This time next week, the dust will be settling on what is very likely to be Gordon Brown’s last Pre- Budget Report. There is at least a chance that some measures — ones that may be buried deep in the small print — will raise serious concern in private equity industry.
It is no foregone conclusion that Mr Brown will knock the stuffing out of this burgeoning part of the economy. But it is apparent that private equity, and the wealth it creates, is squarely in the Chancellor’s sights.
The doomsday scenario for private equity players is that Mr Brown restricts or abandons the tax exemption on company borrowings. At present, interest bills on corporate debt escape tax partly because interest is seen as a legitimate business expense, and partly because the state has a sensible desire to encourage investment in industry, jobs, and the pursuit of improved living standards.
It would be relatively easy for the Chancellor to assert that most of the money borrowed to fund private equity buyouts is not being used for wealth-creating investment in the conventional sense. It is being used, it might be said, to prop up financial structures, which equates to unacceptable tax avoidance.
The Chancellor’s enthusiasm for closing tax loopholes is large. Previous, albeit minor, budget measures shows that the private equity industry is on the No 11 radar screen.
He might appease business leaders who often complain that company taxation is too onerous by moving to spend at least some of the extra revenue reducing across the board corporation tax rates. Mr Brown could raise substantial sums by closing this “loophole.” The total could easily run to hundreds of millions a year. It may raise billions of pounds of additional revenue for the Exchequer.
At the same time, the Chancellor’s laudable desire to work for health, education and all less fortunate poeple means he also needs to maximise tax revenues.
A move on private equity is sure to play well with old-style redistributive Labourites. Mr Brown may also reckon that there are few votes to be lost in soaking private equity. The beneficiaries of the current regime can be cast as undeserving fat-cat directors, raking in millions as they “rationalise” and “restructure” their way to financial performance that improves only in an all-too transitory fashion. Squeezing private equity might win votes if people believe that job security will get better.
There are substantial risks in pursuing tax action against private equity. It would drive down private equity investment returns and since pension funds now invest freely in the asset class, ordinary pensioners and ordinary pension savers could be hit.
Tax changes could destabilise companies — and their employees — that have adopted the high-leverage private equity mode already. It might set off financial tremors that reverberate systemically. It could lead to the preservation of wasteful working practices: changes brought to companies under private equity ownership may be harsh but they may also be necessary. Clumsy legislation could also harm companies that borrow to invest for what the Government might consider the right reasons.
It would also leave private equity industry having to demonstrate greater skill for generating long-term value at companies.
Tax exemptions on corporate borrowing account for a big chunk of the cost of capital advantage enjoyed by private equity players and a good part of the impressive overall investment returns comes from that cost of capital advantage.
Blue chip firms must tell tales
As if the 200-page doorstops that constitute the typical blue chip annual report weren’t already big enough, institutional investors want still more. The Association of British Insurers is urging listed companies to beef up their “narrative reporting”.
In particular it wants more forward-looking statements, in essence better discussion of the material risks and opportunities a company faces in future, and more Key Performance Indicators. KPIs are non-financial measures of achievement, such as figures for staff turnover, health and safety breaches or customer satisfaction.
Much of this information would have turned up in Operating and Financial Reviews, if Gordon Brown hadn’t done a volte-face a year ago, scrapping plans to make them mandatory in company reporting.
A voluntary approach is preferable. But will it work? Forward-looking statements could be very useful, both to investors in weighing up risks, and to boards, in helping to concentrate minds and put in place measures to mitigate those risks.
Shareholders have sacrificed their rights to sue directors for negligence over forward-looking statements. The new regime comes in with the Companies Act next year. The quid pro quo is that companies should go to the trouble of making them as specific as possible. Vague boilerplate warnings are useful to no one.
KPIs could be helpful too, but only if managements resist the urge to manipulate the figures. Goodhart’s Law — that any measure gets distorted as soon as it is targeted by policymakers — applies just as much to company directors boasting of customer satisfaction levels as it does to government ministers spouting about hospital waiting lists.
Train competition inquiry could derail competitiveness
Train leasing companies (Roscos) are a thriving relic of the ultimately futile scheme to create a competitive rail industry at privatisation. By having finance companies invest in the trains, operators could switch and compete without taking on huge capital risks. When the Roscos were marketed to international banks, however, few were interested and it was left to former British Rail managers to see the potential and make a fortune. Now that rail subsidies are heavier than before privatisation, however, anything in the system that makes good profits is liable to be attacked as not giving value to taxpayers. Chris Bolt, the Rail Regulator, wants the Competition Commission to investigate the Roscos because of some unspecified lack of competition.
Unfortunately, a similarly motivated investigation into lending to small business was followed by one competitor withdrawing. High profits have kept three banks in this market. Any barriers to new competition are in this case likely to come from regulation itself. Operators take big risks if they buy new trains within ten years of having to reapply for a franchise, which rules out most of them. But there should be nothing to stop new lessors entering the market. The biggest threat to competition would be a loss of confidence in future profitability that would deter banks from investing in new trains — such as the uncertainty caused by a protracted investigation at the Competition Commission.
- Michael O’Leary may be happier parking aircraft than tanks on the Aer Lingus lawn, but yesterday’s decision to raise Ryanair’s stake in the carrier from 19 to 25 per cent counters the assumption that Mr O’Leary would bow to competition worries and Dublin state intransigence. Or is the plan to distract Lingus from maintaining operational competitiveness?
