Private Equity

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Private Equity; Strippers or Saviours?

by Simon Creer 

A storm of controversy has been growing in recent weeks around Private Equity Firms and their practices. There are over one hundred and seventy active firms in the UK. Executives from a number of these firms have faced a Treasury Select Committee while unions, such as the GMB, are aggressively calling into question Private Equity Firms' investment and management techniques. The question then must be who are these allegedly shadowy figures in business and what do they do?

At a broad stroke private equity describes investment in a company or assets that are not freely tradable on the public stock market. The system provides an opportunity for high-risk start up businesses to gain investment without floating on public markets such as AIM or the FTSE, with their attending regulations.

More often than not a Private Equity firm, a collection of investors, will work closely with the management of the company requiring the investment and will on occasion bring in new management teams with a wealth of experience. The theory is that this ‘hands on' approach will bring about rapid economic growth making the company more valuable.

Once a company is seen to be valuable enough to make the private equity investors a profit the firm will seek an exit. The ‘exit' is usually achieved through an Initial Public Offering (IPO) during which shares are traded on the public markets. In exchange for this investment and turnaround the general partners of the Private Equity Firms are compensated with a combination of management fees, transaction fees and carried interest, of which more later.

The British Private Equity and Venture Capital Association (BVCA) website offers an insightful guide to this type of investment. The introduction describes Private Equity as "a medium to long-term finance provided in return for an equity stake in potentially high growth unquoted companies." The guide continues "Private Equity provides long-term committed share capital to help unquoted companies grow and succeed."

The guide concludes by listing a number of well-known private equity backed companies which includes, Ben Sherman, Earls Court and Olympia, Early Learning Centre, First Leisure, Gala Group, Halfords, Kwik Fit, Linguaphone, Ministry Of Sound and The AA. In fact, writing for the BBC in June of 2006, Mark Gumienny, Managing Director of Candover, a large Private Equity Firm, states that these firms buy one in three of every company sold and those companies in turn employ one in five people outside the public sector.

Mark Gumienny argues that they see their role "as empowering business leaders as they seek to make change." He believes they "offer a capital market in parallel to publicly quoted companies." Why then, with this combination of profit seeking and altruism that Mr Gumienny describes as releasing businesses from, "the treadmill of having to publicly report on everything to a legion of investors they barely know," have Private Equity firms been probed by The Financial Services Agency (FSA) and had to face a Treasury Select Committee?

Company Management by Private Equity Firms 

The predominant complaints against Private Equity firms come in the form of two main grievances. The first involves they way in which they go about managing the companies they acquire. The second involves certain tax incentives, of which these firms take full advantage.

The management of acquired businesses by Private Equity firms has come under attack from the GMB. Phillip Inman reporting for The Guardian quotes GMB spokesman as saying Private Equity was an industry that "had fallen in love with itself and the rewards on offer," and the Unite spokesman Jack Promey claimed "more was known about the cosa nostra than Private Equity Firms before unions campaigned to expose its activities"

Union leaders accuse companies such as Primera, 3i, and KKR of asset stripping for personal gain, sacking workers and cutting off pensioners. One case in point, involves Primera's purchase of The AA. After Primera took over nearly three and a half thousand jobs were promptly lost.

Danny Forston reporting for The Independent in February says, "GMB accuse the industry of generating super returns by making savage cutbacks" Paul Kenny, head of GMB, has allegedly dubbed Private Equity firms "amoral asset strippers after a quick buck." Ian Griffiths, reporting for The Guardian on June 28 2007 on an apparent merger between SAGA and AA, two private equity owned companies, quotes a GMB spokesman as saying £70m of The AA's £200m profits were attributable to the 3,000 plus cuts in the workforce.

Tax Breaks for Private Equity Firms 

The second grievance regards certain tax breaks that Private Equity partners enjoy. The primary complaint focuses on "carried interest." The theory of "carried interest" allows firms to take 20% of profit from the sale of a company it has managed for a minimum of two years and treat it as capital gain rather than income. The result of this is that Private Equity bosses pay only 5% tax on their profits as opposed to an income tax rate of 40%.

This incentive is cited as compensating investors for the high levels of risk they take in pouring money into unproven companies. However, as the industry has grown, their investment targets are becoming less and less risky. It is hard to argue that Alliance Boots, KKR's latest target is a risky investment. Phillip Inman reported on June 22 2007 that "Private Equity bosses have tax breaks because of the apparently high risks they take when investing." However Labour MP Angela Eagle speaking after The Select Committee meeting questioned "whether the tax structure can be justified" she then said "I don't think they can"

In a further twist to the role of Private Equity Firms it was announced during the Blair Brown Prime Ministerial transfer that Damon Buffini the chief executive of Primera has been invited to sit on a governmental advisory board known as The Business Council for Britain. This new body will be tasked with advising the Brown government on how to make Britain a better place to do business but the question must linger. A better place for whom?