On 21 July 2022, the House of Lords is due to debate the following motion:

Lord Sikka (Labour) to move that this House takes note of the economic and social risks created by the regulation and practices of private equity.

1. What is private equity?

Private equity is defined as investment by a managed fund, the primary aim of which is to assume a controlling share of the companies it invests in. The shares that the fund acquires are either not publicly traded or will be delisted after their acquisition. The term private equity is often used to refer to investment in mature firms with the goal of growing the business by reducing inefficiencies. In contrast, seed capital investment for start-ups is referred to as venture capital. Some private equity firms also make venture capital investments.

The ‘target companies’ of private equity investment can be private companies or those which are publicly listed. If the target is a publicly listed company it becomes delisted, or taken private, once the private equity firm has taken control. In 2021, there was an increase in private equity offers for public companies in the UK because of the market conditions created by the coronavirus pandemic. Law firm Herbert Smith Freehills has suggested that this increase was driven by “the large reserves of cash that private equity bidders were sitting on coming out of the pandemic and the potential growth opportunities UK companies present in an undervalued market”. While 2022 has so far seen a decrease in mergers and acquisitions in the UK compared to the previous year, some expect levels of deal-making to remain steady rather than decline further.

Private equity first came to prominence in the 1980s, when it was associated with hostile takeovers. In hostile takeovers, private equity firms acquire control of publicly listed firms against the wishes of their management board. This is usually achieved by buying enough shares from existing shareholders to control the company, or by replacing the management board. The acquiring company can influence the composition of the board because board membership is voted on by shareholders. For example, in 2011 French pharmaceutical company Sanofi-Aventis bought biotech firm Genzyme directly from shareholders after their offers were rejected by Genzyme’s management. While hostile takeovers have become less common in recent decades, some commentators have argued that an increase in mergers and acquisitions generally is likely to give rise to an increase in hostile takeovers.

Private equity investments are funded using a mixture of normal shares, preference shares and debt instruments. Debt is usually 50 to 80% of the overall financing. The term ‘leveraged buyout’ is used to refer to an investment that is financed 90% or more by debt. These can be controversial as the target company’s assets can be used as collateral by the acquiring company.

The vehicle for a private equity investment is a private equity (PE) fund. These are usually limited partnerships. The majority of the shares in a PE fund (typically 99%) are held by limited partners such as pension funds and other institutional investors, which have limited liability. The private equity firm is a general partner, typically owns 1% of the shares and has full liability. It is responsible for managing the fund.

2. How is private equity regulated?

In the UK, it is the fund manager rather than the fund that is regulated. Most private equity fund managers are ‘alternative investment fund managers’ (AIFMs) and are required by the Alternative Investment Fund Managers Regulations 2013 (as amended) to be authorised and regulated by the Financial Conduct Authority (FCA). AIFMs with assets under certain thresholds are subject to a lighter regulatory regime than larger ones.

The FCA has powers under the Financial Services and Markets Act 2000 to make rules that apply to regulated entities (including AIFMs) and to supervise and take enforcement action against them. In an open letter to AIFMs in January 2020, the FCA drew AIFMs’ attention to its requirement for regulated firms to mitigate risks of market disruption, among other things. The FCA said that if firms employ significant leverage in transactions, as is common in private equity takeovers, it expects “commensurately high quality risk management controls”.

AIFMs are subject to reporting requirements in the following areas:

  • pre-investment investor disclosures
  • annual reporting both to investors in the alternative investment fund (AIF) and the FCA containing audited financial statements, information about any material changes to the pre-investment disclosure and information about the AIFM’s remuneration
  • periodic reporting to the FCA on the matters set out in a prescribed template
  • notifications to the FCA and other stakeholders in the event that an AIF managed by the AIFM acquires certain holdings or control of non-listed companies that have their registered offices in the United Kingdom

PE funds are considered by regulators to be high risk, therefore rules restrict participation in these funds to institutional investors and high net worth individuals.

If a PE fund acquires a controlling stake in a company, it usually appoints members to the company’s board of directors. These directors have a duty under the Companies Act 2006 to promote the success of the company for the benefit of its members (shareholders). In doing so they must have regard, among other matters, to: the likely consequences of any decision in the long term; the interests of the company’s employees; and the impact of the company’s operations on the community and the environment.

3. Impact of private equity

3.1 Target businesses

It is disputed whether private equity deals are beneficial for the companies they acquire. Many people argue that PE fund managers place too much debt on their acquired portfolio companies. This means that they cannot take on more debt to finance future projects, increasing the risk of bankruptcy. This behaviour is incentivised, it is argued, because PE fund managers can use the proceeds of the debt financing to pay themselves and investors in the fund a dividend, known as dividend recapitalisation. The structure of PE funds’ investment usually means that the managers are largely insulated from losses; for example, the PE fund manager does not have to sell private assets to pay debtholders. In addition, PE funds often own preferential shares, meaning that they are paid before other creditors and are able to recover their investment in case of bankruptcy. This can lead to excessive risk taking.

Emeritus Professor of Accounting Lord Sikka (Labour) points to the example of the private equity acquisition of high street business Debenhams in 2003:

[…] it was bought by private equity for £600m. Its debt ballooned from £128m to £1.6bn. Within the first three years, its owners extracted returns of over £1.1bn.

This adversely affected its ability to invest in productive assets. Despite subsequent changes in ownership, Debenhams never recovered. It collapsed owing £616m to suppliers, who will recover little. Its pension scheme has a deficit of £32m. Despite making all agreed contributions, thousands of employees will lose some of their pension rights.

However, the Economist argues that the “blend of financial and operational engineering” employed by PE funds has “added genuine value to thousands of firms”. Writing in the Journal of Applied Corporate Finance in 2020, Professor of Finance Greg Brown et al stated that “a large and growing number of studies have provided clear confirmation of productivity increases in the companies or assets controlled by PE firms”. The authors also noted, however, that an exception to these findings is in public-to-private transactions. A number of studies have reported finding only modest and statistically insignificant gains from private equity acquisitions of publicly listed firms.

3.2 Employment

Professors Eileen Appelbaum and Rosemary Batt, authors of ‘Private Equity at Work: When Wall Street Manages Main Street’, point to a study that found that PE-owned establishments had “significantly lower employment and wages post buyout than did comparable publicly-traded companies”. This was “despite the fact that the PE-owned establishments had higher levels of wages and employment growth than their counterparts in the buyout year”. The same study found that employment in PE-owned companies was 3 to 6.7% lower in the first two years after buyout, and 6% lower after five years.

The Economist points to studies with more mixed results, including a finding that among PE-backed firms in the US employment declined in existing plants by 4% relative to others in the same industry. However, in new operations, started from scratch or acquired, it increased by 2.3%. A University of Chicago study of 9,800 American buyouts between 1980 and 2013 concluded that employment shrinks 13% over two years after buyouts of publicly listed firms relative to control firms, but grows by 13% after buyouts of privately held firms.

3.3 Employee pensions

A controversy of private equity buyouts concerns the impact on employees’ pensions. This can happen when a PE-owned company goes into what is known as ‘pre-pack insolvency’. This allows the company to keep trading and save jobs, at least in the short term, by relieving the company of its debts, including pension commitments. Baroness Altmann (Conservative), a former pensions minister, explains how practices adopted by some private equity firms can negatively impact employees’ pensions:

Critics say some directors abuse the system by using it to rid themselves of debt and to buy back their business at a knockdown price, leaving creditors and pensioners in the lurch.

Those affected had generous traditional final-salary company plans, based on pay at retirement. Schemes like these are shielded by the Pension Protection Fund (PPF) if a firm goes bust, but members can still lose a chunk of their retirement income […]

There are safeguards in place to try to stop unscrupulous firms trying to game the system and dump their pension funds onto the PPF.

Despite this, many private equity takeovers have been followed by corporate insolvency and the jettisoning of the pension scheme under a pre-pack.

One example of such a practice concerned the bed and mattress retailer Silentnight Group. In 2021, the Pensions Regulator agreed a £25m settlement with HIG Group, a US private equity firm which bought the company. The regulator said it considered that “HIG brought about the unnecessary insolvency of the original Silentnight Group in order to buy its business out of a pre-pack administration without the pension scheme”. HIG Group disputed the case and did not admit liability.

3.4 Investors

Private equity funds can generate significant returns for their investors. These can include institutional investors such as pension funds and higher education endowment funds. Some argue that these returns are better than investors could achieve by buying equity in publicly traded companies. The Economist highlights that “since the mid-1990s private-equity funds have outperformed comparable share indices over various time periods by two to six percentage points a year”. However, the Economist also argues that the growth of the sector, rising interest rates and the possibility that lawmakers will change favourable tax laws (discussed further in section 3.5) will lead to a decline in profitability.

Professors Appelbaum and Batt argue that returns on private equity investments are not as lucrative as some believe. They say that academic studies show that median private equity buyout funds have not beaten the stock market since 2006. They also contend that private equity returns should be adjusted for the higher risk of this type of investment and the fact that fund managers’ returns are highly variable.

3.5 Taxes

Many jurisdictions, including the UK and US, have a ‘carried interest’ tax provision often utilised by private equity. Carried interest is a share of the profits realised from the fund’s investments that is given to individual fund managers. This is usually taken in such a way as to be subject to capital gains tax (the top rate of which is currently 28 percent in the UK) rather than income tax (which has a top rate of 45 percent). Dean Galaro of law firm Perkins Coie says this can be regarded as unfair because “the fund manager is getting capital gains treatment in return for their services which, in any other setting, is ordinary income”. However, the American Investment Council argues that because profits from the fund come from the sale of assets, it is right to tax carried interest as a capital gain whether its recipient’s contribution to the fund was money, services or both.

Another tax provision which has attracted controversy is that interest paid on loans is tax deductible, while dividends are not tax deductible. This leads companies to favour debt over equity investments. Writing in the Financial Times, Professor of Law Victor Fleischer argues that overleveraged firms (those which are carrying too much debt) are at higher risk of bankruptcy because they cannot reduce costs easily when necessary. This is because dividends can be suspended if needed, but interest payments cannot be missed without risk of bankruptcy.

However, others argue that the deductibility of interest is fair and favouring debt over equity can be a sound business strategy. Also writing in the Financial Times, Jonathan Blake of law firm Herbert Smith Freehills argues that interest is a legitimate cost and should be deductible in the same way as other business costs. He also argues that debt can be advantageous to businesses because it is more flexible than returning capital to shareholders, is often cheaper than equity, avoids diluting shares and allows businesses to spread the acquisition cost of long-term assets and businesses over their productive life.

3.6 Economic growth and stability

The regulator of private equity, the FCA, and the Bank of England have warned that excessive debt in private equity can create risks for the financial system. In a letter to AIFMs in January 2020, the FCA stated that use of “leverage and illiquid investments”, which often characterise private equity deals, presents risks to the investors but can also create risks for other market participants and the wider markets. This includes lenders to these funds, such as banks, and investors in them, such as pension funds. In October 2021, the Bank of England stated that “risks in leveraged loan markets globally continue to build”. It said that these risks could affect UK financial stability through the direct impact on banks and the indirect impact of losses spreading through other parts of the global financial system. However, it said that the core UK banking system was resilient to direct losses associated with leveraged lending.

The British Private Equity and Venture Capital Association argues that private equity can provide benefits to the economy. It states that private equity is a “proven driver of sustainable business growth” and that this is achieved through “operational expertise, sound management and, importantly, through the close working relationship between the private equity backer and the company management team”. It highlights private equity’s role in UK business, including that many UK businesses have received investment from private equity and that over 1 million people are employed in the UK by companies backed by private equity and venture capital.

4. Parliamentary debate

In October 2021, Lord Sikka asked the government what assessment it had made of the takeover of UK companies by private equity firms and their effect on the economy. Lord Sikka argued that the “typical business model of private equity includes high leverage, financial engineering, tax abuse, pension dumping, job losses and asset stripping” and named firms which he considered to have been victims of this practice, including Debenhams and Toys ‘R’ Us. He called for an enquiry into the impact of private equity’s practices on all stakeholders.

Several members raised other issues, including: the impact of private equity takeovers of public companies on employment; environmental and social governance; regulatory oversight; carried interest; and target companies that have relied on government contracts.

In response, Parliamentary Under Secretary of State at the Department of Business, Energy and Climate Change Lord Callanan said that mergers and acquisitions played a positive role in the UK economy and that “such transactions can help to boost UK jobs, increase management efficiency and support businesses to grow on the world stage”. He also argued that the UK benefited in global terms from being an “open and accessible economy”. He said that when private equity-funded acquisitions raised concerns, the government had taken action where there were “clear public interest grounds”.

On 27 January 2022, Lord Sikka asked the government about the impact of private equity on the social care sector. Lord Sikka, and other members, argued that private equity owners of care homes were taking too much money out of businesses and paying little tax, but paying investors significant dividends. Baroness Chakrabarti (Labour) and Baroness Blower (Labour) highlighted that typical wages for care home staff were £9 or £10 per hour, a wage on which it was “hard to survive”.

In response, Parliamentary Under Secretary of State at the Department for Health and Social Care Lord Kamall argued that the most important consideration was the quality of care provided to residents. He highlighted that as of December 2021, 84% of care providers were rated good or outstanding. On the impact of private equity, he said that it was “important not to tar all private equity with the same brush”. He argued private equity turned many companies around, helping them retain jobs. He said that the market oversight scheme would ensure that if a care home became insolvent its patients could be transferred elsewhere.

5. Proposed US law

Some members of the US legislature have proposed a law that would restrict the practices of private equity. In July 2019, a group of Democrat and independent senators and members of the House of Representatives announced they would be introducing a bill designed “to fundamentally reform the private equity industry”. The bill’s proponents said it would “level the playing field by forcing private equity firms to take responsibility for the outcomes of companies they take over, empowering workers, and protecting investors”.

Among other things, the bill would:

  • increase financial and legal liability for private equity funds in the event of certain violations of law
  • give employee compensation higher priority in bankruptcies
  • generally prohibit the payment of dividends for two years from an acquired asset firm to a private equity fund

The bill would modify the tax treatment of carried interest. Under current US law, carried interest is taxed as investment income rather than at ordinary income tax rates. Among other things, the bill would change the law so that the net capital gain of a private equity fund would be treated as ordinary income.

The bill was reintroduced in 2021, following the 2020 presidential election. The bill has been read twice and referred to the congress’s committee on finance.

Cover image by João Barbosa on Unsplash