PE goes into purgatory

Last year, this secretive sector found itself attacked by the unions and summoned by Parliament to explain how it made such huge profits yet paid less tax than the cleaner. The game is tougher now for private equity. James Taylor asks if it can fulfil a new, open role in the business community.

Last Updated: 09 Oct 2013

Last February in New York, Stephen Schwarzman, head of private-equity firm Blackstone Group, decided to celebrate his 60th birthday with 500 of his closest friends. The party was held at the exclusive Park Avenue Armory, where an enormous portrait of the birthday boy formed the centrepiece of a lavish redecoration. Everyone who was anyone in New York was there: Donald Trump and Barbara Walters rubbed shoulders with Wall Street's masters of the universe. The menu, as you'd expect from a man who buys $400 crabs for his lunch, was a gourmet sensation. Rod Stewart provided the entertainment, while Patti LaBelle popped in to sing Happy Birthday. It was the hottest society ticket in town - the coronation of the new king of Wall Street, some said.

Later that month in Germany, the cream of European private equity gathered in Frankfurt for the Super Return conference. There was a noticeable swagger about the buyout executives as they stepped out of their private jets and sipped their champagne. And no wonder - their industry seemed to be going from strength to strength. A few weeks earlier, a consortium of buyout firms (including Blackstone) had launched a £10bn bid for Sainsbury's, one of the most famous names in British business. On the first day, news broke that Kohlberg Kravis Roberts (KKR) and TPG had agreed the biggest private-equity deal in history: the $45bn buyout of Texas utility TXU. Private-equity discipline was re-ordering the flabby corporate world for good, some claimed over their evening cocktails. They were the future.

And the City loved them. Law firms and advisory boutiques grew fat on their huge deal fees. Desperate for their lucrative borrowing business, investment banks fell over themselves to lend money with fewer and fewer strings attached. Executives told of meetings where they planned to ask for a certain debt package, only to be offered substantially more before they'd even opened their mouths.

But some practitioners were growing nervous. After all, this was never an industry that had sought the spotlight. Most of its leading exponents are accountants, lawyers and bankers, not politicians; their skills lie in the nitty-gritty of doing deals, managing risk and delivering results. Over lunch at a nice restaurant in the City, they'll happily chat about everything from finance to football but, as a rule, they have no wish to see their name in the papers. The industry's growing profile - and the increasing scrutiny it would bring - filled many with horror. Schwarzman's $3m bacchanalia was just the kind of publicity they didn't need.

However, avoiding the media no longer guaranteed privacy. Damon Buffini, the boss of UK-headquartered PE firm Permira, had worked his way up from a Leicestershire council estate to a place at Cambridge and then Harvard, before going on to build and lead a hugely successful business - the perfect example of UK social mobility. But most people's first impression of him was formed in 2006, when the GMB trade union parked a camel outside the church he was attending to protest about job cuts at the AA, the vehicle breakdown service. It was alluding to the biblical parable: 'It's easier for a camel to pass through the eye of a needle than for a rich man to enter the kingdom of heaven.'

The venerable union attacked him in newspaper ads, claiming he sacked disabled workers; it passed out sick-bags when he turned up at the launch of the industry's charitable foundation (see panel, p41). Even by the cagey standards of the industry, Buffini had been notoriously press-shy, but suddenly he was front-page news. 'The personal element to the coverage was a little disappointing,' Permira partner Charles Sherwood admits mildly.

The union campaign against the industry rapidly gathered steam. An observer at the launch of the GMB's AA campaign in 2006 - held in the unlikely venue of a small south London gastropub (complete with 'continental' lagers and a finger buffet) - would have found it impossible to imagine the impact the campaign would eventually have: it expanded to become an attack on the entire industry. They would have listened sceptically as the union denounced an industry it clearly knew little about (Terra Firma's Guy Hands even got some of the blame for the AA, despite having nothing to do with it) and expected the campaign to sink without trace. But, thanks to some astute political opportunism, an instinctive eye for the industry's weaknesses and a flair for memorable soundbites, the GMB made it a success, capitalising on the Labour deputy leadership election to make private equity a political football.

The industry didn't help itself, either. Permira and fellow private-equity firm CVC clearly underestimated the GMB's nuisance capacity, failing to nip the AA dispute in the bud. Then SVG Capital chairman Nicholas Ferguson made an off-the-cuff remark during an interview with the FT that some private-equity partners 'pay less tax than a cleaning lady'. It was quickly plastered over the newspaper's front page and beamed around the world. Ferguson later tried to backtrack, insisting that he was quoted out of context, but the damage was done.

The British Private Equity and Venture Capital Association (BVCA) was hauled in front of a Treasury select committee to defend its industry - and did such a lamentable job that its CEO was forced to resign by the weekend. The industry was on the back foot.

It seemed to some in private equity that public sentiment had changed overnight. A few months earlier, they'd been running obscure financial services businesses that nobody outside the Square Mile cared about. Now they were being publicly castigated as rich, arrogant, tax-dodging profiteers who bought companies on the cheap, stripped their assets in order to line their own pockets, and then sold them back to a gullible stock market.

'It wasn't exactly a surprise,' says Permira's Sherwood. 'But things clearly happened much faster than we anticipated.'

As an industry, private equity failed miserably to rise to the occasion. The second meeting of the Treasury select committee took place in June, amid a media frenzy - the queues to get in stretched around the block, with paparazzi lining the street to snatch their first pictures of the mysterious millionaires summoned to attend. There was a palpable air of disappointment that the four buyout executives (including Buffini) looked more like forty-something investment bankers than the Prince of Darkness incarnate. Fortunately for them, most MPs on the committee knew nothing about the industry, so didn't deliver any killer blows. But the performance of those under scrutiny was defensive - shuffling uncomfortably, dodging questions and talking in soundbites - and they failed to impress either the watching throng or even their own kind. 'I thought they just looked shifty,' the head of one UK buyout house told me later.

As a result, private equity was forced to make big concessions. The industry's record on disclosure had become a major bone of contention. 'Private equity makes the Cosa Nostra look like a model of openness and transparency,' TGWU deputy general secretary Jack Dromey told the select committee last summer. And he had a point: with a couple of notable exceptions (such as FTSE-listed 3i), buyout firms have never been media-friendly. That's partly because they have never needed to be - nobody was particularly interested in what they did. But it's also part of the model; these are (mostly) private firms that work on their companies away from the glare of the public markets. So interaction with the outside world was limited. But the suspicion this created was a major factor behind the hostile tone of media coverage last summer.

Desperate to claw back the initiative, the industry looked for the path to rehabilitation. Many of its leading lights believed they had nothing to fear from greater disclosure - it would just prove to the world how effective private equity is as an ownership model. It would prove the benefits of having a smaller, engaged shareholder base; of aligning the interests of owners and managers; of actively managing a company's balance sheet. 'Some of the industry's shyness was quite strange,' says 3i's communications director, Patrick Dunne. 'There's a lot to be proud of, given the value it has created in the last five years.'

So City grandee Sir David Walker was commissioned to produce a report that would advise buyout firms on how to become more transparent, a process that took several months. In public, the entire industry sang its praises; in private, some just hoped it would buy them time. Others questioned the rationale behind a compliance regime that would give them obligations not shared by any other private company in the world. 'We operate under a legal system that's worked for hundreds of years. I'm not sure the idea of treating PE funds as special cases is intellectually sustainable,' says TDR Capital's founding partner Manjit Dale.

Walker published his recommendations in December. He wants private-equity firms to tell the world more about the way they operate, the make-up of their management team, the profile of their investors and the companies they invest in (the biggest portfolio companies will even have to produce a plc-style annual report - 'another stack of paper that nobody will read', as one UK buyout head puts it). And the BVCA has been tasked with producing the research that will prove PE's credentials beyond doubt. Admits Duke Street Capital boss Peter Taylor: 'As an industry, we have to hold our hands up and say we should have got that story across some time ago.'

Not surprisingly, the unions felt Walker hadn't gone far enough - not least because he refused to recommend that management should be forced to publish details of their reward packages. But it should at least force the industry to take its PR more seriously. Although there will be a monitoring group, Walker hopes that enlightened self-interest will be the most powerful motivator - because if private equity really wants to compete for household-name assets, it needs to lose its shady image and establish itself as a respected and credible buyer.

'The need to appear in public is increasingly a criterion for leaders of PE firms and those around them,' says Sir Ronald Cohen, founder of Apax Partners and an ex-chairman of the BVCA. 'They're starting to realise that if you can't communicate, you can't develop your firm and build its brand. So they're beginning to operate more like public companies.'

Dunne at 3i thinks firms will soon see the commercial benefits of transparency. 'Our annual report is a very helpful sales tool, particularly in Asia. It shows that we're credible, open and well-governed.'

But transparency was not the only issue on the agenda. The industry has also lost big tax breaks as a result of the row. Thanks to a deal between the BVCA and the Revenue in 2003, carried interest (the portion of a fund's profits that is divided between the partners, allowing them to earn staggering sums if the fund does well), has been treated as capital gain rather than income and was eligible for taper relief, which could take the effective tax rate down to 10%. Now, Chancellor of the Exchequer Alistair Darling has abolished taper relief and replaced it with a flat CGT rate of 18% (much to the horror of the UK's business community - although he has now conceded that gains up to £1m will keep the 10% rate). This is higher than the current US rate but lower than that of some of Britain's European rivals. So it could have been worse.

The issue of non-domiciles has also been high on the agenda. An increasingly hostile media latched on to the fact that a large number of industry practitioners working in London - up to a third in some firms - were actually domiciled outside the UK so didn't pay a penny in tax. Now it looks as though non-domiciles will have to pay a flat tax once they've worked in the UK for a certain amount of time.

In some ways, this situation is not surprising. London is the most important centre of European private equity, so it attracts the best talent - who can afford skilful accountants to minimise their tax bills. It's a reflection of the industry's growth in the UK, due partly to the increasing importance of the City and partly to government creating an environment where private equity can flourish. Senior buyout figures argue that radical changes to the tax and legal rules would give New York, Frankfurt and Paris a chance to regain ground.

This reliance on the City has been evident in the financial disruption of the past few months. In 2006 and the first half of last year, making money from private equity was an easy game - even if you weren't any good. Firms could buy a company using a tiny portion of their own money, hold onto it for a year or two without doing anything (except some clever financial trickery, perhaps), and sell at a profit because the market's valuation multiples had gone up. And since bigger debt packages meant bigger returns, firms started doing ever-bigger deals.

But thanks to the great financial freeze caused by the US sub-prime fallout, private-equity firms can no longer borrow the vast sums of money they need to complete mega-deals like Alliance Boots. In the first half of 2007, banks were desperate to get in on the act; now, they don't want the risk - and without this debt, big private equity deals can't happen. Buyout volumes fell 62% in the second half of 2007, according to data provider Dealogic.

This may not last for ever (the consensus seems to be that things will start to recover in the latter half of this year), but the rules are going to change. With valuations set to fall, firms won't just be able to rely on financial engineering. Private equity has long boasted of its record on value creation. Now that the market is cooling, it will soon become clear which firms actually created better businesses, with higher revenues and profits, and which made their money by 'stripping and flipping' the companies they bought.

The biggest worry is that the current credit-market woes turn into a full-on consumer spending slowdown. 'So far, it has really been a crisis for people in pin-striped suits; the big imponderable is whether it will affect real people,' says Sherwood.

In recent years, banks have been lending money on ridiculously good terms because very few private equity-backed firms were going bust. But if spending slows, there are bound to be deals that collapse under the weight of their debt burden - just as Focus, the DIY business owned by Duke Street, did last year. 'It was a conservative debt multiple under normal circumstances,' says DSC's Taylor. 'But almost any amount is too much when the market declines suddenly and profits fall.'

If companies start going under and people start losing their jobs, private equity is going to be front-page news again.

But although people in the industry freely admit that times will be tougher in 2008, it's not all doom and gloom. The credit market's troubles are largely confined to the big buyout deals, which represent just a part of it; smaller deals that need less debt are ploughing ahead regardless. And the big firms are putting a brave face on it; most have been expecting this downturn for some time, even building it into their calculations.

Some are relieved that the over-exuberance of early 2007 is over: 'To be honest,' says Sherwood, 'the first half of 2007 was not a happy extreme. It was an uncomfortable environment - prices were very high, and leverage ratios went beyond a reasonable level.'

And it's not just that prices will normalise this year. A falling market can provide an opportunity to pick up good assets on the cheap, just as it did after the bubble burst. Things may be slightly different this time round - there has been so much private-equity fundraising in recent years that most of these firms have plenty of cash in the coffers, keeping prices high - but in areas like financial services, retail and construction, which have all seen huge stock market falls recently, there may be bargains on offer.

Other parts of the industry will positively welcome a downturn - particularly the turnround experts, who specialise in reviving ailing companies, and the distressed-debt units, who buy into troubled companies and trade their debt. Less developed markets may also see more activity: 3i and Permira have both done deals in Asia recently, for example. And innovative deal structures could also become popular, such as building a group of assets by using a portfolio company that they own as a platform.

So 2008 should be an eventful year for private equity. The economic downturn won't last for ever, but it will pose big challenges to the industry in the next 12 months. And the political shift of 2007 is almost certainly a permanent one.

If private equity wants to survive and flourish, it must come out of its shell and prove to a sceptical public that it is a force for good in the UK economy, as it has always insisted.


One way in which the industry can win back some hearts and minds in 2008 is social-venture philanthropy. By applying its disciplines to charitable causes, it can prove that private equity is not all about enriching a select few at the expense of the rest of us. Sir Ronald Cohen's Bridges Ventures, which invests in deprived areas, is leading the way.

However, last year's gala dinner to launch the Private Equity Foundation (PEF), a charity for buyout firms and their advisers, was a PR disaster. Trade unions picketed the event, accusing the industry of hypocrisy, while critics suggested it was just a cynical marketing exercise. And the £5m raised was seen as an insignificant pot for an industry full of millionaires, even though it represented only the first round of funding.

Shaks Ghosh, the ex-Crisis boss brought in last April to run the PEF, accepts that mistakes were made. There will be no dinner in 2008, and the size of firms' donations has been increased. And there's now a specific focus: the foundation will now invest solely in charities that work on improving the skills of 'Neets' - the 16 to 24-year-olds not in education, employment or training. 'Private equity is leading the economy's change to knowledge-based services,' she says. 'The industry recognises that as this happens, there are going to be some people left behind - and it wants to help unlock this potential.'

The PEF is working with its charities to develop a best-practice model, as they look to take on more of the services currently supplied by the public sector. 'We provide them with resources and, in return, they tell us how we can make charities in this area truly best-in-class.'

So is it all just a PR exercise? 'When I talk to our supporters,' says Ghosh, 'every single one wants to make the world a better place. But ultimately, whether they're doing it out of a sense of responsibility or whether they're doing it for the PR, it doesn't really matter. As long as the process delivers money to the right charities in the right way, that's what's important.'

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