So this month’s Off The Record looks at the issue of private equity and venture capital and asks whether they do more harm than good. And if they do harm, should pension funds invest in them?
Supporters of private equity or venture capital firms say they inject new life into tired companies, releasing value, creating wealth and ultimately sustaining jobs.
Critics say they are often little more than asset-strippers, and that leveraged buy-outs dismantle established companies unnecessarily and destroy many of the jobs they provide.
In the UK, which boasts the most active private equity market in Europe, some leading labour unions are calling on the government to abolish tax relief on the billions that private equity firms borrow to fund their buy-outs.
The UK’s Trades Union Congress has also called on the leaders of the G8 group of industrialised nations to impose tougher corporate governance standards on the industry.
European governments, in general, have looked favourably on private equity. A recent survey by the European Venture Capital Association (EVCA) shows that, over the past three years, tax policies have become more favourable to private equity and venture capital in most European countries.
Pension funds, too, have come to see an allocation to private equity as a useful diversifier in their investment portfolios. Currently more than a quarter of all private equity investment in Europe comes from pension funds.
Yet some pension funds, in the Netherlands and Scandinavia, are deciding not to invest in either private equity or hedge funds in view of the controversy surrounding their activities.
Some European governments, too, are trying to rein in the activities of private equity firms. The German government recently introduced a bill that would cut the amount of interest payments that companies are allowed to deduct from their taxable profits.
At the moment German firms can deduct unlimited interest payments from profits. Peer Steinbrück, Germany’s finance minister, proposes to limit the amount to one third of annual pre-tax earnings.
Private equity investors say this would lower the return on deals, since these are largely financed through debt, the cost of which would rise.
The UK government has also acknowledged growing union opposition to the activities of private equity companies by launching a Treasury inquiry into the tax treatment of firms involved in debt-financed takeovers. The government says the review of private equity deals is designed to ensure “commercial decisions are taken on a level playing field”.
There are now fears that a reduction in the tax advantages of private equity borrowing could spread through Europe. Javier Echarri, general secretary of the EVCA, has said that he is “concerned that this might become a pan-European phenomenon”.
No politics in our investments
So should pension funds disinvest or refuse to invest in private equity? The pension fund managers, administrators and trustees in our survey are generally supportive of private equity. They believe it has a role to play in the economy and that pension funds should be free to invest in private equity funds and funds of fund.
Yet our pension fund managers send a few warning shots across the bows of private equity firms. A majority think there is too much debt in private equity deals and governments should end or limit tax breaks for companies that borrow heavily to finance buy-outs.
European governments, notably the UK government, have at one time or other tried to persuade pension funds it is their patriotic duty to invest in private equity. Most funds have taken a pragmatic view of this, investing only to the level they consider sensible.
A minority (40%) think pension funds should invest more of their assets in private equity. Most feel the allocation is a matter of investment strategy rather than patriotic duty. A Swiss manager points out that “the choice is up to the pension fund and must fit into the strategy”.
A UK manager sees allocations increasing purely for investment reasons. “There does seem to be an upward trend towards a level of allocation that has the potential to have a meaningful impact on a fund’s return.”
Pension funds would clearly resist attempts to prevent them investing in private equity for political reasons - preserving ‘national champion’ companies, for example.
A large majority (78%) of our respondents say that pension funds should be able to invest in private equity or venture capital. However, some feel there should be limits to the percentage allocated to private equity.
The suggestion that funds should not invest in private equity because the short-term objectives of buy-outs do not align with the long-term objectives of pension funds gets little support, with only 20% in agreement.
Watch out for fees
The real issue, perhaps, is that
pension funds should get their money’s worth out of private equity investment. Paul Myners, author of the influential Myners Report on pension fund investment, initially urged pension funds to increase their allocation to private equity as part of a
strategy of diversification. Yet in a letter to the left-wing journal New Statesman recently he warned that “pension fund trustees and other investors should wise up to the huge sums being earned by intermediaries from the movement of money from publicly quoted companies to private equity”.
This view is endorsed by many of our respondents. One UK manager observes that “in principle there is no problem with such investments, but not at the very high fees most currently charge”.
Most respondents feel that the current criticism of private equity is misplaced. A majority (72%) say the ability to create long-term value is crucial to what a private equity firm does. And 68% think private equity activity creates more jobs than it destroys.
A substantial majority (80%) think that backing from private equity offers businesses a real chance to improve efficiency.
The central criticism of private equity, and its role in the acquisition of large public companies, is that it depends on exploiting tax breaks on interest payments.
Here there is real concern among pension fund managers. Private equity firms, Myners has warned, are like people buying houses on the back of cheap mortgages. Both will end in tears. Almost two-thirds (60%) of the managers in our survey think there is too much debt in private equity deals, and that governments should end or limit tax breaks for firms that borrow heavily to finance
Pension funds also want more transparency from private equity. Three-quarters of our respondents (76%) agree that most private equity activity lacks transparency.
It is argued that private equity companies should be obliged to maintain the same standard of reporting as is required of all companies, and that transparency should extend to the rewards of private equity executives.
Three in four of our respondents (76%) think that partners and senior executives in private equity firms should reveal details of their pay, “just as directors of public companies are obliged to do”.
Finally, we asked whether pension funds were worried about the effect that private equity deals have on the job and pension security of their own members.
Myners has warned that employees of private equity-owned firms are at the bottom of the food chain in a private equity deal, and get no additional reward for the increased risk attached to their employment. Yet they often pay the price for this reduced security through loss of jobs or reduction in pensions.
More than half of our pension fund managers (60%) agree that private equity deals put the interests of employees last rather than first. Managers are all well aware that a private equity deal involving their corporate sponsor, can lead to a change in the pensions promise.
To that extent, investing in private equity will always be something of a Faustian bargain.