Challenges to Private Equity Business Models: A Tax and Legal Perspective

If you want to be an entrepreneur, or finance a high growth business, move to France. 

A casual reader of the most recent EVCA benchmarking paper – published in 2008 – might be tempted to reach that conclusion.  The EVCA’s regular study aims to assess the extent to which European tax and legal environments favour private equity, venture capital and entrepreneurship. 

It does that by measuring their performance against a number of criteria.  It came as a surprise to some that France – with its comparatively high tax rates and relatively inflexible labour laws – was at the top of the 2008 table. It was just ahead of Ireland and Belgium. The UK dropped to fourth place, having been first in 2003 and 2004. As in previous surveys, Germany was towards the bottom, only marginally ahead of countries with much less developed private equity markets like Cyprus, Slovenia and Slovakia.

Those who compile the report – KPMG, supported by the EVCA Tax and Legal Committee among others – have a tough job. It’s tough because there is clearly lots of room for disagreement about which criteria to use, and about the weight to assign to each.   What’s more important – the corporate tax rate, or the availability of a tax transparent fund structure?  Investment restrictions for pension funds, or capital gains tax rates? And of course even once you have identified the criteria, people will disagree about the score you give for each, especially when trying to synthesise something very complicated into a score of 1, 2 or 3 – like the restrictions on pension fund investments in the asset class. 

So the result is bound to be something of an approximation, and to some extent subjective. France has made many improvements in recent years, and Britain has certainly seen some damage to its reputation as the financial centre of Europe.

Even so, and despite the many excellent reasons to live in France, this study is probably not decisive in many people’s re-location decision. And nor should it be. But that doesn’t mean that it is not a highly relevant study.  It is, especially at the moment.

The composite average score is much less interesting in my view than the individual scores, and the criteria selected by the EVCA to benchmark countries.These criteria provide a checklist for all European Governments of the policy interventions which they can focus on in order to encourage entrepreneurial growth businesses to be founded, to get funded, to grow and develop, to re-structure, to become more efficient, more productive, more innovative.
One thing we do know, is that as Europe emerges from recession, governments all over Europe are looking hard at policies with these objectives.

So we can expect that governments will be more willing to look at these policy suggestions, especially if – as an industry – we can persuade governments that private equity can be part of the solution to the current economic woes.

Here are some of the EVCA’s suggestions:

• Facilitate investment by pension funds and insurance companies.  For many countries that means looking at the quantitative restrictions on investment in the asset class.

• Tax efficient domestic structures are important, especially for smaller funds which need to make use of a low cost vehicle that is suitable for all kinds of investors and is easy to administer. 

• Tax breaks for early stage companies, and for those that invest in R&D.  Lower tax rates more generally may be a vain hope, but it is critical that governments think carefully about how to target tax rises.

• And the EVCA believes that equity based incentives which are aligned with the objectives of investors – sweat equity, stock options, co-investment and carried interest – should be taxed sympathetically.

These are not by any means the only things that government can do to help stimulate the enterprise economy – there are many others.  The European Commission itself has recognised many of them in its reports on risk capital, including – for example – the importance of making it possible for venture and growth funds to be able to raise money on a pan-European basis through the use of a single European regulatory passport.  There is also much academic research on the subject, especially in the US.

And the BVCA in the UK has recently won support for a government backed Innovation Investment Fund, which has been launched in the last few months, with Hermes and the EIF appointed to manage funds of funds to invest in European venture.  We were proud to represent the UK government on that project, which is a project that demonstrates, I think, that governments are willing to back constructive policy suggestions now perhaps more than ever.

As an industry, we know what drives businesses forward, and we know what holds them back.  We have to use that expertise to help governments to develop effective and positive policy. 

It is critical that we are seen as constructive participants in the policy debate, rather than as reactionaries opposed to change.

Private equity as a force for good

But in order to be taken seriously, it is important to explain how private equity can be part of the solution to Europe’s economic woes, and why it is not part of the problem.

Fortunately, there is ample evidence that our industry is a force for good.  Here, for example, are some of the main conclusions from the BVCA’s most recent study of private equity in the UK.

Successive studies – not just from the industry itself, but academic studies too, including one last year for the World Economic Forum – show that private equity owned businesses grow faster, create more jobs in the medium term, and increase productivity and innovation more quickly than their publicly quoted counterparts.  There is more disruptive activity following a private equity acquisition, but the average result is an increase in performance for the benefit of all stakeholders.

We know the reasons for that.  It’s partly because businesses at certain stages of their development need more than just finance – they need hands on, knowledgeable shareholders. 

It’s also in part because of the alignment of incentives at all points in the value chain that has always been at the heart of private equity.  That alignment can be made better, as the Institutional Limited Partners Association (ILPA) recently pointed out,  but it is and always has been core to the private equity model, as ILPA also acknowledged. 

Putting the case for our industry, and doing so in a positive way, will of course also help us to defend it against regulatory attacks.  And, unfortunately, at the moment the balance of regulatory intervention seems to me to be going in the wrong direction.

Much of this is focused on the buyout sector, but most could also affect venture and growth capital funds.
Governments have a mandate to regulate the financial services industry.  In fact, more than a mandate.  In many countries they are competing with each other to be seen to be doing so, because they know it will win them votes.

While it is clear there will be more regulatory intervention, and while we have to embrace that because it is a fact of life – and is probably right – we do have to identify those things that are challenges to the way that we do business. 

Unfortunately, there are a number of those on the horizon. 

Threats to the private equity business model

We, in fact, are at a regulatory inflexion point in much of the world, and misguided interventions could do serious damage.  There are moves afoot that could have the effect of changing the structure of the industry, and affect its ability to recover as markets recover.

I want to cover three main categories of threat: the tendency to treat private equity funds like conglomerates for regulatory purposes; the tendency to treat us as business owners differently – less favourably – than other shareholders; and the attempt to impose “one size fits all” regulation on the industry –  a lazy, and definitely sub-optimal way to regulate markets.

The conglomerate effect

Private equity and venture capital funds have always behaved as active shareholders – that is an important part of their value proposition to investors, and why they are a real and compelling alternative to investing in listed company funds.  But they have also, very deliberately, not behaved like conglomerates, grouping portfolio companies under a single head office, cross guaranteeing debt and trading extensively between themselves.  But that is increasingly how regulators want to treat them.

Regulators have various reasons for doing this.  Sometimes it is because they have policy reasons for wanting to aggregate portfolio companies together. 

We have a live example of that in the UK at the moment. 

New regulations which aim to help the UK achieve its targets to reduce greenhouse gas emissions are coming into force this year. They apply to businesses which use more than a certain amount of energy.  Because the compliance burden is not insignificant, the government has decided not to apply it to smaller,less energy intensive businesses – a simple cost benefit analysis. 

However, the rules have been very deliberately drawn up – and we know it is deliberate because we have discussed this at length with the Government – so that they will aggregate energy use across a private equity portfolio.  That means that if a buyout fund owns five businesses, each of which uses only one fifth of the energy required to put it above the qualification threshold, the “group” – the portfolio – has to comply, and each of those businesses is effectively put to the compliance burden that similar businesses which are not owned by private equity funds would avoid.

The Government wants that result because it says that it wants more businesses to qualify and that private equity funds have the resources to comply. 

This seems quite wrong to me as a matter of principle, but the important point is that regulatory changes like this will force a change in the business model – private equity firms will have to start to operate more like a head office.  In the case of the CRC Regulations, they will need to get reports of energy consumption from all their majority owned portfolio companies, aggregate that across the fund – sometimes even across multiple funds – where appropriate register under the scheme, make payments on behalf of the group, collect those from their investees, receive rebates and work out how to distribute those rebates across the portfolio.  Not something that most firms are geared up for, but something they will have to do in future.

Let me take another similar example – accounting requirements.  There are a number of different regulations at the moment which all seem to be moving the buyout industry towards having to prepare consolidated accounts for their portfolios.  Now, most people accept that consolidated accounts are a nonsense for investment funds.  Indeed, in the US, the accounting standard setters have accepted that and have provided a carve out from the consolidation requirements for investment entities. Unfortunately, that is not the case under International Accounting Standards, and current rules require a private equity fund with majority ownership of any portfolio company to prepare consolidated accounts. 

A number of regulations, including possibly the Alternative Investment Fund Managers Directive, and some new rules likely to come into force in the UK this year, are moving the industry closer to having to prepare IFRS compliant accounts. 

That would, again, be requiring funds to behave like conglomerates.  Preparing consolidated accounts – I am told by the accountants – is not a straightforward exercise.  The simplest way to do it is for all companies in the group to have the same auditors and the same year end.  That is of course possible to do, but it is not the way that funds have operated in the past.  Their portfolio companies are treated as separate businesses.

In this case, I don’t think that there is a policy reason to require consolidated accounts to be prepared. In this case, I think there is a real fear that if a carve out were created it would allow abuse by real conglomerates.

Discussions on this question are ongoing with the IASB - the standard setter – and I hope they reach a sensible conclusion, but that remains far from clear.

There are other examples of this conglomerate approach in regulations.  It has long been the case that grants or exemptions which are available to SMEs – to businesses that fit the definition of a small or medium sized enterprise – may not be available to private equity or venture capital backed businesses.

Again, it seems to me that this is to misunderstand the nature of a fund – perhaps deliberately, perhaps  accidently – or perhaps because policy makers can’t figure out how to accommodate them appropriately. 

This is a point that the industry has to hammer home to regulators.  Our business model is not the same as a conglomerate, and for good reason.  We have to move policy makers away from thinking in that way, and we have to help the technicians to find solutions that they feel comfortable with. 

An unlevel playing field

There are also those who see private equity as destructive owners of businesses; those who have caricatured what the industry does; or those who don’t agree with specific decisions that have been taken.  For those, a policy objective is to put private equity at a competitive disadvantage to other types of ownership model – listed companies, or those owned by sovereign wealth funds, or direct investors.

The UK saw that kind of attack a few years ago, shortly after the industry was labelled as “locusts” in Germany.  Those political attacks were undoubtedly exacerbated by a lack of preparedness on the part of the industry for the sustained media attention which was an inevitable consequence of its rapid growth.

But friend and foe alike also took note that private companies in Europe are subject to different transparency and reporting standards than public companies. 

That led to demands for more disclosure and more transparency for private equity owned businesses than company law strictly demanded. 

The industry responded quickly and effectively to that challenge – the Walker guidelines in the UK, emulated in several other European countries, mandated voluntary public company-like standards for large private businesses. 

Sir David Walker made it clear that there was no justification for treating private equity owned businesses any differently to other large private businesses – the public interest is the same whoever owns the company – and encouraged other owners to adopt them too. 

But the principle of treating private equity firms differently seems nevertheless to have taken hold, and is one of the objectionable principles in the European Union’s draft AIFM Directive.  The Directive includes a section on disclosure requirements for businesses – anything other than an SME, so a pretty low threshold – owned or controlled by a fund. 

These rules would not apply to equivalent private businesses which are not owned by private equity funds. 

Of course, more disclosure and transparency is to be embraced – it will help us to demonstrate that the industry has a good story to tell.  The response of the industry to the Walker guidelines and equivalents elsewhere demonstrates that the principle is being accepted. 

But we must also make it clear that it would be wrong to place our industry at a structural competitive disadvantage.

To take a live example: Kraft’s takeover of the iconic UK brand Cadburys.  Would it really be right to put obstacles in the way of a private equity fund taking over this company that would not apply to a US acquirer?   That is what the AIFM Directive would do.  It would require higher disclosure standards than would apply to a Kraft-owned Cadburys.

That cannot be right, and I believe that as an industry we have to argue strongly against it, or it could end up undermining our ability to do business.

“One size fits all” regulation

Of course, the AIFM Directive is a case in point here.  Although that directive is not all bad, and does seem to be getting better as it goes through the complex EU legislative procedure, it remains an example of poorly constructed, knee jerk regulatory reaction, which seeks to impose restrictions on a segment of the market without first taking the time and trouble to properly understand it. 

Some of those changes are objectionable in principle and pointless, and will just make it bit more expensive to raise and operate a fund.

But there is a clear danger that some of them will damage the industry even more fundamentally, and drive people, businesses and investors away from London, Paris and Frankfurt. 

Actually, I think that this is an area where the industry has already fought back very hard, and where regulators have started to listen sympathetically.   There is a recognition among many involved with the Directive that the regulation needs to be more carefully targeted and cater for the specificities of the private equity industry.  But that debate is absolutely continuing – it is far from over.

But another big debate is looming – capital requirements for institutions which treat shareholdings in unlisted companies as a block, and fail to take account of the fact that the risk profile of different strategies varies hugely within that very broad market segment.  These could be very damaging.  I am sure we will hear more on that subject in the years ahead.  Regulators have to be sophisticated enough to understand the specificities of the businesses they are regulating.

Taxation

Finally, a very brief word about tax.

Much of the European private equity industry is built upon capital gains.  Founders of businesses and management teams take stakes in their own businesses, which aligns their interests with those of the other shareholders.  Carried interest holders do not usually receive their carried interest until realisation of assets and until returns above a benchmark have actually been delivered to investors.  Again, they do this by taking an equity stake in the underlying businesses, giving them a share of the capital gains that are realised for investors. 

Most modern tax systems recognise that capital gains should be taxed differently to income – usually at lower rates, certainly if it relates to long term gains made on the sale of businesses.  And tax systems do not tend to limit the capital gains tax treatment to those who make financial investments to businesses – most recognise “sweat equity” in the same way.  Profits made from the sale of businesses built with the help of ideas and hard work on the part of the owner are still treated as capital gains, and generally not taxed as remuneration for the owner-manager. 

That tax treatment is under threat in two ways. 

In the United States at the moment, there is considerable momentum behind the movement to tax carried interest as employment income.  It is not yet certain where that debate will end up, but in Europe, for the time being, most countries do still accept that, in principle, capital gains made by management teams and indirect equity holders are subject to capital gains taxation, in most cases subject to restrictions to prevent abuse, which in some countries – like France – have been tightened recently.

But capital gains tax rates themselves are also rising.  Our industry relies on entrepreneurs and business owners taking a stake in the success of their businesses.  It is important that they are incentivised to build businesses for capital reward, rather than drawing large current salaries.  The place of capital gains tax rates in our tax systems is an important constituent in that mix, and it is not clear how changes to the system will affect the incentives of entrepreneurs.  Policy-makers need to be careful here.

So there are a great many fronts on which the industry needs to fight – some of them technical and some political.  These causes are going to be worth fighting, because as an asset class some of the assumptions that we have relied on for the last twenty years are being challenged. 

It is not necessarily wrong for policy makers to challenge them.  That is their job – especially at the moment. 
But in my view many of the challenges are ill-conceived, and often stem from misunderstandings of what the private equity industry does and how it does it.   

This is an important defensive mission, but I have argued that we must not ignore the positive one too.  Not just to argue against bad regulation, but to fight for a more sympathetic environment for the companies that will define Europe’s future.

This is no time to ignore policy makers, or to seek to fight with them.  I think that we have to find ways to work with them to develop bold proposals for the decade ahead. 

Simon Witney, Partner, SJ Berwin LLP