Tuesday, April 13, 2010

Private equity and debt interest taxation

Problem: Tax rules that allow debt interest to be offset against profits create a preference for debt over equity funding, which contributes to over-gearing and systemic risk and encourages financial engineering and short-termism, especially in private equity

Solution: Equalise the tax treatment of debt and equity, instead of the current system where dividends are taxed but interest can be deducted from taxable profits. Policy Exchange (p60-66) estimates that if debt and equity were taxed equally at 10%, headline corporate tax could be reduced from 28% to 17% for the same tax revenue. The idea has many supporters including John Plender at the FT, Bank of England, IMF, Institute of Fiscal Studies and Conservative Party.

Private equity benefits include:

• Modernizing investee companies
• Helping industry to shed non-core assets
• Challenging PLC management
• Sheltering companies in transition from quarterly public reporting
• Restoring bankrupt companies with fresh capital
• Providing an alternative source of returns for diversity-seeking investors
• Adapting PE business model with the economy and needs of their investors (or limited partners, LPs)

Problems from PE reliance on financial engineering:

• Makes unviable LBOs viable purely for tax reasons
• Transfers wealth from taxpayers through interest deductibility
• Diverts R&D spend and capital investment to service debt
• Miss-allocates resources as buyout firms target cashflow companies instead of turnarounds
• Increases bankruptcy risk through unsuitable capital structures, eg high gearing against cyclical earnings, adding to welfare costs from unemployment and inequality
• Reduced customer service has economic costs, especially in infrastructure and health
• Distribution of PE-related leveraged loans increases financial systemic risk, especially as PE refinancing peak in 2012 approaches
• Transfers equity yields from future pension savers to current PE investors
• Distorts the tax system by blurring income and capital, allowing inefficiencies such as the taxation of carried interest as capital

General policies against short-termism:

• For executives, make share-based incentives vest over longer periods to reduce gearing incentives, link executive pay also to non-financial measures related to delivery of the corporation’s purpose such as customer ratings, market position and market share
• For equity owners, equalize the time horizons of asset managers and their underlying investors to remove the pressure for short-term gains, such as geared dividends or takeovers
• For lenders, restore discipline to securitisation through higher disclosure, retention of risk by originators, independently funded credit ratings and more buy-side diligence.

Reforms to the PE industry:

• For the General Partners, or managers, of PE firms, improve transparency on the true origin and extent of returns, including effects of fees and tax subsidies, and extent of true risk taken by GP after fees.
• Reward operational turnarounds through long-term tax incentives, while discouraging financial engineering through higher taxes on debt.
• Exclude PE firms from tax grouping rules (as with OEICs) and keep liability for acquisition debt and the risks from over-gearing at bidder level
• Extend the “Source of Strength” doctrine from bank holding companies, requiring PE firms to provide assistance for subsidiaries at risk of bankruptcy. Rank GPs with LPs so that financial assistance is funded with clawbacks on PE management fees and carried interest as well as investor funds

Problems with tax reform of debt interest:

• Abolishing debt interest deductibility could push firms into bankruptcy, needs transitional implementation
• May not stop excessive gearing through sale-and-leasebacks, needs coordinated provisions
• Does not address credit bubbles caused by low interest rates and excess savings in China and Germany
• Could reduce investor returns if profits are retained

The EC’s proposed Directive on Alternative Investment Fund Managers is pushing for measures...
...on PE and hedge fund transparency and disclosure. However, these are aimed more at identifying systemic risk by revealing counter-party exposure than improving the market and role of PE itself.

The debate around the AIFM, which has earned plenty of air time and outrage from industry partisans, has diverted attention from more effective PE reforms and helped build a misplaced consensus that reform must be internationally coordinated.

The main sticking points on AIFM are reportedly about depositories and non-EU funds. The depositary rules could add substantially to industry costs while the “passport” debate on non-EU funds has raised fears of protectionism and a letter from Timothy Geithner. However, it does little to further the aims of the Directive’s authors as far as PE is concerned.

Further reforms should include making PE firms disclose their tax deductions and fees by investment, together with the impact of these on investor returns. This would help PE to showcase returns from operational and strategic improvements and defend charges that it merely arbitrages the tax rules on capital.

Further disclosure would also help. Despite the secretive nature of the industry – which adopted the name “private” equity in the 1990s to distance itself from discredited LBOs of earlier decades – it should identify all amounts invested and returns on an investment, whether from exit, dividends, loans or fees, in a way that allows the outcome to be assessed from both a GP’s and an LP’s perspective.

This would help GPs to justify their management fees, which are under increasing pressure, where they have created value and show where they have genuinely shared investment risk with LPs. It would help eliminate cases such as Linen’n Things, where transaction and management fees resulted in a profit for the GP despite LPs being wiped out and the company driven into bankruptcy (described in Josh Kosman's well-researched expose The Buyout of America, p42).

The next step is for governments, acting alone or together, to design tax incentives that reward genuine operational turnaround. These could come from capital allowances, capital gains regimes or even corporation tax holidays that reward risk-taking in a similar way that patent law protects drug development. There are plenty of ways to create positive incentives for PE, let the creative minds get to work.

Other reforms to consider include taxing dividend recapitalizations (eg by full, as opposed to partial, removal of interest deductibility on debt used to finance special dividends), excluding PE firms from tax grouping rules, restricting the use of target company assets as collateral for acquisition debt, and extending the “Source of Strength” doctrine from bank holding companies to include PE firms.

This last proposal, also suggested by Josh Kosman, would require PE firms to provide management and financial assistance for investee companies facing bankruptcy as a result of their LBO debts. If the financial liability proved to be larger than the PE firm’s original equity stake, it could be topped up with clawbacks on PE management fees and carried interest, as well as additional calls on LP funds. The liability would not have to be that high; just enough to wipe out the equity, profits and fees from the bad investment and the goodwill of the LPs. PE managers could then be relied on to make it a very rare occurence.

Update: This August 2010 report from Oliver Gottschalg of the HEC Paris business school found that the private equity asset class on average yields only minimal and statstically insignificant Alpha (7.6% versus 6.8% from equaly risky public market investments). As the FT then reported, given that PE funds are locked up for 10 years and are subject to leverage risks, any claim that the private equity industry fails to beat public markets, as this research suggests, is a "serious indictment".

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