Cicero Policy Briefer

Issue 13, June 2007

The misrepresentation of private equity

By Mark Twigg

There can be few things in financial markets that have attracted as much attention in recent months as the world of private equity. Often seen to be shady and lacking in transparency the masters of the PE universe have been hailed as everything from the saviours of Britain’s fallen corporate angels, whilst at the same time being slated as nothing more than asset strippers and casino capitalists.

A slew of major deals have attracted growing media interest, not least with the recent £11bn deal by private equity group KKR to take Alliance Boots private. This deal marked a significant landmark in the growing influence of private equity; not only was it by far the largest deal in the UK to date but it was the first time a private equity firm has successfully pursued a FTSE 100 company. A psychological barrier that was always on the cards, maybe, but which finally signals that perhaps no deal is too big. One of the major reasons for PE’s elevation has been the increasing trend towards ‘club deals’ which see consortiums of PE firms literally club together to share the fund raising, not to mention sharing the investment risk, which is itself no bad thing. Equally, there has been growing interest in the sector from a range of institutional investors, particularly the pension funds looking for bigger returns to close their gaping final salary shortfalls.

The trade unions have been largely unimpressed with this rapid growth, citing concerns over PE-driven cost-cutting and its negative impact on job prospects and the loss of staff benefits. Meanwhile, the well of media debate has become poisoned by a small minority of cases that have not only enjoyed a very high profile, but have become perceived to be emblematic of what is going on across the PE sector. In truth, notwithstanding the media agenda and its focus on bad news (“if it bleeds it leads”), the concerns of unions and media pundits have proved to be largely unfounded.

Most studies have revealed that private equity has a broadly positive impact on employment. One study by the University of Nottingham business school showed that a company’s employment levels are typically 36 per cent higher five years after a leveraged buy-out. Perhaps, PE cost-cutting—rather than reducing headcount—might actually materialise in other, more positive ways. For example, have any studies been undertaken to show the impact of PE investment on a company’s energy use, or the efficiency of its processes such as procurement, manufacturing or distribution? I cannot find any studies, though I would wager that firms under PE ownership could well end up employing more environmentally sound processes resulting in smaller carbon footprints. Not such a bad prospect in a world rightly obsessed with global warming and ‘carbon neutrality’.

Whatever the rights and wrongs of PE activities, regulators will be increasingly called upon to take action—and to do so through the prism of a media debate which often distorts the truth for the sake of a sensationalist headline. The Financial Services Authority (FSA), which has a statutory duty to deal with matters of potential investor detriment and wider systemic risks, will no doubt come to play a more central role in making sense of this debate. What are the major challenges for regulators? With minimum investment subscriptions typically in excess of £250,000, investors should be able to look after themselves. However, while there is no immediate danger that these investment vehicles will start to percolate into the hands of retail investors, there is still a danger that small time investors could end up being exposed indirectly through their pensions and other investments. Again, this should not be a major problem so long as the pension funds are being properly advised.

Another important consideration is the degree of leverage usually involved in backing up these investments. So far, the use of debt has raised concerns that PE firms are effectively disguising equity to reap the rewards of generous tax relief on interest repayments. An ongoing Treasury review will report back in time for the Pre-Budget Report in the autumn as to whether abuse of the tax system is occurring, and if so, what to do about it. For the FSA, its interest in gearing has a different motivation. Its figures show debt to equity ratios of around 6.4:1 are occurring in the largest deals, which presents it with a dilemma. With inflation now breaching the Bank of England’s target range as set by the Chancellor, the only policy the Bank can pursue is to tighten up monetary policy with a series of base rate increases. More expensive borrowing increases the risk of default; private equity might not be immune from so-called ‘credit-events’ and at a time when private market fund raising is outstripping the levels seen on the public markets. We could have an apparent perfect storm on the horizon with large capital flows into opaque, highly geared investments at a time when the cost of borrowing is set to rise.

How likely is it that such a doom-laden scenario will arise? Well, the FSA seems to think not very likely. Its recent publication in November 2006 cited in total seven risks presented by heightened PE activity. This includes potential risks to market liquidity as a result of an over-reliance on debt financing. However, the bigger fear for the regulator was the issue of potential market abuse and conflicts of interest. Both issues are already being addressed as part of an industry initiative, under the able chairmanship of Sir David Walker, formerly of the Securities and Investment Board (SIB). This review will report its findings sometime in September across a range of issues, notably examining the current reporting standards and whether a case can be made for introducing a new voluntary code for disclosing greater information into the public domain.

With measures such as these, the PE sector has belatedly demonstrated that it is up for a meaningful debate with policymakers on how best to mitigate risks in the sector without resorting to heavy-handed tactics. More of the same is required in the coming 12 months. Only through much greater dialogue (supported with more than a little bit of research) can the industry take the sting out of its critics’ arguments and reach the sort of ‘evidence-based’ regulatory outcomes that have made Britain a safe bet for global investment.

Mark Twigg can be contacted on +44 (0)20 7665 9537 or click here to email.

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