" /> The IUF's Private Equity Buyout Watch: June 2007 Archives

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June 27, 2007

Taxes are only half the story, the other is DEBT: Proposals to tax private equity firms are just the beginning, not the end of the debate

Few would doubt that closing tax loopholes which allow private equity firms to deprive public revenues of billions is an important and necessary step. There’s also no doubt that this is the most popular (and populist) measure that can be taken. But it’s far from adequate if governments are serious about reigning in the buyout funds. The main problem of leveraged buyouts by private equity funds is just that... leverage.

As pointed out in the IUF’s A Workers’ Guide to Private Equity Buyouts:

“A corporation will typically have a balance of 80% equity to 20% debt, on which it pays interest. In a private equity buyout this ratio is reversed, since 80% to 90% of the purchase is financed through borrowing. The private equity fund usually provides just 10% to 20% of the equity as cash and the rest is borrowed. The assets of the company being acquired are put up as collateral to secure the debt and once taken over the target company (and not the private equity fund) must take this debt onto its accounts and meet the interest payments.”

When workers first hear or read about this there’s always a pause - a moment of confusion or hesitation. Did I hear that right? Is there something I’m missing? A company pays for its own takeover through huge amounts of debt? It’s a completely reasonable reaction. In a rational and sane world this wouldn’t and couldn’t happen. But it does. And where does this leave the company that has just been taken over by a private equity fund? Massively in debt.

But the debt doesn’t stop there. Debt is also raised through "dividend recapitalizations" or "dividend recaps":

“This simply means that the company borrows money and the money borrowed is paid out to the private equity fund as a dividend. Here again we see a key difference with established notions of corporate accounting. Whereas dividends normally reflect a positive balance sheet, private equity uses debt to fund dividends and bonuses.” (A Workers’ Guide to Private Equity Buyouts)

So here is where the debate on taxes needs to be taken further. While current tax proposals focus on “carried interest” (the percentage of profit, usually around 20%, that a private equity fund manager gets when an acquired company is sold off), less attention has been given to dividend recaps. Yet these dividend recaps now account for close to one-third of all income flows back to the new owners in the global private equity sector. More importantly, we need to ask whether taxes alone are enough of a deterrent. Billions in taxes may eventually be paid, but tens of billions of accumulating debt raises a whole new set of questions.

At a seminar on private equity buyouts organized in Tokyo by UNI-JLC and IUF-JCC on 7 June 2007, the crucial issue of “sustainability” was raised. With so much debt from the time of takeover (where the debt used to buy the company is added to the books of the company itself) and with more debt added through "recaps” (borrowing more money to pay a special dividend to the fund as the one and only shareholder), plus all that interest on debt that must be repaid, the question is obvious: is this sustainable? Can a company continue to operate under such a debt burden? More importantly, this outflow of cash and rising debt means a drop in long-term, productive investment. So again we’re compelled to ask: is this sustainable?

Take the formula, “debt + cash outflow + recaps + interest payments on debt + more debt = declining productive investment “ and the implications for jobs and job security are obvious. So too are the implications for the financial system as a whole. As the head of the National Bank of Australia remarked last year, it’s likely that the private equity boom “is going to end up in tears". More recently, the UK’s Financial Services Authority (FSA) states in its report on private equity, excessive levels of debt pose serious risks for the financial system.

The question of debt is relevant not only to the viability of companies taken over by private equity funds, but also the stability of the financial system as a whole. So while politicians are just coming to terms with the need to tax private equity firms, trade unions must escalate demands for more comprehensive regulation and ensure that - before the door is closed on debate - governments deal with the whole truth of private equity buyouts, not just half of it.

Private equity firms lobby against new US tax proposals

“Earlier this month, as the Blackstone offering was being prepared, Senate Finance Committee Chairman Max Baucus, D-Mont., and Charles Grassley, R-Iowa, introduced legislation that would require publicly traded partnerships to be treated as corporations for federal tax purposes. Under current law, income distributions from publicly traded partnerships are taxed at the capital-gains rate of 15% -- below the top corporate tax rate of 35%. On Friday, Rep. Sander Levin, D-Mich., introduced a bill in the House that would jack up taxes paid by managers on carried interest to as much as 35% from only 15% now. Carried interest is a portion of the profits from an investment that's paid to the manager. In the private-equity business, it's often used to compensate managers for investing alongside their clients in a buyout. “Private Equity Ends Week On Top In Battle With Congress”, Dow Jones, 22 June 2007.

“... on June 14, Schwarzman was the master of the financial universe, fresh from a blitz of media attention and about to launch the most anticipated initial public offering of the year. An hour later, his victory lap was thrown off course by word of a bill in the U.S. Senate to more than double Blackstone's tax burden -- the first of what are likely to be a slew of proposals and regulations aimed at hedge funds and private-equity firms.... House Democrats fired a new salvo on June 22, when Ways and Means Chairman Charles Rangel of New York and Financial Services Chairman Barney Frank of Massachusetts introduced legislation that would tax all fund managers' share of profits at the 35 percent corporate rate, instead of the 15 percent capital-gains rate they currently pay.” Ryan J. Donmoyer and Elizabeth Hester, “Blackstone Sparks Lobbying `Battle Royale' Over Taxes”, Bloomberg, 25 June 2007.

“The private equity industry is not just sitting back and waiting for Congress to raise their taxes. The Private Equity Council, a less-than-year-old trade group representing many large buyout firms in the United States, has hired big guns from the lobbying world to defend their interests in Washington” “Private Equity Lobby Girds for Tax Fight”, New York Times, 25 June 2007.

Private equity firms "paying less tax than a cleaning lady or other low-paid workers": private equity tax loopholes in the spotlight

Finally it seems that action will be taken to close tax loopholes that have allowed private equity firms and their billionaire bosses to get away with paying so little tax. As the debate heats up the comments of Nick Ferguson, creator of the business that became Permira and the chairman of SVG capital, the leading subscriber to Permira’s funds, have hit a nerve: “Any common sense person would say that a highly-paid private equity executive paying less tax than a cleaning lady or other low-paid workers... can’t be right.”
Quoted in Robert Peston, “Private grief”, BBC News - Peston’s Picks, 4 June 2007.

“Tax is a highly emotive issue, especially among people who work hard for a minimum wage and pay hefty percentages of that to outgoing Chancellor Gordon Brown. They take a dim view of those with Croesus-like wealth whose adroit use of the tax regime allows them to pay a few percent on what is often massive capital gains.”
Selwyn Parker, “When private equity players are paying ‘less tax than a cleaning lady’, the question is: are we being taken to the cleaners?”, Sunday Herald, 23 June 2007.

“Gordon Brown has signalled a clampdown on the loophole.... The anomaly is due to rules that Brown himself introduced to encourage entrepreneurship. Those starting their own business or investing in start-ups would be charged capital-gains tax of just 10%, rather than 40%, when they sold their stakes on, provided they held their stakes for two years. Private-equity reward structures have exploited this ‘taper relief’. Partners typically receive a 20% share of the profit from selling firms in the portfolio after a certain threshold has been reached. This so-called “carried interest” is effectively a performance fee, but is treated as a capital gain.” "Private equity bosses pay less tax than cleaners", MoneyWeek, 8 June 2007.

“Some of the City's richest bosses could see their earnings slashed after it emerged they were paying tax at a lower rate than their office cleaners. The Treasury yesterday said it would look at closing a loophole that allows the multi-millionaire chiefs of private equity firms to pay as little as 10 per cent tax on their earnings.” "City fat cats 'paying less tax than cleaners'", Daily Mail, 5 June 2007.

“Top capitalist Nicholas Ferguson went on to condemn this tax avoidance. "Any common sense person would say that a highly paid private equity executive paying less tax than a cleaning lady…can't be right." The 'private equity' people he is talking about are the successors to the asset strippers of the Sixties. Buy a business. Sell the assets it does not need. Close its pension scheme. Get rid of the dead wood. And in two years sell it for twice what you paid. Today it is called 'private equity'; Mr Ferguson and others say it is a Good Thing and overall creates jobs. Whether it does or not the executives, who have bought the business largely with borrowed money, pocket the profit. Then comes the tax trick. These profits are classed not as income but as capital gains. Due to changes introduced to help struggling businesses in 2002, as long as they keep their shares in the business for two years the rate of CGT drops from the normal 40% to just 10%. Someone who earns a million pounds a year – an amount many of them would scoff at – saves more than £300,000 a year in tax. Kerching!” Paul Lewis, “No tax please, we're City-ish”, SAGA, 7 June 2007.

“Some (though far from all) in the industry now argue that they ought to be paying at twice the rate, or 20%. Their largesse seems calculated to deflect demands for more.” “Taxing minds”, The Economist, 21June 2007.

“The widespread dislike of private equity may be a global phenomenon, but taxing it is done one country at a time. And, unless there is a coordinated fiscal attack on private equity, firms will simply move to where the tax treatment is most favourable. Nothing is more globally mobile than capital.” "Taken to the cleaners", The Economist, 12 June 2007.

“Paul Myners, a former chairman of Marks and Spencer, on Monday joined the growing chorus of criticism of the preferential tax treatment of private equity gains.Mr Myners, Low Pay Commission chairman and author of a 2001 government report into fund management, questioned why buy-out executives could earn huge payouts but pay less than 10 per cent tax. His comments follow an outcry from trade unions at the tax breaks enjoyed by buy-out firms and come a few weeks before top private equity chiefs face an influential parliamentary committee looking into the industry.” Kate Burgess and Andrew Taylor, “Myners adds to criticism of buy-out taxes”, FT.com, 4 June 2007.

June 26, 2007

GMB Congress report on PE’s broken pension promises

The IUF-affiliated GMB (UK) has produced an in-depth report on Private Equity’s broken pension promises for its congress. Download the report - click here

Recent GMB-related press articles can also be downloaded by clicking here and clicking here

June 15, 2007

UK Financial Services Authority alarmed by leverage in buyouts - The Independent (UK)

“The City watchdog yesterday voiced fresh concern about potential market abuse by private equity firms and the "excessive level" of borrowing they use to buy out public companies. In a report released just a day before the Treasury Select Committee begins an inquiry into the increasingly controversial industry, the Financial Services Authority said it believed its statutory objectives were at risk from both.... But it stopped short of imposing new rules, preferring instead to increase the supervision of private equity companies and the banks that lend to them.”

Continue reading: James Moore, “FSA alarmed by leverage in buyouts”, The Independent, 12 June 2007.

Click here to download the FSA's feedback statement on the discussion paper "Private equity: a discussion of risk and regulatory engagement" (11 June 2007)

June 13, 2007

Second private equity fund drops out of bidding for Coca-Cola Korea Bottling Co (CCKBC)

A month after the private equity fund CVC Capital Partners withdrew its planned bid to take over Coca-Cola Korea Bottling Co (CCKBC), another private equity consortium - MBK Partners and Woongjin Capital - also withdrew its bid. While the official reason given was a disagreement over price, the public opposition expressed by the IUF-affiliated CCKBC unions was also a likely factor. In an open letter to CCA and a press release issued in both Korea and Australia, the three CCKBC unions declared that they would take industrial action to stop any attempts by private equity funds to enter the bottling plants to assess its value. Any guarantees from a private equity fund were viewed as meaningless since such funds are geared towards piling up debt and imposing business decisions based on a short-term “exit” strategy.