Tuesday, November 20, 2007

Private equity: escaping to a parallel universe

It is depressing, but not really a surprise. A code of conduct being introduced by the private equity industry has been watered down, the Financial Times reports today. As the newspaper said:

The UK private equity code of conduct announced on Tuesday comes just as the storm of controversy over the secretive industry has died down. Concerns that buyout groups were profiteering by taking over iconic companies, stripping them of value and laying off employees sparked parliamentary hearings in the spring. By autumn, Northern Rock’s woes and the credit crunch had grabbed the spotlight, and fewer buy-out deals were being done due to higher funding costs.

Defenders of the industry contend that these firms shake up sleepy companies and make them more efficient, which is good for the economy. Whatever the merits or faults of these arguments, the Tax Justice Network has its own beefs.

The first is well-known: private equity partners tend to pay very low rates of tax. In June 2007 Nicholas Ferguson, one of the most prominent figures in Europe’s private equity industry, told the FT that “any common sense person would say that a highly-paid private equity executive paying less tax than a cleaning lady or other low-paid workers, that can’t be right.”

But there are two other fundamental problems that have not been quite so widely noticed.

First, the whole process is subsidised by our tax systems – and this is one of the keys to their profits. Private equity firms load the companies they buy with debt – typically “lent” by a subsidiary of the company based in a tax haven: it will therefore pay little or no tax on its subsidiary’s interest income, and the borrowing company will write its interest costs off against tax. The net result is that the company as a whole cuts its tax bill. Typically private equity companies use very high “leverage” rates – just 20% from the wealthy private equity owners, and 80% in borrowings.

This financial engineering is just that: it does absolutely nothing to improve the efficiency, innovation, or overall quality of the business in question. What it does is abuse our tax system and our democracy: in effect, the rest of us pay their taxes for them.

A first step in tackling these tax subsidies would be by using transparency: let these companies tell us how much of their profits come from this abusive financial engineering, and then let democratic politics sort out whether or not we want to accept this. Such a transparency requirement would be a fundamental prerequisite of any palatable code of conduct. It is depressing to read this, then, in the Financial Times’ Lex column:

The final version drops a requirement that individual firms disclose how much of their profits came from leverage and financial engineering rather than operational improvements. Instead, information will be published on an industry-wide basis. It goes without saying that details of private equity bosses’ compensation will remain under wraps.

But there is another huge problem with these transactions: they shift large parts of the capital stock of nation states offshore, even if the parent companies are located onshore. Ownership of companies is thus removed from processes of democratic accountability. This highlights one of the most pernicious characteristics of tax havens: not only do they subvert national tax systems, but they also undermine systems of national regulation.

These activities are prime examples of the ability of élites to carve out brave new worlds just for themselves: reaping the benefits of tax and regulation systems in the onshore world, then escaping from their responsibilities to pay their way.

One last thing. All this borrowing – which is wired into the DNA of this secretive industry – should make everyone worried, particularly in the current uncertain environment. Lex again:

Unfortunately, the code also does little to address the next big problem looming on the horizon: what happens when one of these highly-leveraged deals starts to go bad?



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