Tuesday, July 10, 2007

'The Ugliest Face of Capitalism'

One of my wife's favourite movies is the modern day Cinderella story of Pretty Woman. The lead male character, played by Richard Gere, is a private equity financier. He buys companies, plys them full of debt, and then asset strips them, selling the parts for more than he paid for the whole. The principle female character, a hooker played by Julia Roberts, says they are the one and the same - 'We both screw people for money'.

During my visit to the Mother Country, I have been surprised by the amount of media coverage of the private equity (PE) industry. And it's not to sing their praises.

The sticking points appear to be

  • the low tax rates they attract on profits
  • the miniscule amount of corporate tax they pay
  • the 'cloak and dagger' nature of the industry
  • that they load companies full of debt and then asset strip them
  • the egregious sums of money that accrue to the partners
Having worked in the industry for many years (i used to work for a hedge fund that provided private equity firms with leveraged finance), i have some insight into these issues.

i) Do they pay too little tax?
In a word, yes. There is no need for PE firms to only be subject to Capital Gains Tax on their earnings (which if held for two years reduces to 10%). The much earlier seed financing of Venture Capital has a legitimate case to argue for tax breaks but PE firms don't invest in small businesses. Nicholas Ferguson, head of SVG Capital, remarked that it was unfair that private equity partners should pay less tax than their cleaners, saying

"generous tax breaks were designed not to make private equity executives very rich but to encourage investment and entrepreneurship".

He is right. The tax break on 'carry' must end.

ii) Do they pay too little Corporate Tax?
No. In a nutshell PE works by buying under-geared (too little debt) but cash-generating businesses and plying them full of debt. As interest payments on debt are fully off-settable against profits, they are highly tax-efficient and often PE companies end up paying no Corporate Tax at all. However, this tax break is open to all companies, both public and private. And Corporate Tax is a very poor form of tax.

iii) Is it a 'black box' industry?
No. PE owned companies are privately owned, are not listed on Stock Exchanges and therefore not subject to the intense media and shareholder scrutiny that applies to all public listed companies. That they don't have to answer to the tyranny of quarterly reporting or to comply with th onerous Sarbanes-Oxley laws enables them to take a longer term view of the business and to actually focus on making money. Is this a good thing? Well, Polly Toynbee has a predictably old-fashioned view,

'They rarely appear in public to be called to account. How often do you see one on Newsnight?'

Polly neatly demonstrates that her ignorance of finance is matched only be the envy of her politics. PE firms are private. They do not need to be in public to be held to account. They most certainly do not need to be on Newsnight defending themselves against hysterical journalists.

However they do have to provide full disclosure (often quarterly) of their business to the bond and bank market so it's not to true to describe them as black boxes.

iv) Don't they just load companies full of debt and then asset strip them?
Yes and no. PE firms do load their companies with debt. That much is true. Often to eye-watering levels (banks are now happily funding business models with debt levels of up to 10x EBITDA or earnings). However, they are not asset strippers. The most common strategy i came across was quite the opposite - 'buy-and-build'. This is where a PE firm buys, say, a publishing business, then buys a market research company, combines the two, takes out costs and refloats on the Stock Market at a fat premium.

v) Don't they earn obscene sums of money?
Yes, they most certainly do. And this is what the debate is really all about. The fact that they turn around failing businesses, that they buy gems from fund managers too sleepy to notice them, and the fact that they add jobs in the long term, is all irrelevant against the charge of excessive wealth generation for a few greedy evil capitalists.

Dave Calhoun was recruited from GE to run VNU, a Dutch media group for a reported $100m package.

And this is where i take issue. Capitalism makes people richer. Only the most dogmatic head-in-the-sand socialist would now dispute that. However, it does so at a very uneven rate. I think people are prepared to accept the likes of Richard Branson becoming billionaires because they have risked their own money time and time again, created thousands of jobs and have paid millions in taxes. However, they are not prepared to accept the likes of Dave Calhoun earning $100mm for three years work as he is taking minimal risk and he is not building a business.

And it is in this area, individual wealth creation, that the PE model is most at risk. When the credit cycle turns, as it inevitably will, this industry will take a beating.

Sources; Eclipse of the Public Corporation, by Michael Jensen
'The Business of Making Money' - The Economist
Title 'the Ugliest Face of Capitalism is a quote from ex-Guardian editor, Seamus Milne