It was pure New Labour rhetoric: the chancellor declared a burning ambition
for social justice while promising rewards for enterprise.
The date was March 17, 1998. Gor-don Brown had been in 11 Downing Street for
less than a year. In the House of Commons, he rose to his feet to deliver
his second budget. Within moments, Brown trotted out one of New Labour’s
favourite soundbites: this would be a budget “to advance the ambitions not
just of the few but of the many”.
The government aimed to create “a tax system that makes all work pay, that
encourages skills and rewards enterprise and entrepreneurship throughout the
economy”.
Brown introduced a tax break “for those who build up businesses or stake their
own hard-earned money in them”: someone holding a business asset and selling
it at a profit after 10 years would pay only 10% tax on the gain.
This was a big move: it meant the exchequer was taking a strikingly generous
attitude towards those who made their money through capital gains rather
than income.
Two years later, Brown gave a further concession. To benefit from the 10%
rate, people would no longer have to hold on to an asset for 10 years; the
low rate would kick in after only four. In 2002, he brought this down to
just two.
Brown’s intention in creating this “taper relief” was clear – he wanted to
demonstrate his support for people “who build up businesses”. If their
companies prospered, then these entrepreneurial individuals could hold on to
virtually all the gain from selling their companies.
But the resulting disparity – between a 40% marginal tax rate on income for
the better paid and a 10% rate for capital gains – has been enjoyed not only
by small-business entrepreneurs but also by private-equity executives who
are among the best-paid people in the land.
The chancellor’s generosity in the tax treatment of capital gains has now
become a politically uncomfortable issue. IT was one of the private-equity
industry’s own number – Nicholas Ferguson, who built up Schroder Ventures
before it became Permira – who last week highlighted the curious, unintended
result of Brown’s tax reforms: executives in buyout firms can end up paying
a lower rate of tax than the people who clean their offices. “I have not
heard anyone give a clear explanation of why it is justified,” said Ferguson.
The political fallout of his comments came quickly. On Tuesday, the taxation
of private equity was raised with Brown at the GMB trade-union conference.
The chancellor responded: “We will make sure there is justice and equity in
the treatment of tax arrangements in that area.” That was interpreted as his
willingness to clamp down on tax breaks for private-equity tycoons.
Even before Ferguson’s remarks, the private-equity industry was coming under
increasingly close scrutiny. For more than a year, the Treasury has been
looking into “carried interest”. This term refers to the stake held by
partners in private-equity funds. What Brown is concerned about is that
these investment profits are taken as capital gains rather than as income.
This enables private-equity partners to cut their tax bills to 10%, rather
than facing a 40% tax bill if the profit were taken as income.
The chancellor’s long-standing adviser and protégé Ed Balls has signalled that
he is concerned about the tax treatment of interest payments by
private-equity firms.
On Tuesday the Treasury select committee will hold the first hearings in its
investigation into the private-equity industry. Five top private-equity
houses are to appear before it – Kohlberg Kravis Roberts, Permira, 3i,
Blackstone and Carlyle.
A sixth, CVC, will not take part, despite being the joint owner with Permira
of the AA and having made one of Britain’s most controversial private-equity
deals – buying Debenhams from the stock market and then refloating it after
selling off assets and slashing costs. The stock became an albatross for
investors.
The private-equity industry acknowledges it has an image problem. Permira’s
managing partner, Damon Buffini, was thrust unwillingly into the limelight
when he was picketed by the GMB. The industry subsequently pledged greater
openness. But it is thought that only Permira and 3i have submitted written
evidence in advance to the select committee.
Insiders believe that Permira, which has come under fire over job losses at
the AA and Birds Eye, has encouraged three of the companies under its
umbrella – Hogg Rob-inson, Gala Coral and All3Media – to submit evidence of
their own, trumpeting the positive experiences they have enjoyed under
private-equity ownership.
The select committee will look at every aspect of private equity, including
the effect of private-equity takeovers on employees; transparency; the risks
in highly-leveraged deals; and the impact on long-term investment in
companies that move from the public to the private sector.
It will also examine whether companies that are owned by private equity really
are more efficiently run. This is an area of vexed debate between supporters
and detractors of the industry.
The CBI’s submission to the committee says: “Private equity makes a dynamic
contribution to the economy, and can bring a new sense of direction to
long-established businesses. Successful transactions lead to new investment
and more jobs.”
The TUC, however – citing research by Julie Froud and Karel Williams from
Man-chester university – says: “If the debt leveraging is stripped out of
the equation, the returns generated by private equity would be mediocre at
best compared with the stock market as a whole.”
But it is tax that has become the red-hot topic for the private-equity
industry. The sums involved are huge. And this is where Brown’s apparent
willingness to clamp down comes into play. THERE are essentially two tax
issues. First, there is the question of interest payments on debt. This can
be offset against a company’s operating surplus when calculating the profits
on which tax is paid.
Private equity is not unique in this regard. The position is the same for
quoted companies or indeed someone with a mortgage on a buy-to-let house.
But private-equity deals tend to be highly geared: they are financed using a
small amount of equity and a large amount of debt. Might the Treasury try to
limit the degree to which interest payments can be used to reduce taxable
profits? It is not out of the question. Germany is planning new rules under
which any interest payments above €1m a year could be offset against a
maximum of 30% of taxable profits. Denmark is weighing up a slightly
different idea: for tax purposes, interest payments would be limited in two
ways – to 6.5% of the value of a company’s assets and 80% of operating
profits.
In Britain, it might be possible to introduce such measures, but they would be
highly complex to administer if they were to avoid hitting many companies
outside the private-equity sector.
The second tax issue would seem to offer the Treasury a more promising
opportunity to pursue Brown’s “justice and equity”. He could unwind the
generous taper relief on capital-gains tax that he introduced in 1998, 2000
and 2002. The most obvious move would be to extend the period for which an
asset has to be held to qualify for the lowest rate of capital-gains tax.
Could any new, longer time limit be introduced only for private-equity firms?
“It would be very difficult to define,” said Simon Perry at the accountants
Ernst & Young. He added: “Taper relief created an incentive to build
businesses – those issues haven’t gone away.”
Tim Jenkinson, professor of finance at the Saïd Business School in Oxford, who
will give evidence to the Treasury select committee this week, thinks a
change in the tax regime is inevitable.
He said: “Tax rules on carried interests have to be changed. [Taper relief]
had certain unintended consequences. It was brought in with good motives as
part of a drive to encourage entrepreneurship. But private-equity executives
are putting typically 1% of the capital into a fund, but getting a 20% claim
on the profits: the economic interests aren’t aligned. The private-equity
industry hasn’t done anything wrong, but private-equity executives can earn
as much as £50m in carried interests and pay a marginal tax rate of only 10%
on that – it seems so blatantly wrong.”
There is scope for making a further technical change that would affect the way
carried interest is taxed. At the moment, for
the purposes of calculating taper relief on capital gains, the clock starts
ticking when a private-equity firm takes over a business. But often,
private-equity firm partners gain an entitlement to a stake in the target
company only much later – when certain performance targets have been
met.
Some argue that the reference point for capital-gains tax calculations should
be moved to this later date: then, to get taper relief, the private-equity
partner would have to wait two years from that point.
Such a change would be significant. But it would also involve unravelling many
aspects of tax law covering all partnerships – even those that have
nothing to do with private equity.
Might tighter tax rules on private equity drive the industry offshore? A
senior figure who specialises in private-equity taxation doubts it: “The
sheer sophistication of the financial infrastructure here makes it by far
the best place in Europe to do deals. And the point is that the issue of
taper relief is one of personal taxation, not how the businesses are taxed.
“The individuals concerned really would have to get out of the UK –
to places like the Isle of Man and Guernsey. Do you really think they would
do that when they are trying to do deals in London and manage businesses
they have bought here?”
RISE OF THE BARBARIANS
THE TERM private equity was scarcely recognised a few years ago. Today it has
become synonymous with shadowy high-rolling City financiers who have a
hunger for takeovers and the huge profits they can bring.
Yet the phenomenon has been around for at least 20 years. KKR’s titanic battle
for control of RJR Nabisco was concluded in 1988 and inspired the book
Barbarians at the Gate. Many of the current generation of private-equity
practitioners were still at school then.
Over the past three years, private equity has emerged as a huge and powerful
force. In 2006, the value of global private-equity deals was nearly $750
billion (£380 billion) – five times the figure for 2003.
The British private-equity industry alone is reckoned to have invested more
than £75 billion in businesses around the world, second only to American
private equity. According to the British Venture Capital Association, the UK
private-equity industry has about 5,000 direct employees; and it has brought
huge income for the bankers, lawyers and advisers who service it.
For Britain, last month’s £11 billion takeover of Alliance Boots marked a new
high-water mark; it was the biggest private-equity acquisition in Europe and
the first of a FTSE 100 company.
But the Boots deal has been comfortably eclipsed by takeovers on the other
side of the Atlantic. A consortium of private-equity firms successfully bid
$45 billion for the American power company TXU.
And, strikingly, of the 65 companies in the FTSE 350 that have been taken over
since the start of 2005, 27 went to private-equity buyers.
For stock-market investors, this has become a huge consideration. Not only do
they need to ask whether shares in a company represent sound value, they
also have to ask if the company will be the next target for the
private-equity sector – and what that means for their investment.
