Tuesday, 3 July 2007

Private Equity and tax

The hot business topic of the moment seems to be Private Equity (PE). Robert Peston has regularly blogged on the subject on the BBC business website and today has covered the latest PE story, that the AA and Saga have avoided paying any corporation taxes on earnings before interest, tax, depreciation, amortisation (EBITDA) of £430m because they are so loaded up with debt that their liability for tax is reduced to zero.

In his final comment, Robert writes:

"And you can dismiss the private-equity argument that the tax liability is merely transferred to those who lend to their companies. Some of these lenders pay tax in the UK, but in a globalised financial world most don’t."

I think he's wrong on that specific point, as I'm sure the Inland Revenue would expect foreign banks to be paying UK taxes on profits made in the UK. But I think the more interesting issue is around the capital structures that PE use and why.

Modigliani and Miller's theorem forms the basis of thinking on capital structure and the two key propositions are that in the absence of taxes (and other factors - see article) the value of a company is unaffected by its capital structure and that the cost of equity increases with the proportion of debt to compensate for the increased risk. That second point is of note to the employees of companies taken private as there employment becomes riskier - something for which they are rarely compensated.

Of course, the provisos in the theory don't apply in practice, so financial engineering does matter. In a recent blog - Private equity: Some thoughts - Evan Davis, the BBC's Economics editor nails the issue when he talks about the asymmetry of risks in PE deals where the leverage (taking large loans to finance deals versus relatively small amounts of the investors capital) means huge potential returns to the upside but limited potential losses to the downside. The other issue Evan mentions is that a provision in the tax system to encourage entrepreneurship, the low capital gains tax rate on assets held for more than two years, means that the PE partners pay almost no tax (about 5%) when they do sell up as it counts as a capital gain rather than income.

It's easy to lose sight of the fact that wealth creation isn't a zero sum game and that raises the question of what benefit there is to the UK economy from the PE industry. The direct benefit seems limited, as they pay little in taxes, and it's a small industry, so I doubt if it employs many people (10,000?) who would be gainfully employed regardless. Where they do provide a valuable service is when they genuinely turnaround struggling companies and the role they have in keeping the managers of listed companies 'honest' (when underperformance = takeover).

The downsides seem starker, particularly if you are an employee in many of the companies taken private (Saga being a notable exception in having widespread equity participation amongst its employees). As mentioned above, the capital gains tax rates are low to encourage entrepreneurism but as the gains from financially engineering existing companies and then spinning them back onto the market have been so great, the funds available to startups, as Evan Davis notes, have significantly reduced. Losing that stream of new companies is probably of greater significance to the long term health of the economy than anything else in this debate.

So, does it matter that people earning tens or hundreds of millions if not billions of pounds should pay either no tax or lower tax rates than the company cleaners? If these people contribute so little to the country do their wealth generating efforts count for anything (especially if it is diverting resources from more useful activities)? Are these people just taking up space in London and driving up house prices?

I just don't know but I'm not convinced that they are a valuable sector that should be pandered to. The inequity that the sector highlights is unhealthy for society and people making this kind of money should be prepared to stump up their share to the society that allows them to prosper. If they aren't they can sod off to Monaco for all I care!

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