The private equity industry is used to being called names: locusts, vampires and vultures. It has shrugged them all off and is enjoying a boom that has prompted soul-searching across the City of London as British companies are picked off at a record rate. Wm Morrison, the supermarket chain, is the target of the UK’s biggest leveraged buyout since 2007. The UK should not be overly concerned about private equity ownership. But there are arguments for tempering some of the outsized incentives the industry enjoys, namely tax breaks and leverage.
Private equity is awash with money, buoyed by stubbornly low interest rates and investors hungry for yield, attracted by a sector that does not move in lockstep with markets. Meanwhile, Brexit and the pandemic have depressed valuations of British companies. These trends have prompted a record 345 buyout bids for UK companies, 13 of which are listed, in the first half of 2021. Fund managers complain of substantial undervaluing of target companies’ shares. This argument has been given short shrift by dealmakers, who quite reasonably question what fund managers were doing sitting on shares if they were so undervalued.
More substantive are funds’ complaints of an uneven playing field. Private equity argues that it is beneficial in turning around struggling companies, away from the glare of public markets’ short-termism, and that such companies need investment only buyout groups can afford. But the industry’s record should also give some pause for thought: job losses are common in the short-term — although dealmakers argue restructuring can bring different jobs in the long-term — and there is some evidence of a higher risk of bankruptcy for companies backed by private equity in the longer term, particularly in sectors with thin margins such as retail. A five-year exit plan, as is typical for private equity, is hardly long-termist.
A Fortress-led consortium is Morrison’s preferred bidder, following pledges to safeguard pensions and minimum £10-an-hour wage. The government has sought assurances. But such promises should be approached with caution as they are often not legally binding.
Rather than restricting ownership, it may be better to restrict buyers’ tools. Both the UK and US impose caps on interest’s tax-deductibility. Britain could also look at limiting the amount of leverage deployed, which magnifies private equity’s profits but can saddle companies with unsustainable levels of debt. One model might be the limit imposed by the European Central Bank on lenders extending riskier loans to six times a company’s earnings before interest and other costs.
One reason private equity is in a rush to spend now is that President Joe Biden has proposed changes to the tax treatment of one of the industry’s most prized streams: carried interest. This is the “20” in private equity’s infamous “2 and 20” fee structure: management fees of 2 per cent, plus 20 per cent of any profits over a set amount. “Carry” has been treated as a capital gain rather than income — therefore subject to less tax — since private equity was a fledgling industry. Biden has, controversially, proposed a near-doubling of capital gains tax to nearly 40 per cent.
The UK this year quietly shelved any alteration to carry’s tax treatment. One argument for parking the issue was that it would put the UK at a competitive disadvantage. If Biden’s proposals go through — a big “if” — the UK should dust off its consultation. Private equity provides a useful function in any ecosystem, but it should not be allowed to feast unfettered.