Legal Village

Private equity - the challenges

Posted 5/03/2007 by Charles Martin

There has been a cacophony of noise around the private equity industry over the last couple of weeks. Last week the industry met for some concerted soul-searching in Frankfurt at the Super Return conference. The quality of debate and thinking on all sides is improving bit by bit.

The industry recognises that it is now of a scale and profile that means that it needs to explain itself and the benefits it offers to a much wider audience. It needs to achieve a higher level of public and political support to continue to prosper.

Everyone in the industry has his or her own view of the issues but all agree that it must do a better job of communicating the benefits that it offers.

• The private equity model (as a way of running business) is successful, achieving alignment between management and owners. It offers a tight governance regime that focuses on performance in the business, allowing change to be implemented discreetly and investment to take place without the short-termism of the public markets.

• Private equity achieves good (but not, in the long run, disproportionate) returns for its investors. These investors include all our pension funds. The stakeholders that therefore benefit from this are broad. It is interesting to note that in the US, 23% of private equity investment comes from the state pension funds and the like.

• It is a catalyst for change. If private equity is too often associated with redundancies and bad news, that is because those changes are being implemented to create stronger, more efficient businesses, which is ultimately for the benefit of the economy and everyone in it.

• Private equity takes real risks and is not a one-way ticket to profit.

• Some of the most talented individuals in both the business and financial community now operate within the private equity industry, bringing their skills to bear, not only for their own benefit, but for the benefit of the wider economy.

Having said all of that, the industry is beginning to accept that the challenges it faces are not only to do with communicating these benefits better.  It is also beginning to ask itself some crunch questions about what might need to change.

• Does it pay enough tax? Of course the answer to this question is pretty subjective and will vary from jurisdiction to jurisdiction. Also it must be asked at the level of the funds themselves (which are often off-shore) and at the level of the personal wealth that it generates (both for the individuals in the industry and for the management teams that it backs). In the UK the debate centres around taper relief for management and private equity executives and the tax deductibility of interest on the quasi-equity loans that private equity houses (as opposed to banks) make available to their investee companies.

• Is a small number of individuals simply making too much money out of the industry? This debate does not generally centre on the management teams that private equity backs but around the private equity houses themselves. Management fees that are appropriate to cover overheads on small or medium-sized funds may produce a very large surplus on mega-funds. Twenty percent carried interest above a certain hurdle which, whilst not unfair as a way of sharing the cake with investors, begins to attract public interest when the absolute numbers are as large as they are in the mega-funds. Whilst the tax issue that I referred to above can be dealt with by governments, the private equity community itself (principally the investors who have not successfully negotiated them down) is asking itself questions about these fee and carry issues.

• Is private equity transparent enough at the portfolio company level? Is it not fair, once private equity has invested in large companies that have significance for a broad range of stakeholders (including customer suppliers, employees and others), that it should provide much more information about what is going on in the company? The European Private Equity & Venture Capital Association (EVCA) and an ad hoc industry group in the UK are looking closely at this. In tackling this, however, we must not end up with a stifling, expensive regime, as happened in the US when legislators responded to Enron with Sarbanes-Oxley.

• Does private equity always leverage responsibly? No-one could disagree with the argument that leverage can pose threats to the wider economy. There are occasions when pressure on a private equity sponsor to maximise returns and/or meet vendor price expectations can result in dangerous leverage.

There are many arguments against being too heavy-handed, in particular in dealing with the tax issue. The same tax deduction for interest is available to all corporates (although leverage is generally lower outside private equity). Global conglomerates engage in their own tax mitigation by using international tax treaties to reduce tax payable in jurisdictions like the UK. It will always be difficult and dangerous for any one country to tackle the tax issue. Private equity is a global business and will migrate its operations to more benign jurisdictions – given the significance of the financial services sector (certainly in the UK), this could be highly damaging. Many in the private equity industry would say that hedge fund managers pay less on-shore tax: why discriminate?

These areas of concern are not just the province of journalists – they are legitimate questions that the industry is grappling with. If it does so successfully – and presents its benefits clearly – it will emerge from the present fracas in a stronger and more sustainable state.

If it fails to do so, no doubt misconceived tax and other legislation will be introduced, to the detriment of those countries that do so and the industry at large.