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Balls Weighs In On Private Equity Debate

by Robin Pilgrim,, London

12 March 2007

Speaking last Thursday at the London Business School, Economic Secretary to the Treasury, Ed Balls commented on the debate over private equity currently taking place in the UK.

The UK Treasury's Select Committee announced last week that having taken note in particular of the Financial Services Authority’s Discussion Paper, entitled ‘Private equity: a discussion of risk and regulatory engagement’, and the creation by the British Venture Capital Association of a working group to look into disclosure in the private equity industry, it would undertake an inquiry into Private Equity Funds.

Speaking last week with regard to private equity, Mr Balls explained that:

"You will know that, starting from some high profile specific cases, wider fears have been raised that private equity firms can be particularly short-termist - and therefore impact negatively on jobs and investment in the companies in which they take an interest."

"For some, the fear is that private equity is simply based on financial engineering - rearranging a company's balance sheet and potentially taking on excessive debt without transforming the underlying commercial reality of the business. For others, the fear is that private equity relies on "hollowing businesses out", dressing companies up for sale, making short-term earnings look good at the expense of long-term investment in capital, skills or R&D."

"But, as I have argued, we know too that private equity can be a positive form of governance and help to reinvigorate a company and strengthen its long-term prospects. This is achieved mainly through changing management incentives, improving productivity and making more efficient long-term investment decisions."

He continued:

"Private equity, like any other form of ownership, has good and bad aspects - and it has features of both long-termism and short-termism. But the evidence does not suggest that Government has any intrinsic reason either to "favour" private equity or to do the opposite."

"Our aim should be to support economic dynamism and long-term investment and job creation. And the Government's objectives in the field of private equity should be no different from its objectives in relation to any other form of ownership: to promote an environment of long-term, sustainable business success, underpinned by a strong culture of clear disclosure to, and engagement with, underlying investors. This is the way to ensure that "good" long-term investment propositions prosper."

Speaking with regard to the taxation of private equity, Mr Balls announced that

"The Government has actively promoted a number of tax measures which have been particularly relevant to investment in early-stage firms. These include the Enterprise Investment Scheme, R&D tax credits payable for small businesses and capital gains tax taper relief. But the question has been raised in recent weeks as to whether our tax system gives an unfair advantage to private equity over other forms of ownership - in particular as a result of the tax-deductibility of interest."

"There is, of course, nothing specific to private equity in the tax-deductibility of interest. Any kind of company can claim it, and most quoted companies do. It is also the international norm - that interest is in general treated as a business expense and deductible from taxable profits for companies in any form of ownership. We have no plans to review this principle."

"However, concerns have been raised with the Treasury that something further may in some cases be occurring - in particular, that 'shareholder debt' is replacing the equity element in highly leveraged private equity funding arrangements. This shareholder debt is a form of risk-bearing equity that is treated as debt for tax purposes, giving these arrangements a tax advantage that is inconsistent with the principle that interest is a business expense. Tax legislation already distinguishes between debt and equity and contains detailed provisions to ensure that equity is not disguised as debt to obtain a tax deduction. Rules have changed from time to time over many years to adapt to the development of new financial instruments and forms of debt, most recently changes in 2005 to enable the transfer pricing rules to be applied more readily to the issue of shareholder debt."

"Today, I can announce that the Government will review the current rules that apply to the use of shareholder debt where it replaces the equity element in highly leveraged deals in the light of market developments, to ensure that existing rules are working as intended and report back by the Pre-Budget Report. This is consistent with the Government's focus on ensuring that commercial decisions are taken on a level playing field, take a long-term view and maximise opportunities for employment and investment."

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