Private equity under fire

As most readers will no doubt be aware there has been a fierce debate engulfing the private equity (PE) industry. Not least the increased presence and power of these players in the M&A market but also the fabulous personal wealth that has accrued from mega deals which, in turn, appears to be taxed at very low rates.

The rise of PE has occurred for many reasons and it has not been just the generous tax breaks. The availability of debt capital, low interest rates, and the decisions by companies to raise money or realise value in an alternative method to a stock market listing have all played their part.

The industry has been scrutinised by the Treasury as it was generally felt that the super rich were getting too generous tax breaks. This situation has developed because in many instances, where a tax break is big enough to make a difference to behaviour it ends up being exploited in a way that was not intended.

The main way that big PE funds have exploited the system to their advantage is the use of debt. Companies that are owned by PE investors pay lower corporation tax as interest payments on debt are tax deductible, and as partnerships, they can have a debt to equity ratio of 90%. What is more employees and partners of PE firms qualify for business asset taper relief that is applied to Capital Gains Tax when the business is sold. Business assets attract maximum taper relief of 75% after 2 years (4 years for disposals before 6 April 2002). Full business asset taper relief therefore results in an effective CGT rate of 10% for an individual who is a higher rate taxpayer, or 5% for a basic rate taxpayer. Partners in PE firms essentially "carry" this relief as part of their renumeration which can be 20% of the profits from selling companies as they have put up 20% of the capital in the form of loans. This relief was originally designed to encourage entrepreneurs and investment by allowing investors in businesses or entrepreneurs who sold up to be taxed at a lower rate to encourage risk taking and increase the availability of business capital. One argument has been whether the ability to reap profits from such leveraged investments in companies is actually employment income as they are only able to do it by virtue of their jobs.

The debate reached its climax at the Treasury Select Committee meeting last week where the leaders of the PE industry and unions answered questions from MPs.

On one side, there were the unions arguing that private equity funds were secretive cost cutting asset strippers, who loaded businesses with debt and were only in it for the short term. As such, they damaged business, employment prospects and didn't pay enough tax to boot. On the other side we had the Private Equity chiefs arguing that they had turned around businesses, risked their own money and were a valuable engine to the economy, attracting talent and money to the country.

Readers of the Business Sale Report might have noticed that from the sidelines smaller mid-market companies and Venture Capitalists were shouting to be heard, during the ever increasingly politicised debate, that they should not be tarred with same brush and any punitive regulation or tax could seriously damage smaller businesses. The essence of that argument is that Venture Capital fund managers contribute to the economy by backing and giving hands-on support to new businesses. Lower mid market private equity firms contribute to the economy by investing money, time and expertise in underdeveloped businesses with potential to become market leaders. What is more, the tax breaks afforded to the smaller riskier buyouts are well deserved.


There has been a large body of evidence that private equity firms investing in smaller companies (with enterprise values of up to £75m) are additive to the economy and jobs, doubling the growth rate of profits during four to five years of ownership.


Of course, during the debate the big players were at pains to highlight the success stories of big Private equity deals. They pointed out that Travelodge had built 80 new hotels under Dubai International Capital. Gala Coral, owned by Permira, employed 2000 staff when it was bought from Bass and now has more than 18,000. Admittedly a fair chunk of that came through acquisition, but the point has been made that it isn't all bad. But on the flip side the AA deal has grabbed the headlines because of job losses and huge payouts to investors and the Boots pension trustees have been fighting with KKR saying they need to contribute more to the pension fund.

So what is going to happen now? The debate has gone quiet as the Treasury is due to report in the Autumn.

So what tax changes could we see? Several ideas are being mooted. For example the Government could reduce interest deductibility by imposing stricter limits on the amount of interest that can be deducted against tax or by reclassifying interest on shareholder loans as a form of dividend. The Government might scale back business asset taper relief restricting it to investors in small and medium sized businesses or even set up a banding system. Another possibility could be the abolishing the distinction between business and non-business assets. However, here at the Business Sale Report we feel that this is the least likely option due to the fact that the relief has always been aimed at stimulating business not investment. Two separate reviews have been launched by the Government. One of these is to examine the personal tax rules that allow executives to enjoy tax rates as low as 10%. The other is into the tax treatment of equity-style debt. Whatever the outcome it is likely that the ability of PE partners to receive relief on the so called "carry interest" will be limited.

We can be sure that Gordon Brown as the new Prime Minister will want to be seen as doing something. The most important thing to hope for is that any populist tax initiative (i.e. the windfall tax on privatised utilities ) doesn't damage the mid market Venture Capital and Buy-out industry. We shall have to wait and see.

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