A primer for Jack Layoff.....er Layton

PRIVATE EQUITY: Locust or lifeline?
by Peter Atrill
ACCA the global body for professional accountants
18 Oct 2007

Synopsis: The private equity industry has developed rapidly in a relatively short period of time. It has now reached a point where it has entered the public arena through the acquisition of large, listed businesses. This has drawn attention to certain business practices, which critics have been quick to denounce. It has also exposed tax anomalies that have created unfairness among taxpayers.

When a different point in the economic cycle is reached, those who have issued dire warnings against Private Equity’s heavy reliance on debt may be proved right. High levels of gearing impose strict financial discipline on the managers of a business. Expenses have to be tightly controlled, underperforming assets sold, and surplus workers dismissed if the business is to meet its interest payments and maturing capital repayments. To tighten control further, and to encourage wealth-maximising behaviour, managers of the business are often rewarded through aggressive incentive schemes.

Studies in the US suggest that, on average, returns from private equity over recent decades are not impressive when compared with stock market returns7. This is a somewhat surprising conclusion, particularly given the higher level of financial risk borne by private equity-backed businesses. It should be expected that their returns would significantly outperform stock market returns. In fact, studies in both the UK and US suggest that, once an adjustment is made for the risk premium arising from high levels of gearing, average returns from private equity are at best mediocre and at worst significantly underperform the market

Introduction:

Although the private equity industry is still at an early stage of development, it has provoked much controversy. In the eyes of some critics, it is little more than ‘casino capitalism’. Private equity firms simply acquire businesses, sell off their assets, shed employees, and undermine the working conditions of those remaining: all to make fat profits for a few. Unsurprisingly, these claims are vigorously denied by private equity firms, which view themselves as an essential ingredient of a strong, dynamic capital market. They, and their supporters, argue that private equity helps in developing leaner, more efficient businesses, which, in turn, helps the economy as a whole. Indeed, it has been suggested that the methods employed by private equity firms offer ‘a compelling business model for the 21st century’[1].

In this article, the case for and against private equity will be explored. Possible benefits will be examined and the problems and risks associated with the growth of private equity will be identified.

What is private equity?

Private equity firms raise their funds from private sources, such as pension funds and wealthy individuals, and use these funds to acquire a controlling interest in a business which they see as underperforming. Having acquired a business, they attempt to improve its fortunes through strong management and tight financial control. Although they invest mostly in unlisted businesses, they have recently extended their reach and have begun to acquire listed businesses. Following acquisition, these businesses are usually de-listed and restructured, perhaps with the intention of re-flotation at some future date. As well as providing investment finance, private equity firms also offer advice on strategic and financial issues to their client businesses.

A private equity firm will normally provide finance for a business through a mixture of debt and equity. The debt element is usually large so as to produce additional benefits from gearing. (The Automobile Association (AA), for example, was acquired in 2004 by a private equity firm for around £1.8bn, of which £1.3bn was financed by debt.) The debt is typically underwritten by banks but is increasingly offered through the debt market.

High levels of gearing impose strict financial discipline on the managers of a business. Expenses have to be tightly controlled, underperforming assets sold, and surplus workers dismissed if the business is to meet its interest payments and maturing capital repayments. To tighten control further, and to encourage wealth-maximising behaviour, managers of the business are often rewarded through aggressive incentive schemes.

The trend towards the acquisition of large listed businesses such as Hilton Hotels in the US, Alliance Boots in the UK, and Qantas Airways in Australia have brought private equity deals much more into the public arena.

This new trend has been attributed to an incentive effect created by fee income linked to the size of private equity investments and to a less bracing competitive environment than is the case for acquiring smaller businesses.

Whatever the underlying reasons, these deals have placed the spotlight on what has formerly been the fairly secretive world of private equity. The business methods used, and their social and economic impact, have attracted the attention of trades’ unions, financial regulators, and governments.

Locusts or lifelines?

Private equity is now big business. In the first half of 2006, more than £11bn of private equity was raised in the UK, which was more than that raised through initial public offerings on the London Stock Exchange[2]. The British Venture Capital Association (BVCA), the industry body for private equity, sees the increasing importance of private equity as a positive development. It argues that it is good for the economy, good for jobs and good for pensions. Around 1,300 UK businesses receive private equity investment each year and, according to the BVCA, private equity-backed businesses have grown faster and created more jobs than FTSE250 businesses over the past five years.

Furthermore, as many pension funds invest in the private equity funds, the returns they receive benefit pensioners[3]. Supporters of private equity concede that producing leaner, more profitable business can be a painful process. Tough decisions have to be made - but the end justifies the means.

Thus, according to one leading supporter:
‘There is no room for passengers nor surplus assets in an efficient business and there is a need on occasions to downsize the workforce and sell off assets to make the business more viable in the future[4].’

It is not just the business itself that may be affected: the methods employed by private equity firms may create echoes elsewhere. Other businesses, particularly those feeling vulnerable to a takeover from a private equity firm, may adopt similar methods, such as high gearing and downsizing, in order to remain viable and independent. Critics of private equity point to the increasingly high levels of gearing used by private equity firms to finance acquisitions.

This trend is partly due to the ready availability of cheap debt and partly due to the rising acquisition costs as a result of increasing competition among private equity firms. The key question, however, is where will it all end? According to the UK Financial Services Authority (FSA) the default of a large business, or a group of smaller businesses, backed by private equity now seems inevitable[5]. If so, it may create financial shock waves that will adversely affect both the liquidity and volatility of the debt markets and, perhaps, affect the wider economy.

Implications for Capital Markets and Stock Exchanges:

The longer-term implications for capital markets resulting from the growth of private equity have also caused concern. It has already been mentioned that listed businesses are increasingly targets for private equity businesses and, once acquired, are promptly de-listed. It is also the case that growing businesses, which normally seek access to finance through a stock market listing, can now have their financing needs accommodated by private equity firms. Both result in fewer listed businesses, which has worrying implications for businesses and investors. From a business viewpoint, the benefits of listing, such as accurate share valuation, access to a wide pool of finance, and the opportunity to develop and transform, can be a real loss. From an individual investor’s viewpoint, the opportunity to invest in large, growing, businesses becomes more limited and capital markets become less attractive.

Inherent Complexities:

The complexity of many private equity deals has also caused concern. When structuring a particular financing package, a range of complex financial instruments, including derivatives, may be employed involving many different parties. As a result it is not always clear who bears the financial risk and what their likely reaction will be in a crisis. Furthermore, the participation of so many parties in private equity deals leads to an increased risk that price-sensitive information will be leaked. This is a particular problem, where listed businesses are targeted for acquisition.

Disclosure concerns:

The recent trend towards acquiring large listed businesses has been greeted by calls for private equity firms to be more transparent and accountable. It is argued that not enough information is publicly available to permit a proper assessment of the performance of private equity firms. It has also been argued that there is a need for businesses that receive private equity backing to communicate to a wider group of stakeholders such as employees, suppliers, and customers concerning the aims and objectives of a business and its plans for the future. It is worth pointing out, however, that, on occasions, the acquisition of a business by a private equity firm may actually improve transparency.

For example, when the AA formed part of Centrica plc, the utilities group, information relating to the business within the annual financial reports of the group was sparse. However, since being taken over by a private equity firm, a 56-page annual report on the business is now published[6]. Nevertheless, it is generally the case that higher standards of transparency and accountability are required now that private equity has entered the public arena.

Tax Unfairness:

Critics have suggested that the taxation system works to the benefit of private equity: first, because of the tax relief available on interest payments, and second, because of the ‘taper’ relief on capital gains tax. As interest on debt attracts tax relief, the cost of debt becomes cheaper and so, it might be argued, encourages higher levels of gearing. While this relief is available to all businesses, it is nevertheless true that private equity-backed businesses tend to exploit this more. Some believe that there should be a limit on the amount of tax relief for interest payments in order to make high levels of gearing less attractive. Indeed, some European countries are already toying with this idea. This proposal, however, is based on the belief that high levels of gearing are also imprudent levels of gearing, and that the market has misjudged the level of debt that businesses can sustain.

Credit risks to the economy:

When a different point in the economic cycle is reached, those who have issued dire warnings against heavy reliance on debt may be proved right, but their day has yet to come. Private equity executives receive much of their rewards from their share of the profits in the selling of a business (known as ‘carried interest’). In the UK, gains on the sale of business assets are liable to capital gains tax, which ‘tapers’ from a high point of 40% down to 10% where an asset has been held for more than two years. If possible, it is usually better to receive rewards in the form of ‘tapered’ capital gains rather than income as the latter is taxed at 40% for high earners. This generous level of taper relief for capital gains was introduced to reward entrepreneurs and risk-takers. However, a problem can arise where there is a misalignment between amounts invested and the claims made on the gains from sale. Whereas private equity executives may inject only 1% of the total equity capital, they may receive a 20% stake in the gains from sale. There appears to be a fair degree of acceptance, even within the private equity industry, that this situation creates unfairness among taxpayers.

Private Equity Investment Returns:

Private equity is generally assumed to generate high returns for investors and there is plenty of anecdotal evidence to support this assumption. Nevertheless, studies in the US suggest that, on average, returns from private equity over recent decades are not impressive when compared with stock market returns7. This is a somewhat surprising conclusion, particularly given the higher level of financial risk borne by private equity-backed businesses. It should be expected that their returns would significantly outperform stock market returns. In fact, studies in both the UK and US suggest that, once an adjustment is made for the risk premium arising from high levels of gearing, average returns from private equity are at best mediocre and at worst significantly underperform the market[7,8]. This average performance, however, masks a much wider range of returns than with listed equity investments: for the investor in private equity funds, therefore, the choice of investment fund is critical.