Questions for Ed Balls
Ed Balls鈥檚 and whether British companies in general invest with a long-enough time horizon was welcome, largely because this is a serious issue of profound importance to our future prosperity 鈥 but one that ministers rarely touch even with a mile-long barge pole.
It鈥檚 just a bit too huge, serious and daunting for most politicians. And to Balls鈥檚 credit, there wasn鈥檛 as much of the speaking-clock-style 鈥渢hese are our great achievements鈥 stuff that normally fills such ministerial addresses.
The more significant points he made were that he, as minister for the City, recognises the contribution that private equity can make to UK productivity growth, that there are good and bad private equity firms (wealth-creating long term investors and short-termist, asset-stripping cowboys), and that a mindless crackdown on the industry would deprive the UK of an important source of capital and management expertise.
But there are some big questions that he left unanswered, possibly because to do so might turn him into an hors d鈥檕euvre either for the City鈥檚 sharks or for the predators of the trade unions and the Labour left. So here are those questions, for him to ponder:
1) Does he really think, as he implies, that the three-year investment time horizon of many private equity firms is long enough for an economy wrestling against India and China, where they plan 10 and 20 years ahead?
2) He takes comfort from the fact that private equity-owned businesses are still a smallish proportion of the British economy. But that鈥檚 to look at the stock rather than the flow of deals. For years now, money pouring into private equity for purchase of British businesses has far outstripped new money going into UK listed businesses. According to the Financial Services Authority, the UK equity market capitalisation shrank by a net 拢46.9bn in the first half of 2006 and has not grown since the last quarter of 2004. Does he think this rapid transfer from public to private is healthy and sustainable?
3) There will be no general review by the Treasury of the principle that interest should be deductible from corporate tax. But the debt in private equity deals is on a sharply rising trend, as measured by the ratio of borrowing heaped on private equity-owned businesses to their earnings before interest, tax, depreciation and amortisation (an accounting proxy for cash flow). When you couple that with the increasing volume of private equity deals, it means that there is sharp downward pressure on corporation tax revenues for the Exchequer 鈥 because more debt means more interest payable which means lower taxable profits which means less tax. Isn鈥檛 that erosion of the British tax base a serious worry?
4) The Chancellor introduced a 10% rate of capital gains tax largely to encourage the creation of new fast-growing businesses in the UK and provide an incentive to entrepreneurs. Does he think that the spirit of that CGT reform is being met in the way that the partners in private equity firms typically benefit from this 10% rate on their 鈥渃arry鈥 (if they pay tax in the UK at all, they will typically pay 10% on their very substantial share 鈥 usually 20% 鈥 in the capital gains on any private-equity realisation)? Are the many tens of millions of pounds that private equity partners pocket from these deals really rewards for the kind of risk-taking that the Treasury wanted to encourage with the 10% rate?
5) These days everybody loves transparency. And certainly a sensitively drafted code of disclosure for private equity-owned businesses 鈥 of the sort that鈥檚 being encouraged by the Treasury and Balls 鈥 might see some of the rapacious cowboys driven away. But isn鈥檛 there a risk that new disclosure rules will be at best cosmetic and at worst damaging? The point is that private equity houses that engage in bigger deals, such as Permira, already publish a great deal of financial information about the companies they own. They are motivated to do so, in order to create excitement and interest from potential investors or trade buyers for the moment when these businesses are sold. On the other hand, the smaller and younger businesses owned by private equity might find new disclosure requirements both prohibitively expensive and potentially damaging (if the veil were drawn back before they are robust enough to withstand competitive onslaught). So let鈥檚 not fool ourselves that transparency is always a public good.
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Robert, I have a few questions with regard to your 5 points.
1) Having worked closely in the China and India economies, there is little evidence to suggest that companies think 10 -20 years ahead. Their governments think ahead in these type of timeframes and it should be made clear that our government should also be doing so, in order to ensure that UK business is enabled to be competitive over the longer time frame.
2) The market will clear. It has become increasingly obvious that the PE model allows greater efficiency to be found in companies, as it is easier to align incentives. In public companies, there has been much spin about "shareholder value creation", but fundamentally, the incentives of a board to generate that value are less than clear. Until the incentives of the boards of public companies become truly aligned to value creation, a greater proportion of investment will go to private companies (ignoring the financial risk dimension)
3) Fundamental economic principles define the optimal point of gearing for any company. Over the long term, over-geared companies have a greater default risk, that may or may not be priced into current values. I am not sure that advocating that the chancellor should disallow interest for tax is a constructive argument: it will impact a great many other businesses aside from those owned by PE and fundamentally impact the attractiveness of the UK as a market to operate in.
5) Your final comment is petulant. I for one would be very grateful for greater transparency of information on PE owned companies. Better information is generally "for the public good", as it helps make more perfect markets.
Robert,
A couple of points on your interesting column.
1. Sadly, I am old enough to recall the great growth story of the 60's and 70's - the Japanese economy, that was supposedly built on the long term strategic investment plan led by MITI. We don't hear so much of that today whereas our supply-side reforms of the 80's and 90's seem to have been of greater lasting impact.
2. You are wrong to say that partners enjoy 20% "carry" in deals. Classic carried interest will be funded by 20% of the gain in value of the overall fund, but partners in the firm will typically share in 60% - 75% of the carried interest plan - i.e. 12% - 15% of the gain in value. This is still a substantial sum but not as great as you suggest. However, you fail to point out that senior managers in the pe fund may also participate in co-investment plans where they are allowed to invest their own funds in each deal made by the fund. The aggregate effect is a "double-dip" in the profits of the deal (assuming the investment makes a positive return).
One man's expense is another man's profit. Corporation Tax is just as good on the profit made from money lending as it is from trading.
Similarly a low corporation tax rate doesn't help businesses grow - as you have pointed out investment expenses are tax deductible. All it does is help increase the profits of those selling them on. If you want to grow business then a flat 30% CT rate would be best - coupled with a scrapping of secondary class 1 National Insurance.
Please remember to think of the wider economic flows when talking about taxation. We have enough 'individual sitation thinkers' muddying the waters as it is.
I think that there is something wrong with the sentiment expressed here:
"...that there are good and bad private equity firms (wealth-creating long term investors and short-termist, asset-stripping cowboys)..."
Does Robert not think that it is overly simplistic to say that good private equity is concerned with growing and developing business and bad only with shrinking and asset stripping?
Simplistic because sometimes companies need to be "asset stripped" so that capital can be more effectively deployed elsewhere in the economy. Liquidation serves an important market function that is too often ignored.
That is not to deny that it can have many short term painful effects (particularly on those that lose their jobs). But we've got to realise that the economy needs to be flexible which means growing and shrinking in different ways as appropriate. It is not appropriate to grow in all ways at all times (nor is it possible).
I would expect the 成人快手 to actually research the facts before reporting on the private equity industry.
Please explain what "tax breaks" the PE industry enjoys in respect of debt finance? Since 2005 the PE industry has been subject to the same rules on deductiblity of debt as every other corporate in the UK.
In addition, lending banks also pay tax on the interest income deducted against the portfolio company profits - so where exactly is the loss to the exchequer?
Dear Mr Marr
PLEASE.. As Mr Balls the quistions raised in this mail.
In my opinion, young people are still seen as a negative problem to be controlled and contained and the truth is that the solutions offered by many of the good intentioned consultations, rarely go beyond `asking them (young people) what they want` and more often that not, state the blatantly obvious.
Despite all the hoo-haa surrounding papers like 鈥淭ransforming Youth Work鈥 and statements such as 鈥淧laces To Go Things to-do鈥 and most recently `Aiming High` from a rural practitioner鈥檚 point of view, they have offered little, if any means of increasing opportunity in rural Teesdale. I firmly believe that these - rural - difficulties are not fully appreciated by policy makers and we are increasingly dealing with the consequences, manifesting itself in many ways from young peoples disappointment that their needs and aspirations, are more often just `noted` rather than being met in any real tangible way. How will Mr Balls ensure that there will be equitable shares of the expressed spend for rural young people? Will Mr Balls ensure that it is rural proofed?
Keith Jones
Barnard Castle
County Durham
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