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From my experience of Private Equity to say that they they manage the company closely is complete rubbish. They buy-in with the management and leave them to get on with it. The private equity houses will move on to the next deal and will sit and wait for the management fees to come in. They will only get involved on the occurrence of certain event and when they want to refinance the company.

If someone buys a house does it up ands sells it capital gains tax applies.But if they keep doing it then it becomes a trade and income tax applies.Rather than mess around with CGT rules for equity financiers why not apply basic principles.Job done.

The thing that's most worrying about this practice is that the 2 quickest short-term ways to improve company profits are - firstly, to decimate the workforce, often in departments such as R & D, thus saving on salary payments - and secondly, to extend the repayment period of the company debt, thus reducing immediate annual payments. The resulting 'savings' are then touted as an 'improvement' - but in reality, no added value has been put into the business, and the long term potential of the enterprise is severely reduced.
What's needed is legislation to make these funds take a longer term view - perhaps any tax benefits should only be payable if the business is still successful after 10 years...

Good article Evan, although anyone who has been following your colleague Robert Peston's blog will no doubt be familiar with much of it already.

However there is one thing I still don't understand about Private Equity, and maybe someone can explain it to me. If i own shares in a company which is a target for a private equity takeover then what is to stop me from refusing to sell my shares and thereby continuing to receive part of the profits? What happened to all the people who owned a few hundred shares in Boots when it was bought?

Evan,
This is a very poor piece of analysis, even by your low standards. I strongly suggest that you spend a bit more time understanding what private equity is, and how it works, before writing anything further on the subject.

Another issue not mentioned with private equity is when they get stuck into companies with what we would call solid finances eg Sainsburys.

As a company Sainsburys own a large amount of property worth several billions of pounds. The private equity companies are looking to release the asset value of the property portfolio and increase the debt that the compnay is carrying thus as you say increasing the level of debt and risk associated with the company.

This is not entrepreunerial behaviour this is very simple financial engineering that carries with it a high level of risk for all parties including the staff employed by the company.

Private Equity companies should be playing on a level playing field and the tax system should be modified and tax the private equity company and partners accordingly rather than the existing system that minimises their tax liabilty.

My view is that the business model that private equity encourages is not a sustainable model. Well done to the unions who have now woken up to this and are challenging the private equity sector.

As someone on the inside its worth pointing out that the view that private equity is all about over-leveraging companies is a bit sensationalist.
Firstly, the debt equity ratio of a deal varies greatly with the size of the deal, and most that happen are mid-sized where debt might be 60% at most.
Secondly, as you say, "they have a very big incentive to run the company well, because they stand to gain all the profits from so-doing". Hence, if an investment goes badly and worst case, goes bust, no-one makes any money. It's not in private equity investors interests to make a deal overly risky by putting in too much debt. Where PE houses are doing this, it's not because of a fundamental flaw in the PE model, more that they're not very good at their job!

Mr. Davis,

In the vast majority of cases, the firms that are taken private by the private equity crowd are undervalued - the standard market has indicated that these firms are 'sick' or at least have a limited future in their current form. As you noted, stockholders typically have a fairly short-term perspective regarding returns to their investments and that typically guides their judgement when it comes to control of their assets. That short-term mindset can have dramatic ill effects on a firm's ability to make substantial changes to its underlying way of doing business to adjust to new market realities. Few stockholders will be willing to put off profitability for 2 to 5 years while a firm re-invents itself in response to technology advances and/or globalization. Such re-invention requires that control of the firm be assumed by a group - the private equity types - that are willing to forego current profitability in order to reconstruct the firm to better compete in the future. While the short-term result is risk, possible job losses and asset sales, the long-term result is an emergent firm that is far stronger and more valuable to shareholders, workers and society at large - assuming the 'deal' works out properly.

You are correct in that the rewards can be high for the risk-takers and that a substantial portion of the risk is borne by the banking system - assuming that the banking system finances the deal as in your example. I suspect however that the banking system should be re-evaluated rather than the tax system - risk-taking is inherently an objective of private equity rather than for banks. Banks are supposed to be very conservative institutions - rightly so - and I would be no more in favor of a foolish (risk-taking) banker on a conventional corporate board than one loaning funds to a private equity group for a high-risk venture.

The essence is this: increasing taxation on private equity returns will only have the net effect of discouraging risk-taking, to the long-term detriment of potentially viable business firms and society at large. The governmental agents that advocate higher taxation of high-risk based returns are demonstrating the same short-term perspective that shareholders typically have.

Why should private equity investors be allowed to put the debt (own funds or borrowing into the company they have just bought? The debt is theirs just like my debt in buying shares or property. I can't offset this if I sell at a loss later. These rules are set up by the wealthy for the wealthly so that they and their friends can make even more money at the expense of the rest of the population.

In addition you have not mentioned the asset stripping which either makes them lots more money or mitigates any potential risk/loss even further. As you point out usually the companies are sold off within a few years so it's for the quick buck like lots of stock market investment.

For those reasons PE is not like a builder buying a house with a hefty mortgage and doing it up and selling it. Only if the builder is a limited company can he offset his losses against tax. Your average small self employed builder could lose the property and face bankruptcy if he fails.

As you say they have these very high tax advantages in PE just like start-ups, but these are not start-ups so should be treated differently. As I said above this is all about the wealthy and influential setting up situations to benefit themselves and their friends and they'll fight tooth and nail to preserve the status quo putting up all sorts of flim-flam arguments.

As an employee of Aliance Boots their acquisition by KKR has worked out rather well for me.. We're being given the offer price for all the free shares the company has previously granted us. As for long term job security that's not really an issue for me as a student but I can understand the aprehension faced by many employees of the former publicly-owned companies being bought out.

The trend of growth of private equity seems to be encouraging a shift in power towards a few managers and away from thousands of shareholders and the generous tax breaks and lack of liability do little to prevent this.

I believe that there is a noticeable degree of unwarranted "anti" bias in Evan's comments. However, the private equity sector's ability to promote (NOT spin) its case is admittedly woeful.
First,putting all private equity under one title is like calling all floating vessels "ships" while the reality is that vessels range from rowing boats to supertankers.
Second, that part of the industry under the spot light is really just a section of the worldwide M&A boom.Its relevance to historic venture capital is between nothing and zero.
Thirdly, "venture capital" (which is where it all started 25 years ago in the UK) has been correctly identified by "Iron First" / Bandit Brown as requiring some support.
Why ? - investment statistics produced by the BVCA (joke) show that some 75% of their members' early stage investments fail. The pension funds and institutions that invest in BVCA members' funds like to see very good returns and the BVCA members clearly do not, to an extremely large degree, generate those from early stage investments ergo- the customer doesn't like it !

To encourage that investment activity therefore, HMG allowed direct (as opposed to investment through funds) private investors to benefit from CGT deferral reliefs, income tax breaks (EIS) and taper relief. Had it not been for these incentives, the very low level of early stage investment seen in the UK would have all but disappeared.
Benefits - Microsoft started in the 1980s on the back of US-based private / person investors.

The fact that taper relief has been hijacked (quite legally) by the M&A private equity sector does NOT mean that everyone is abusing the system.

Evan - clear differentiation is required.

p.s. Try reading Jon Moulton's letter in to-day's FT if you want to see how the Unions are distorting history and the facts - nothing changes.

The points that have been missed out of the article....
Private Equity funds are structured so that the PE managers (the deal makers and staff at PE firms) would only typically invest 1% of the total fund size, eg 拢10m in a 拢1bn fund.

The management at PE houses take their management fee from the investors directly, eg they call for it separately from each individual investor and not 'out of the company' as stated above. Eg the PE house's management fee is based on the size of the fund and is irrelevant to the companies purchased or the success of its companies. The real money arrives on a percentage of profits once all companies are sold in the fund.

My final point is that pension funds are the largest investors in Private Equity. They are also the largest investors in the stock market. I know that I'd prefer my pension to be making gains of 100-150% in PE rather than 8% in equity and bond markets.

Over-tax Private Equity and pension funds will suffer.

Do the banks not seek a personal guarantee from the private equity investors in such loans?

Thanks Evan,you have really explained the position very clearly.I feel that this situation can easily get out of hand. A large number of Britain's private hospitals will soon be owned by private equity companies and with new hospitals being financed by PFI's a significant part of a national resource wiil pass completely from public review.The taper relief from capital gains tax was meant to encourage owners of small businesses realise the capital they had built up after several years' work not to be exploited by transitory serial investors often not even domiciled here.Perhaps this benign treatment of gains has had to be offered to these foreign investors inorder that they keep their capital here to fund our balance of trade deficits .

If the main victims of private equity are notmal trade creditors, then should there be more transparency on companies that have loans with preferential credit status?

The points that have been missed out of the article....
Private Equity funds are structured so that the PE managers (the deal makers and staff at PE firms) would only typically invest 1% of the total fund size, eg 拢10m in a 拢1bn fund.

The management at PE houses take their management fee from the investors directly, eg they call for it separately from each individual investor and not 'out of the company' as stated above. Eg the PE house's management fee is based on the size of the fund and is irrelevant to the companies purchased or the success of its companies. The real money arrives on a percentage of profits in the fund.

My final point is that pension funds are the largest investors in Private Equity. They are also the largest investors in the stock market. I know that I'd prefer my pension to be making gains of 100-150% in PE rather than 8% in equity and bond markets.

Over-tax Private Equity and pension funds will suffer.

Private equity investors have little interest in the long-term health of the company and are only interested in their own short-term gain. The fact that they can enrich themselves to such an extent and pay so little tax is quite ridiculous.

They may claim that they are merely benefitting from risk-taking but in most cases they invest little of their own money and the instead take advantage of cheap debt which has been so readily available in recent years.

When the next recession arrives, and it may be just around the corner, those companies that have been "raped" by private equity investors (and I use the term "investors" loosely) may find themselves struggling to service unmanageable debts and therefore fighting for survival. Only then will be see the real consequences of private equity. By this time of course, the short-term private equity investors will have long since bolted with their multi-million pound gains on which they'll have paid tax at a rate as low as 10%.

Many of the major players in private equity are already multi-millionaires so it seems perverse that the very people who least need such a low rate of tax are allowed to legitimately get away with it.

This could turn out to be the next great financial scandal and questions are sure to be asked about how this government allowed such an inequitable and unfair situation to have developed?

Evan, my fear is, what happens when one (or even worse a couple)of these big private equity acquisitions takes a tumble. The amounts involved are vast and the damage that would be sustained by the banks would be tremendous. I fear that the ripples from a PE takeover collapse might just spur on a real global economic downturn.

I would just like to clarify that 鈥楶rivate Equity鈥� is in fact the banner term for the industry. Private Equity comprises many different types of fund strategy including buyout (LBO), venture capital (VC) and mezzanine capital.

Buyout funds generally take on a lot less investment risk than VC funds. Thus there is a better argument to remove taper relief from buyout funds than VC funds.

As mentioned above VC funds are needed to allow risky new businesses a change to succeed. It is important that people realise that as a whole the private equity industry is a positive thing.

Henry (post 17): if you are a trade creditor and you do not routinely credit check your customers, check the status of debentures held by preferred creditors, and so on, why not? Just because a trader is imprudent in his/her trade dealings and reckless in granting credit doesn't mean that the Government should change the legislation.

With reference to Graham Gibson's post, if someone buts a property (or any other UK land) with a view to developing it this will actually be taxed as income rather than capital gains.

Property is generally a poor counter-point on the tax front since PPR (tax free sales of personally occupied property) actually distorts this asset class even more than any difference in tax rates between capital and income (although this is another debate).

There is an argument for having identical CGT and income tax rates but this differential was largely driven by Labour wishing to be seen to support entrepreneurship and is relatively cheap since capital gains raises a very small proportion of overall tax in the UK.

On the PE front, my (relatively limited) experience was that even on large transactions the focus was not on cost cutting but aggressive growth of the companies concerned. It is true that a leveraged company will offer greater returns in the event of successful running but this is true across the board and it could well be argued that especially during the recent period of cheap liquidity the majority of large publicly owned companies were under-leveraged to acheive optimal returns.

I think we may also be moving towards the end of the current pe cycle with long term bond yields rising and equity prices having caught up from their post dot com crash.

The amounts of debt involved while large are small in the overall size of the debt market and the issues in (for instance) the US sub-prime mortgage market will probably have a greater effect on the banking system than a few high profile PE failures.

There is so much money floating about this planet at the moment. The banks are desperate to put it anywhere for a small increase in return and therefore a PE loan looks attractive.

But just wait until global interest rates have risen to their correct values to control the current credit bubble. We will not be worrying about taxing the gains made by PE, but the bankruptcy of debt laden companies which will suffer the double effect of interest payment increases and reduced consumer demand.

PS is it just me or does the PE acquisition of large brands, of which I can no longer own any part (unless I can afford to buy the whole company!) feel like a return to serfdom?

You said, "It totally changes the way we run companies. Out goes the Anglo-Saxon version of stock-market capitalism. No more do executives get paid a salary for running companies on behalf of disparate shareholders who keep the profits which are generated".

I don't believe that the change is a great as you think. There has been a debate for many years about the attitudes of Directors & Managers of publicly quoted companies to their shareholders. This has seen the rise of the non-executive Director whose responsibility is to protect shareholder value. There is plenty of evidence to show that Directors have structured businesses to maximise the profitability in terms of personal profit through share options, share awards and other short term profit related strategies.

In practice we have seen PLCs structured with excess debt for the directors benefit, increasing share price but reducing dividends to shareholders. Structured short term appreciation does no good to institutional shareholders who hold shares long term on behalf of you and me through or pension and insurance funds.

The virtues (if they can be called that) of Private Equity are i) the down side of the losses are not felt by public shareholders & institutions. ii) large PLCs seeing themselves as Private Equity targets often react defensively by increase shareholder value by running themselves more effectively and in the process reducing the excess value that the Private Equity predator would otherwise have squeezed out as personal profit.

If a complacent PLC fails to manage themselves effectively and gets taken over; then they weren't acting adequately in the interests of their shareholders in the first place.

Having read your article I still don't understand it. Most of today's business and finace seems to me to be slight of hand.
I was once told that the biggest crooks wear suits and work in the city and I think the only people who will disagree with that are the very same.
Lets be honest here, big business, especially the banking and finance sectors are completely devoid of morals or honesty, so it's no surprise that they've found another way to fleece the rest of us.

It seems a matter of political opinion on the rights and wrongs of making money through financial engineering. However it does appear that we are going through a major change in business ownership and although we are assured its a two way street the loss of apparant British ownership of major companies seems more pronounced than the gains.

After Labour claiming Mrs Thatcher sold off the family silver it appears Labour is allowing the sale of the furniture as well.

I would have thought then that the obvious solution to both this crisis and the house price crisis is to weaken a bank's ability to gain security.

If a company fails then it should be referred to court by the insolvency practitioner and the judge should be able to set aside any loan security where that loan was made 'unreasonably'.

You could do the same with houses and refused to let banks enforce their security where an independent review thought the loan 'unreasonable'.

The net result of both these measures is to increase the risk to the banks, and that puts the cost of the money up.

We should stop raising interest rates and start selectively raising risk.

NeilW

Anyone that owns a house in the UK is doing exactly what the private equity industry is doing: buying an asset, mainly with borrowed money, and then hoping the value of that asset goes up. If it does, you win big. If not, you lose the lot. A house which is your principal private residence is exempt from CGT. Capital gains attract 40%, tapering down to 10% at best. I don't understand why everyone is making such a big deal of this: the private equity industry is treated much less favourably than anyone who owns a house, and we've all had a spectacular run on that over the last ten years. Finally, the wealth created by the industry is what ultimately funds our pensions. The better the industry does, the more the pension funds will hold for their future beneficiaries.

Its a shame that the first line of your explanation is already wrong. Private Equity does not mean "Investors borrow money (from banks)". Private Equity simply means that a company is purchased by an individual or group of individuals and taken off the public stock market. It may or may not be done with borrowed money, equating "private equity" with "leveraged buyout" is very sloppy journalism.

Evan,
I think the missing ingredient is also the amount of cheap debt available. If my history serves me well, and i am sure you could correct me, KKR and others during the 1980s used corporate bonds rather than bank debt to finance their acquisitions of RJR Nabisco and others. The same macro-economic environment exists now with large amounts of liquidity making debt more affordable. Surely if the economic conditions changed then, as i am sure they will do now, with tightening monetary policy would this not make PE less competitive in relation to shareholder ownership? I also question whether 'value' is being created. Is not the price of companies going up because there is a lot of money from pension funds, banks, etc chasing a small number of deals? Certainly the prices being put on firms seems to be beyond conventional valuations (again see RJR Nabisco deal in 1989).

Evan

The rush to private equity reminds me of the very late 90s when daily news stories abounded of companies taking money from then very inflated pension funds caused by the stock market bubble to invest elsewhere in the business.

At the time, everyone claimed that the stock markets would never crash because of X, Y and Z. We now know they were very wrong with the large deficits now accured by most large pension funds.

Unfortunately the same seems true with this latest private equity craze. When interest rates rise again to more normal levels, the debt these private equity owned companies will be saddled with will cause their collapse.

However those non-domiciles who benefited from the private equity venture will be safe in their tax havens with large personal fortunes whilst the majority of society will have to deal with the consequences.

Whilst I agree with the fundamental concepts of private equity, I do feel it is generating a new breed of 'Robber Barons' and something should be done to re-adjust the balance.

In answer to John Hailey's question of what prevents shareholders not selling to a private equity bidder - the UK Companies Act contains provisions which forces minority shareholders to sell if a bidder owns can get 90% of shareholders to accept his offer. Having seen the profits being made in private equity, institutions have on many occasions forced private equity bidders to improve their offers and in some cases these institutions (where they exceed 10%) have refused to sell and as a result become holders of unlisted shares.

Also "John E" is wrong to suggest that extending debt repayments will improve a company's profits as debt repayments are capital transactions that are not reported in company's profit and loss accounts.

Dear Evan,
The only question left for me to ask is how can I buy into some of this private equity. Is it really private, a sort of secret society?

Regardless of whether private equity is good or bad, those who think it is good, feel that we should reward the people making money from it by keeping a low tax regime for them. Does this mean that private equity is far more important that all the small businesses in the UK who will have their tax rates increased over the next few years? Do these private equity groups take more risks than a small business person? Probably not in relative terms. If private equity should retain low taxes, perhaps all businesses should pay lower taxes?

No sane person would try to run an engine, or any other system, for long
periods above about 80% efficiency. The problem with private equity is
it takes a low efficiency company, runs it up to 110% and then, just
before collapse, sells it to a bunch of chumps at an inflated price.

Lets say that we don't care that this is no fun for the staff. However a few months down the line all the competent staff will quit and find somewhere nice to work. What's left will be the 'desperate' and the 'too thick to realise they are being ripped off youngsters'. In short the company will burn out and die.

So we destroy the company and throw all the chumps money straight down the toilet. You have been warned. NEVER buy shares in an ex private equity company.

Venture Capitalists are indeed different animals..

They generally wait until a company has a product and preferably some revenue and then do a deal based on the "tag along" principle. This means that even if the VC only owns a minority shareholding it can sell the entire company regardless of whether the other shareholders want to do that or not.

Few VCs will now invest at the start-up or spin-out stages. This is now the province mainly of wealthy individuals or Angel type consortia.

I am reminded of what Richard Lambert - the Director General of the CBI - said recently which was: "In today's rapidly changing economic world order, we must create more global enterprises if we want the UK to remain in the top tier of world economies. Yet in the past 20 years the number we have built from scratch has been low."

Given the culture of the PE and VC community is anyone surprised?

Evan, As one of the idiot bankers you refer to in your e-mail I feel your rather un-balanced article will wrongly influence the views of many of those currently trying to understand the industry. As evidenced I have to say by a number of the posts above. I doubt I have the space to write an adequate response but would like to point out the following:

1) Private equity as an asset class draws its investors from a wide base with a significant proportion of these pension funds. So indirectly a large proportion of the population benefit from the performance of PE

2) Banks do not allow buyouts to be geared up to anything like the 90% level used in your example, for the very reason that unlike your mortgage there isn't usually an equivalent asset sitting behind the loan. Debt in buyouts is structured based upon the cash expected to be generated by the business after rigourous due diligence i.e. on a basis of affordability.

3) While employees in PE firms may benefit from taper relief, the businesses themselves do not in any way benefit from exceptional or unusual tax breaks. A couple of years ago the UK tax legislation prevented taxable profits being reduced by deduction of interest charged on the equity invested in the business.

I could go on but hopefully these three points give a bit of prespective to readers. I just hope the first 40 odd read this and take it on board.

Anyone that owns a house in the UK is doing exactly what the private equity industry is doing: buying an asset, mainly with borrowed money, and then hoping the value of that asset goes up. If it does, you win big. If not, you lose the lot.

Complete nonsense. It's partially true for property developers or even those trendy new second mortgages, but homeowning in the traditional sense is entirely different. You borrow money to buy a house to live in, not as an income, that's a secondary concern. You're not gambling on the house's value increasing, but rather on your personal ability to service the debt. Negative equity does not cause you to lose everything, it's not paying the mortgage that does that.

In any case, houses don't go bankrupt, they do not (in and of themselves) employ staff or serve/supply customers; and the risk is all on the buyer. The creditor can just repossess (because the house still has intrinsic value - even if it's less that what it started, the bank can still get something back).

Companies are different. A company can lose it's intrinsic value, and has it's own obligations to meet. A leveraged buyout shifts the risks from the buyer to the bought and the creditor. As the bought is little more than a slave, the responsibility lies with the creditor.

But they too earn fees on the transaction, so they want the business.

I'd like to know exactly what these fees are, but it seems the solution is to do away with them. When the banks have to take the debt seriously then they'll nip the abusive takeovers in the bud as they will lose out.

Correct me if I am wrong but was not the Great Depression in the USA triggered off in the main by the borrowing of speculators to gamble on the upward movement in the share market?
Private equity appears to be very similar in that they rely on an overborrowed buyer appearing at a later date to provide them with a profit, rather than competant managent of the company in question to generate profits.

Just one point - the overwhelming majority of companies in the UK are not listed on any stock market. Most of them are financed by debt, frequently a second mortgage.

I will ask just a simple question.

When a private investor buys a house he can take the interest as an expense and hence out of his profit. And hence pay less tax!!
On a 拢100,000 @ 5.5% compound interest you are paying around 拢6000 or so as interest. add 拢3000 as capital. Total out going 拢9000.

For a private investor, it cost 拢3000 as he can just take the 拢6000 as expense. Its not fair "level playing field".

Why then, when I want to buy my first house I can't get the same tax relief for me to be on par with them?

Simple answer this question and you will get the root of the current house price valuation boom!!

Nice article but I don't think you should need more convincing on the point of low capital gains tax for start-ups. It has been quite clearly demonstrated by academics that a low rate of capital gains tax is one of the most significant factors in stimulating venture capital. In turn, venture capital is one of the most effective means of stimulating innovation (three times more effective than corporate R&D for example). Given that Europe is supposed to be building an innovation based economy and is already lagging massively behind the US and being caught by India and China in terms of innovation, it would be madness to increase capital gains tax. In fact, I think it would be the single worst tax change any government could make to our long term economic prospects.

Anyway, the philosophical justification for treating capital gains tax as different than income is straightforward. Making a capital gain requires taking a risk trying to increase the value of an asset. Making capital work is the basic requirement for growth in a capitalist economy. The more it is incentivised over labour-derived income the better for economic growth.

Evan, this is an interesting article but I think you have inadvertently confused some people with an inaccurate description of the process. Firstly, private equity funds raise their money from a variety of sources - banks, pension funds, hedge funds and private individuals. Therefore the benefits of these deals are more widely (if not evenly) spread than you indicate. And of course, since the transactions involve bidding above the current market rate for the company then the pension funds and public shareholders "win" in the short-term. You also gave the impression that the PE funds then somehow transfer their debt to the companies they buy. This is not the case at all. The PE fund pledges funding to a proposed transaction. The new transaction vehicle then raises its own debt from the banks to complete the funding. This is an important distinction. In my experience at the smaller end of the market total debt is typically between 40%-60% of the value and at the larger end this could be 70% - but these are much rarer.

Private Equity firms take a business worth nothing and turn it into a business worth something.

Surely that is good for the UK overall?

Any jobs or assets lost in the process were surely doomed anyway if the business was failing and worthless.

Evan, am I missing something here? It's been widely reported in the news that private equity investors are taxed at 10%, a figure you seem to agree with. However, according to this page (https://www.hmrc.gov.uk/rates/cgt.htm), which you would hope would be definitive, CGT is taxed at 40% once you reach the basic rate tax bracket.

What's going on?

I think this is an unwarranted concern, based on a somewhat naive view of how financial risk works. Echoing David #8: long term lenders to a company (unless it is irredeemably bust) ALSO have an interest in keeping it going, and it cannot keep going without working capital, as unpaid suppliers would force it to stop trading. Hence trade creditors may not have formal seniority, but they do have considerable de facto protection.

Therefore, the most junior long term lenders are in fact taking a bigger risk than you, and they guage the riskiness of the debt against the probability of default (not necessarily bust) over a long time period. Even a relatively high but still remote probability of default (junk status) translates into an almost insignificant probability of bust over a 1-2 month trade credit. Furthermore, the riskier the long term debt, the more expensive is it is for the company, which puts a natural limit on how high the gearing tends to go, and forces balance sheet restructuring when things start to go bad. This often means resorting to debt and equity markets, and that's hard to put a lid on. In many cases, the credit status of the debt is already public, so you can check it. What's more, public scrutiny may also be the only way for PE investors to exit their positions, through IPOs in a few years.

So yes, your terms of trade has perhaps worsened ever so slightly, but if you really believe the markets and banks are idiots enough to enter into large scale long term debt transaction at a super-toxic level without charging for it, you are right to worry. Personally I think it is highly unlikely.

Hold on a minute! Most home-buyers are hedge funders too: we take out debt to buy an asset, hoping that it goes up in value (whilst enjoying a rent free environment) before selling it on. In some cases we, like hedge funds, use the collateral in our homes to borrow more and use as our own tax-free income!
The difference is that home-buying & selling doesn't involve any capital gains taxes at all. Which might be why so many people borrow so much to buy these appreciating and almost risk-free assets. It's time all sorts of realised Capital Gains were taxed on the same basis.

Re Comment 31 - there's another mistake in that first line, "Investors borrow money ..." - well, investors invest money in an LBO (usually around one-third of the acquisition cost), that's the 'equity' bit of 'private equity'.

Davis's example of 10% equity would be an extremely hair-raising version of an LBO. He's using the extreme and suggesting it's the norm. Hmmm not too fair and balanced ...?

Also, he doesn't clarify (and most others don't) where all this private equity money comes from - it's now largely from the big institutional investors seeking higher yields, away from the (public) equity market and the bond market.

So yes it is clever financial engineering, but in the sense of 'fundamental shake up of global capitalism'.

Evan,
Would you classify Branson's Virgin group (when it is not listed) as essentially a Private Equity group, that just happens to brand all its companies with the same brand?

Surely Branson must also be using all the tax "efficiencies" available when he decides to sell a Virgin company.

Wot, no article about troubled hedge funds resulting from the subprime fiasco Stateside managed by Bear Stearns?

You say that you don't understand why there should be any capital gains concession for entrepreneurs. Let me explain. The government is the main beneficiary from by efforts. Every year I pay the government much more money than I pay to anyone else. This is compulsory, the government does little to help and a lot to hinder. Reduce the incentive still further and many fewer people will bother to put thenselves through the blood, sweat, tears and stress of a business start-up. Check the figures and see how important we are.

Is private equity not simply about taking investment back to where it has always been in most small private companies and if this produces greater returns than investment via the the stock exchange and equity capital then it is surely compensating for the inefficiency in our economic sytem? How this is affected by problems in the taxation system is an altogether different matter and highlights the failure of the goverment to keep ahead of the game in this area

There is no mention for management to achieve their goals and make a quick return on investment that they will tend to be draconian with their workforce and head count.

I had worked in a private equity backed company where 40% of the workforce were made redundant since they took over.

There was very weak HR policy so the management could get away with treating the staff very poorly and even abuse them in some cases.

Staff morale was severely affected and people's domestic lives were being ruined

The risk of PE companies defaulting on their loans is largely traded off by banks into the credit defaults swap markets. In flourishing economies the PE model works very well for banks, PE partners,pension funds and the CDS counterparties.

When economies take a dive and there is a credit crunch resulting in falls in corporate earnings the credit chain unravels leaving wiser but poorer pension funds.

Rob

COMPANIES BUYING THEMSELVES

Your article on private equity suggests that it is lawful for a company to be left with a debt incureed to buy that company. Yet, I though S151 of the Companies Act 1985 made it a criminal offence for a company to financially assist in the purchase of its own shares (as in the Guiness case). So how do these buyouts avoid such a basic rule of company law, as there is no exception for such buyouts, or are the responsible authorities asleep?

The ignorance and self delusion of this article and most of the subsequent posts is quite staggereing. I can only assume that all involved have no real exeperience in business. Anyone who has been involve at board level in a plc will find it amusing that these people label private equity as "short term" when making investment decisions or 2 - 3 years. My experience of institutional investors on the stock market is that they are making and changing decisions over a matter of months. There is no long term view on the stock market, every quarter, half and year has to be better than the last and plc management is hamstrung by it.
The other point which everyone it conveniently avoiding, and it applies to the emotional arguments ot the unions and the left in general is what would happen to the companies if private equity didn't move it. It is a nice little fantasy that these people hold on to that the companies would carry on merrily, share holders collecting the meagre 8% returns, employees in blissful employment and they all lived happily ever after!
Now wake up! The reality is many of these companies are going down the pan, might not be today,or next week or next month but it will happen; and when it does all thes staff will be unemployed, the assets won't be worth selling off and the shareholders get nothing. That is the reality of many of the companies taken over and improved by prvate equity.
So start accepting life is tough and it isn't fair, but if we don't encourage investors to take a leap of faith, wait several years for a return whilst they sort out these businesses we'll all be unemployed.

#53, not sure if I understand the problem. If someone borrows money to buy a controlling interest in a company, and subsequently transfers some of the debt to that company, that doesn't mean the company assisted in the purchase. Whoever lent the money did that.

#50 I assume you're referring to the end of money linked to commodities such as gold and silver (pounds sterling). Why is a metal such as silver any more a "real" basis for money than say, sea shells or glass pearls? It's economic value was largely a factor of its scarcity and peoples affection for shiny objects. Would you really want inflation to be determined by the success of mining companies and general fashion sentiment?

What's more, the Dutch Tulip and South Sea bubbles both happened when money was generally linked to precious metals, and many of the abstract concepts you might be referring to (derivatives, futures etc) stem from those times. The South Sea bubble was a very fashionable thing until it burst, heavily promoted and assisted by very dubious financial smoke and mirrors.

Apologies for the wrong references in my last posting #63 (at time of writing, that is). #50 has now become #58 and #53 has now become #61. There seems to be a tendency for the numbers to change with each update..

Trevor (#64), I think they are interesting questions, but I don't share the downbeat view of our current world, as I think our understanding and management of these concepts have come a long since, for example, Bretton Woods. On some of the specifics:

"How does the conceptual credit system relate to the system of physical goods and services that the credit system is supposed to facilitate?"

I believe it is done through tracking the prices of a basket of selected goods and services, which provides the best estimate of the money's "real" value. In my opinion a much better solution than tracking the price of silver!

Your link between working and earning money is a little tenuous. Yes, you can earn money other ways, but that normally means getting a return on your capital, assuming you have some. If you don't, engaging in "physical" labour is not only rational, it's pretty much essential for survival (or at least a comfortable life). That's probably why most of us still do it! ;) So some rich people employ some smart people to get the best possible return on their capital. Nothing new there..

'What value will "money" eventually have, and how would we get enough food to keep the economy running, if the economy generated conceptual money faster than it can generate the food and material products required to feed, cloth and house the people who feed the economy?'

This sounds suspiciously like inflation. Well, you could go for the stone-age "Mugabe-approach", and order everyone in the country to halve their prices. Or you could do what the BoE tries to do, and put the brakes on the money supply through the interest rate. I think it neatly illustrates some of the progress made over the last century. Will it stop speculative bubbles from happening? I don't think anything will.

this is very thought provoking.
can you or anyone of your kind give a list of at least 50 companies under the iTraxx europe with their credit default probabilities?

i could not find it from the internet. can you tell me which website it is found, please. i need it to teach my business administration students.

If they didn't exploit the gaps, we wouldn't know they were there. So maybe we should thank them before they were exploited in a more economically dangerous way.

The 鈥榣ess 鈥� benign鈥� view on the growth of private equity doesn鈥檛 seem to add up.

鈥楽uppose investors borrow 拢9 million to buy a company worth 拢10 million, and they put up 拢1 million of their own. Their investment is heavily geared. If they can create a 5% increase in the value of the company, they add 拢0.5 million to it. But because they keep the whole increase in value for themselves, their initial 拢1 million investment has not risen by 5%, but 50%. A fantastic return (particularly if it's taxed at 10%).鈥�

What Evans fails to mention is that the value of equity is itself dependant upon the level of gearing. The shares that were worth one million pounds when private equity bought the firm would now be worth less because any potential buyer would be concerned about the level of gearing. Therefore, to generate a 50% return on their equity investment they would have to increase the value of the firm by more than 5% as stated in the example. Since the value of the equity has fallen!

The basic point is that in a relatively efficient market (such as the UK stock 鈥� market), the participants tend to be sophisticated. Private equity firm鈥檚 gain they鈥檙e profit by selling the firms back to these sophisticated buyers and would thus have to offer real value to generate a profit.

I suspect that rising interest rates, especially the real rate moves happening on the bond markets will put a stop to much of this. M&A and PE rely on low rates for cheap finance and apparently better returns.

However, the black clouds are starting to gather. I understand that the no defunct Kwik Save was a PE project, which obviously has no return now. Whilst it is not the same, the hedge fund industry's bets on derivatives and risky instruments are now coming home to roost with problems at Bear Sterns

Interesting how these supposedly sophisticated investors leap for the lawyers when it goes wrong.

Cheers Evan,
Your break down analysis helped me grip the topic which enabled me to reserach it very throughly in preparation for an interview.
Anjlee Ruparelia.