, that private equity's claim to superior returns is "exaggerated and misleading". Second, that those returns are entirely due to cheap debt and rising stock markets. Third, that private equity groups "engage in activities to maximise their own profits at the expense of their investors". A confidence trick? But can all those supposedly sophisticated investors who last year poured $432bn into private equity - and half of whom are likely to increase their allocation this year - really be such deluded saps? Of course not. Sure, investors know that three quarters of private equity funds fail to beat the stock market. But they also know that the top 25% of funds do outperform the stock market, according to a study by McKinsey - "and did so both by a considerable margin and persistently". This variation in performance simply proves what many in the buyout industry have always maintained: that private equity is a tricky business, and that investors must choose their funds with care. But why do some funds consistently outperform? Is it really just a matter of cheap debt and lucky timing? True, both are important drivers of returns, but that hardly amounts to a case against private equity. Most businesses use leverage to juice up returns to some extent; private equity-owned businesses tend to do so more than most because their shareholders accept the risk of their equity being wiped out. As with hedge funds, leverage is part of the attraction. Meanwhile, it would be remarkable if market timing was not an important driver of returns - particularly three years into a bull market; after all, private equity groups are first and foremost investors, whose job it is to spot value. That said, at this stage in the cycle, with valuations already high, many buyout groups are assuming no multiple expansion on current investments. Besides, this so-called cheap debt is often not as cheap as it looks. Buyout groups can't borrow on the same terms as central banks. Permira reckons its blended cost of sterling debt - including racier debt instruments such as secondlien loans and pay-in-kind notes - is over 9%, which, after allowing for the tax benefits of debt, falls to 6.5%. If Permira relied on leverage alone, it could only buy companies expected to deliver annual returns of more than 6.5% - hard when this is the earnings yield of the FTSE All-Share. No buyout group would contemplate a deal without a clear strategy for growth. For example, General Healthcare, backed by BC Partners, bought three hospitals and built one from -8-

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scratch in the UK. And UK retailer New Look, has added more than 1m square foot of new space under Apax's and Permira's ownership. Better investors, better owners In fact, studies show that operational improvements are just as important drivers of private equity returns as leverage and market conditions. In a study of 60 buyouts, McKinsey found that only a third was due to higher leverage and 5% to rising stock markets. The rest reflected the focused and active involvement in these companies by their private equity owners. A similar study by Ernst & Young of the 100 largest private equity exits in the boom year of 2005 found only a third of the returns were attributable to leverage and a third to multiple expansion. The rest was due to business change. Indeed, the deals that yielded the highest returns were those involving change. Is private equity better at driving change than the public market? In fact, the question is often irrelevant. Many buyouts involve companies that have never been listed, such as subsidiaries of larger groups that may have been starved of investment, or run with other priorities. Meanwhile, public market buyouts typically involve companies with failed strategies, or that require major restructuring. In these situations, private equity brings the advantages of a single owner: rapid decision-making, clear incentives, short lines of communication, and, increasingly, a wealth of expertise. All the big buyout groups now employ top business leaders as advisors. Apax Partners has recruited former BP boss John Browne; Carlyle has hired former IBM boss Lou Gerstner. Of course public companies can, and do change too. But often it takes the threat of a buyout to galvanise the board, as in the case of Marks & Spencer or Saint Gobain. Increasingly change in the public markets is driven by activist investors, who will incur the costs of a campaign to change strategy or management. But fighting an entrenched management is hard work for a minority investor relying only on public information. Historically, public markets have not been good at holding boards to account - particularly in Europe. Shareholders often prefer to sell poor-performing investments. They don't have the time, skill, or incentive to drive change. Private equity eliminates the socalled principal-agency problem, whereby ownership and management are separated. That gives it a real advantage. Sure, this active ownership does not come cheap. In addition to high management and performance fees, some firms - but by no means all - charge portfolio companies management and transaction fees. These often look outrageously high, and they do indeed line the pockets of the private equity groups at the expense of investors. But firms know they can only get away with these charges if they deliver on returns. If returns fall short, they will struggle with future fund-raising. Does the pressure to generate those returns lead to decisions that could harm the long-term value of the business, such as taking out large cash dividends, or selling too quickly? That's hard to judge. But private equity has little trouble finding buyers for its assets, not least because these companies tend to perform -9-

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well after they change hands. Initial public offerings of private equity-backed companies outperformed other IPOs and the market as a whole between 1980 and 2002, according to a study by Jerry Cao and Josh Lerner of Harvard University. In fact, private equity has a strong incentive not to float dog stocks: not only do they typically retain a chunk of equity in the companies they IPO; they also know they will need to come back to the public markets again, so they have a reputation to uphold. Barbarians or liberators? That's not to deny the industry is changing. Private equity's past success may not be a very good guide to the future. Have buyout groups become greedy, raising mega-funds purely to pocket the management fees? Can the megafunds invest all this cash without sacrificing returns? Time will tell. On the other hand, investors are piling into these mega-funds with their eyes open. The firms raising mega-funds are those with a track record. These mega-funds also offer other advantages, including access to the biggest deals, which is where the biggest gains potentially can be made, since these managements are more likely to have been shielded from their owners; and portfolio diversification, which should lead to less volatility, since it means risk is spread more widely. Higher returns and lower volatility: that's the Holy Grail of investment. Like the original barbarians, private equity has succeeded because it encountered an old order that had become complacent, ill-disciplined, fractious and often corrupt - leaving it wide open to attack from a more focused, better organised and more determined adversary. But whereas the barbarians left a trail of destruction and despair, private equity has triggered an economic renaissance in every country where it has been embraced - while countries that have resisted private equity languish at the bottom of the growth and jobs league. Private equity's success may be troubling for those with a stake in the old order - mediocre managers, trade unions and traditional fund managers. But for employees, investors and everybody else who has an interest in healthy companies, these barbarians should be welcomed as liberators. Additional research by Nicole Lee

Published 27 February 2007

An imbalance of greed and fear
By Hugo Dixon
The smart money knows that today's liquidity-inflated financial markets are full of risk. That was clear from private discussions at last week's World Economic Forum in Davos. And yet private equity houses, hedge funds and investment banks are acting as if the good times will continue.

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Skewed incentives, that pump up greed and dampen fear, explain the discrepancy. Huge fortunes will be made if the good times roll on; but the insiders won't lose much if there is a crash because they are often playing with other people's money. Peer pressure at events like Davos insidiously magnifies the greed. Russian oligarchs, mining magnates and Indian moguls rub shoulders with hedge fund and private equity billionaires. A $50m fortune means nothing. Being a billionaire is merely an entry ticket to the super-rich league. Even many of the $10bn-plus guys, who are still in a class of their own, are driving hard to increase their fortunes. The main way to get seriously rich quickly these days is to play the hedge fund or private equity game. The incentive system - the notorious "2 and 20" under which managers get 2% of funds under management as an annual fee and 20% of the profits - favours those who can scoop up the biggest pots of other people's money. The prime drive has become to gather assets rather than to deploy them effectively. That's not to say the smart money likes to make bad investments. But when things go pear-shaped - as with Amaranth last year - the managers don't share in the losses or give back past takings. In a well-functioning market, greed and fear are appropriately balanced. But the "heads-I-win tails-you-lose" structures rife today have distorted the emotional balance. Liquidity Hedge funds and private equity houses are only able to play this game, of course, because the world is sloshing with liquidity. To hit the jackpot, they need to gear up with borrowed money. But why is there so much liquidity? Partly it's a macroeconomic story, linked to savings gluts in China and oil-rich countries. But skewed incentives are part of the explanation here too. Look at leveraged loans, which are fuelling the private equity bubble. Last week saw a new high-water mark when Blackstone upped its bid for Equity Office Properties to $38bn. Leverage multiples have reached levels that many banks think excessive. But they are still lending. They are doing so because they have become skilled at passing the parcel. Banks originate the deals, take fat fees, then syndicate the loans onto others. At Davos, bosses of two big players in the leveraged loans businesses privately boasted at how they had cut their risk exposure in recent years while maintaining or even increasing the amount of new loans they were making. What's worrying them, though, is that playing pass the parcel is becoming harder. Private equity houses are using their position as favoured clients to - 11 -

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make demands that banks feel queasy about but unable to deny. The LBO houses don't just want higher leverage multiples. They are increasingly asking banks not to syndicate the loans immediately but to hang onto them for six months. And they sometimes also want them to put in temporary equity - socalled equity bridges. What this means is that, if there is a crash, banks could be left holding some pretty hot potatoes. If that happens, it won't just be bad for the afflicted banks. Liquidity could dry up suddenly, causing a generalised financial panic. The smart operators are aware that the party can't go on forever. But the longer it continues, the more money they'll make. What's more, there's no obvious reason why it has to end now. There may be kindling on the forest floor, but where's the spark that's going to ignite it? The snag, of course, is that as time passes, more kindling accumulates. When the conflagration comes, it could be dramatic.

Published 29 January 2007

Of debt and taxes
By Edward Hadas
There is a spectre haunting the private equity industry: tax. As the industry's leaders talk over the issues at their annual festival in Frankfurt, they are likely to shrug off accusations of being locusts and asset-strippers. An end to the taxdeductibility of interest payments, on the other hand, would hit them where it really hurts: in their wallets. Germany and Denmark have already made moves in this direction. Other countries could, and should, follow suit. The case against interest deductibility is clear. It gives companies an artificial incentive to pile on debt. Despite that, most public companies have tended to operate with reasonably conservative balance sheets. But the charge of the private equity brigade in recent years has changed all that. Not only are more and more companies being leveraged to the gills by buyout groups; an increasing number of public companies are mimicking them. While it is perfectly logical for smart financiers to exploit the tax system, there are two worrying macroeconomic consequences. First, the corporate tax base of many countries could be eroded. For example, five of the top ten UK companies owned by private equity paid no corporation tax last year, according to the Daily Telegraph. Second, if there is a downturn, more companies are likely to go belly up. For these reasons, the tax deduction ought to be eliminated. But it would be wrong not to make a compensating adjustment. The neatest way to do this would be simultaneously to cut the rate of tax on profits. The numbers in every

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country would be different. But, in the UK, tax experts estimate that a "neutral" proposal would be to cut the corporation tax rate from 30% to 25%. Of course, what is neutral for the government and for the corporate sector as a whole wouldn't be neutral for every single company. There would be winners and losers. Companies with no debt would come out ahead because they'd be paying a lot less tax. But businesses with lots of debt - especially LBOs - would end up paying more. Think of a typical LBO whose operating profit is £100m. Imagine it is financed with £750m of debt, on which it pays £50m of interest. Under the current system, its pre-tax profit would be £50m, its tax bill £15m and its earnings £35m. But, if the tax deductibility of interest was abolished and the tax rate cut to 25%, tax would rise by £10m to £25m and earnings would fall to £25m. For some companies, a sudden change in the tax system wouldn't just clobber profits; it might tip them into bankruptcy. That, though, isn't a reason not to change the system. It is a bit like saying that it is dangerous to take away a drug addict's supply. The answer is neither to keep plying him with drugs nor to go cold turkey, but to phase in the change. Five years would be ample time for companies to recapitalise. The case for the defence As they nibble their canapes in Frankfurt, the private equity executives will be justifying this tax break to each other. But their arguments aren't very strong. One will be that this isn't a break that just benefits private equity. True, but irrelevant. The tax break should be eliminated for all companies. Another claim will be that no single country can afford to act unilaterally, otherwise it will see capital flowing away. That scare tactic doesn't seem right. Countries implementing such a change might well see fewer LBOs. But the lower rate of tax on profits ought to attract other types of investment. A similar rogue argument is that such a tax change would be bad for share prices. It would only be bad for the share prices of highly-geared companies. A final claim is that changing the tax system would undermine the private equity industry which has been such a vibrant sector of the economy. Well, the titans of the LBO world would think that. But frankly if they are really good at creating value by taking companies private, they don't need a tax subsidy to do it. Some countries have already started to act. The latest German government proposal is to limit the tax deductibility of interest expense to 30% of pre-tax earnings, compared to the 50%-plus in typical LBOs. Denmark is planning to be even tougher. What about the two biggest western capital markets? Well, the US isn't likely to follow suit. After all, the concept of tax-deductibility of interest is deeply ingrained in the nation's psyche. It applies not just to companies but to individuals' payments on their mortgages. - 13 -

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The question is a little more open in the UK. As yet, the government has shown more interest in protecting the flourishing private equity industry than in changing the tax law. But it might see the situation differently if the current uproar over private equity persists.

Published 27 February 2007

The real UK private equity tax loophole
By Simon Nixon
What is the best kept secret in UK private equity? That partners in buy-out funds pay as little as 5% tax on their performance fees. This tax break is now costing the UK taxpayer several billions of pounds a year. One can understand why the buy-out prince-lings are exploiting this break for all it is worth. But it is hard to see how it is in the public interest. How, though, does the industry get away with such low taxes on performance fees? After all, the normal tax rate for people above a certain income in the UK is 41%. The answer is that this bonanza is the unintended consequence of three changes in the tax code over the past two decades plus a special deal cleverly negotiated by the industry four years ago. With buyout funds getting bigger, the lost tax revenue looks set to shoot up. The origins of the tax break date back to 1987 when the government, in an effort to encourage more venture capital funding for small companies, agreed to allow performance fees to be taxed as capital, rather than income. In those days, capital gains tax was 40%. So the treatment afforded private equity only a modest advantage, allowing investors to net any gains off against prior year losses. But in 1998, this innocuous-looking loophole became much more attractive, thanks to the introduction of "taper relief" on capital gains. Hoping to boost entrepreneurship, the government slashed capital gains tax for people owning shares in their own companies or in unlisted businesses from 40% to just 10% providing they had owned the asset for 10 years. The real bonanza, though, started in 2002, when the government changed the rules again. People only needed to own shares for two years to qualify for 10% tax. With the help of some creative accountancy - including wheezes such as artificially inflating the base cost of the original investment to account for the "sweat equity" or hard work provided by the working partners - it wasn't long before the industry had got the effective tax rate on their performance fees to somewhere between 5% and 10%.

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How the maths works To understand how the industry gets away with this treatment, it is necessary to look at how a typical private equity fund is structured. Normally it is an 80:20 partnership between investors (limited partners) and the buyout group (general partner). Both sides supply a tiny slither of equity - perhaps 0.01% of the total funds, according to a British Venture Capital Association document. The bulk of the fund's capital is supplied by investors in the form of loans. (Note that these loans are quite separate from the leverage that buyout groups load onto the companies they buy). At the end of the fund's life, the profits, after repayment of the loans, are split 80:20 between the investors and the buyout group. The 20% that the buyout fund receives is its performance fee or "carry". But because it is technically a return on an investment of equity, it is taxed as if it was a capital gain. To see just how big a bonanza this is, consider the impact on a £10bn megafund of the sort now being raised by industry. The actual partnership equity could be as little as £1m. The buyout group itself would put up only £200,000. The rest of the £9.999bn would be supplied by investors in the form of loans. Finally assume the fund closes after six years, having achieved its target 20% annualised return. The initial £10bn would be worth £30bn. The partnership first has to pay back the loan. Say the interest rate was 8%, that would come to £16bn. That leaves a £14bn pot - of which the working partners get 20% or £2.8bn. Now, if that performance fee had been taxed as income, the government would receive a cheque for £1.1bn. But taxed as a capital gain, the effective tax rate might be as low as 7.5% - or just £210m. In other words, the Treasury loses out £900m. Special deal In 2003, this gravy train nearly ground to a halt. The new taper relief rules had proved a bonanza not just for private equity but for any company with highlypaid employees. Suddenly, everyone was setting up elaborate "share-based" pay schemes designed to disguise income as capital gains. So the government introduced new rules requiring employees to declare shares received as part of their pay package as income. On the face of it, these rules seemed to apply to private equity performance fees too. Indeed, many accountants and lawyers warned their clients that this was likely to be the case. Yet remarkably, the BVCA negotiated a special deal with the government, exempting private equity from the new rules and preserving its 1987 loophole. Perhaps understandably, the BVCA has not published the Memorandum of Understanding that spells out this deal on the public areas of its website. Having sold the pass, the UK tax authorities seem to have been regretting this deal. They have been continually looking for ways to wriggle out of it. And so - 15 -

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they should. Sure, changing the rules would not be easy. It might involve primary legislation since the industry could challenge any move to tear up of the current deal via the courts. But the government should push ahead for two reasons. First, it should never have agreed the 2003 Memorandum of Understanding. The working partners' equity in a buyout fund is not risk capital in any common understanding of the word. Hedge fund performance fees, in contrast, are treated as employment income and taxed at the full 41%. Second, this loophole is costing the Treasury a fortune. Official figures show that taper relief will cost the government £4.5bn this year, up from £550m in 1998. A good deal of this is likely to be going to the private equity industry, according to someone familiar with the situation. No one is going to complain if buyout groups put their own money into the fund on the same terms as the limited partners, or co-invest with the fund on individual deals. In those cases, any gains should be treated as capital. But carried interest is a different matter. Of course, the private equity rejects any suggestion its tax treatment should change, raising the familiar cry that it would trigger an exodus of people and capital from the UK. But this is nonsense. The tax affairs of individual buyout group employees have no bearing on the economics of private equity deals in the UK, any more than they do on deals in France or Germany. True, a few private equity employees may be tempted to leave the UK. For them, Ireland, Luxembourg and Jersey await. But London would still remain the European centre for sourcing, arranging, financing and advising on private equity deals. Indeed, it cannot be said often enough that London's status as the world's leading financial centre does not and should not depend on it being a tax haven for the international super-rich.

Published 5 March 2007

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Private to public
By Nicole Lee and Hugo Dixon
The private equity industry has long avoided public scrutiny. But a new consensus is emerging among the industry's top brass. Blackstone's Stephen Schwarzman, Carlyle's David Rubenstein, and Permira's Damon Buffini all agree that the buyout business has to embrace openness. But what exactly should LBO houses to disclose - and why? The starting point is to realise that there are several constituencies that have a legitimate interest in the industry's activities: investors; employees in the companies they buy; and the general public. The latter was not a constituency that mattered much in the past because private equity was mostly involved in smallish companies. But now it is involved in bigger companies and so many more deals, it has impinged on the public consciousness. This has stirred up debates about public policy, including whether LBOs houses strip assets and don't pay enough taxes. It is to address these public interest questions that private equity has to become less private. This is not a matter of ethics but rather one of enlightened self-interest. There are three practical things the LBO houses should do. First, they should disclose industrial plans for the companies they buy. With small companies, they only need to communicate with their workforces and investors. But with big companies like TXU or, potentially, the UK's J. Sainsbury, disclosure means public disclosure. Second, they should reveal more about how they finance their companies. Employees have a legitimate concern that excess debt could undermine job security. It makes sense to allay that concern. Again, there has to be a differential approach between small and big companies - with public disclosure only needed for the big ones. Finally, the industry should reveal more about how they achieve their returns. One could say this is a matter just for private equity houses and their investors. But, again, as the industry gets so big, it has a public dimension. Outsiders worry whether the returns are really the result of smart decisions and hard work - or the product of rising markets, leverage and tax optimisation. It won't come naturally to many in the industry to share this information. But, if they are making good returns as a result of hard work, they have something to be proud of. If not, hiding in the shadows won't help.

Published 1 March 2007

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Missing the point
By Simon Nixon
Context News: Trade unions from across the developed world are gathering in Paris today for a conference to discuss the private equity and hedge fund industries. The unions want G8 leaders to take "rapid international action" to tackle the rise of debt-financed investment, Brendan Barber, general secretary of Britain's Trades Union Congress, wrote in the Financial Times. Considered view: Private equity/Unions: Trade unions are invariably wrong in matters of economics. And they are wrong now about private equity. Unions from across the developed world are gathering today in Paris to vent their spleen against the buyout industry, citing the usual charges: asset stripping, excessive borrowing and failing to pay enough tax. They want "rapid international action" against the industry. But as usual, the unions miss the point. That's because they are asking themselves the wrong question. There is nothing very mysterious about the rise of private equity. A host of studies show that the best buyout groups deliver consistently impressive returns - and do so not just by piling on debt but by growing earnings. SVG, a UK company that invests in Permira's private equity funds, has outperformed the UK stock market by 10% a year over the last 11 years. And it reckons that only 20% of its returns are due to leverage. The unions would do better to ask what has gone wrong with public companies. Why do they tend to under-perform compared to private ones? The fault lies with public market shareholders. Their historic failure to exercise effective ownership has left boards free to run companies in the interests of management and employees. As a result, many companies became inefficient, bureaucratic and resistant to innovation and change. It's not at all clear why unions care so much who provides the capital, or whether companies pay dividends or interest. In fact, the biggest private equity investors are the same pension funds that pay the retirement incomes of millions of trade union members. But if unions really want to keep companies in public ownership, they should focus on finding ways to improve public company performance. In fact, the answer may be staring them in the face. In the US and Britain, a new breed of activist investor is forcing public companies to shape up. US investor Nelson Peltz this week persuaded Cadbury Schweppes to split itself in two; London-based Hanover Investors recently replaced half the board at UK media group SMG. By rights, trade unions should applaud these moves. But alas, many prominent activists are hedge funds. And attacking hedge funds is the other item on the agenda in Paris.

Published 16 March 2007
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Angels or Demons?
By Hugo Dixon, Editor-in-Chief, breakingviews.com
Are private equity houses demons or angels? Reading breakingviews.com over recent months, you could have come away with both points of view. Two of our most senior columnists, Edward Chancellor and Simon Nixon, have respectively argued the “Case Against Private Equity” and the “Case For Private Equity”. Such vigorous internal debate is healthy. It helps define the public debate on the topic. But these opposing views are personal views. The following is an attempt to summarise our overall house view on the matter. This is more nuanced: private equity has strengths but also weaknesses. Mind you, so does public equity. There are really no demons nor angels here – just ordinary human institutions that can and should be improved. More specifically:

Private equity can, and often does add value to companies. That’s what Texas Pacific did with Continental Airlines and Apax and Permira have done with New Look, the UK retailer. Private equity can add value, partly because the owners are not fragmented, as they are in public companies, and the managers are highly incentivised to perform. Equally, LBO houses sometimes do well because they buy Cinderella assets from big public companies that can’t focus on them. That’s what seems to be happening with Dunkin Brands, which was bought from Allied Domecq by a group led by Bain Capital. But most of the huge profits that private equity houses have made in recent years have been the result of the liquidity boom. Leverage multiples have been rising. This has often allowed them to sell out at higher multiples than they buy. And, because their investments are leveraged, the returns on their equity can sometimes be staggering. Private equity has also benefited from exploiting the tax deductibility of interest payments with great effect. It is wrong to describe this as a tax break for private equity as it is something which applies to all companies. That said, it is undeniable that private equity has exploited this more effectively than public equity. This distortion to the tax system should be remedied. Interest payments should no longer be tax deductible but there should be compensating cuts in company taxes so that the overall burden on industry is unchanged. Private equity principals have also benefited from another tax quirk which, on both sides of the Atlantic, allows performance fees to be treated as capital gains rather than income. The benefit is more extreme in the UK than the US. But, in both countries, the tax treatment should be changed. It is not obvious that giving tax breaks to people who are already extremely rich fulfils any particularly useful public policy purpose. - 19 -

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The incentive structure of private equity houses is skewed. The typical reward system gives the LBO houses an annual management fee of 1.5%-2% a year and 20% of the profits above certain hurdles. This is a type of “heads-I-win tails-you-lose” structure. The private equity bosses get a big slice of any gains but don’t share in any losses. This is encouraging private equity houses to raise bigger and bigger funds - the latest crop are about $20bn in size - and invest them rapidly, even if that means taking bigger risks. While markets are booming and liquidity is sloshing around, end-investors may not worry too much about the downside scenario. But when the markets turn, there could be some nasty accidents. The private equity bosses themselves, though, will still be sitting pretty. Public companies often suffer from a principal-agent problem: the owners are so fragmented that they do not hold the managers properly to account. The link between owners and managers is the board of directors. But often boards are not properly informed, professional or incentivised – and sometimes they are not adequately independent from management. Corporate governance on both sides of the Atlantic can therefore be weak. But the weaknesses of corporate governance don’t mean that the public company model is dead. Corporate governance can, and in some cases is being improved – as recent moves by US companies to institute majority votes for directors and non-binding votes on executive compensation suggest. The biggest needs are: stronger, more independent boards; and incentive structures that align managers’ compensation to the achievement of good shareholder returns and don’t give fat rewards for failure. The public company model can also improve as a result of more engaged shareholders. The growth of shareholder activism, spearheaded by the hedge funds - like Atticus when it hounded Phelps Dodge or TCI with its prodding of ABN Amro - is largely a welcome development. The activists are helping to remedy the principal-agent problem. Public equity has one big advantage compared to private equity: liquidity. At a time of rising markets, investors may not rate that so highly. But, in a downturn – when liquidity in general could drain away – the ability to sell shares will seem a lot more valuable than it does now. Being locked up for years in a private equity fund could be the source of massive frustration.

In summary, there is room in modern capital markets for both public companies and private companies. Even private equity houses acknowledge that the public markets are a useful exit route. And Blackstone has embarked on its own IPO.

Published 8 May 2007

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