Pirvate Equity Regulatory UK

[Audio] Private equity: the UK regulatory response Iain MacNeil* 1. Introduction The rapid growth in private equity in recent years, and in particular the scale and consequences of large-scale buyouts of public companies, has led to calls from many quarters for some form of regulatory intervention. The rationale put forward for intervention varies from the elimination of specific regulatory advantages that are claimed to be available to participants in private equity to more broadly framed arguments that private equity is short term in its outlook and provides unjustifiably high returns to its participants with the costs being largely borne by other stakeholders in the corporate sector. The regulatory debate has triggered a flurry of activities, with a Parliamentary Select Committee, the Treasury, the Financial Services Authority (FSA) and the private equity industry all currently engaged in some form of enquiry or consultation, in which the issue of regulation is at the top of the agenda. This briefing note attempts to explain the regulatory response to private equity in the UK and to set it in context. Following the pattern of the official consultations (above), it focuses on the 'buyout' component of the private equity market since it is in this field that the calls for regulatory intervention are focused. 2. The regulatory debate The broad regulatory debate on private equity in the UK has focused on four main issues: the deductibility of interest paid on loans; the taxation of 'carried interest' earned by partners in private equity firms; the responsibility of private equity firms for pension fund Key points � Rapid growth in private equity in recent years has generated a public debate over the possibility of regulation. The Financial Services Authority (FSA), British Venture Capital Association (BVCA), Treasury and the Treasury Select Committee have all been active on this front in recent months. � This briefing note provides an overview of the current state of play in the UK, taking account of the final guidelines published by Sir David Walker and the changes to capital gains tax that have been announced by the Treasury. � The BVCA guidelines will bring within its enhanced disclosure regime around 65 portfolio companies and will operate on a 'comply or explain' basis. � The FSA has indicated that it will focus on the risks of market abuse and conflicts of interest arising from private equity transactions, but it does not envisage a discrete regulatory regime for the sector. � Iain MacNeil, Alexander Stone Professor of Commercial Law, University of Glasgow, Glasgow, Scotland, UK. 18 Capital Markets Law Journal, Vol. 3, No. 1 � The Author (2007). Published by Oxford University Press. All rights reserved. For Permissions, please email: [email protected] doi:10.1093/cmlj/kmm038 Advance Access publication 18 December 2007 Downloaded from https://academic.oup.com/cmlj/article/3/1/18/337243 by King's College London user on 11 February 2023.

[Audio] deficits in companies they acquire; and finally governance and disclosure in privateequity owned firms. The one feature that these issues have in common is that they lie outside the regulatory remit of the FSA. Taxation issues are a matter for the Treasury, while governance and disclosure fall within the responsibility of the Financial Reporting Council, although the Department of Trade and Industry (DTI) would be likely to become involved in any regulatory intervention in that field. Each of these issues is now considered in more detail. The deductibility of loan interest from taxable profits has attracted attention in the context of private equity because of the highly leveraged nature of many private equity transactions. While this feature has been viewed in some quarters as promoting private equity buyouts by favouring debt finance over equity finance, the core of the argument is problematic. Debt finance is in principle available to all listed companies, and there is no regulatory reason why such companies could not adopt a financial structure with gearing comparable to a private equity-owned company. Neither the company law nor the listing rules in the UK regulate gearing, with the result that it is a matter for individual companies who are able to make decisions in the specific context of their own business and the conditions in the debt market. Many listed companies have recognized the benefits of higher gearing in recent years and have undertaken share buy-backs with a view to increasing their financial gearing. If such replication of financial structure is possible within listed (or even other) entities, it is difficult to see how a convincing case can be made for limiting the tax break within one type of legal structure and not within another. And even if the case is accepted, there are likely to be problems in drafting legal provisions that (a) bite only on private equity and not other legal structures and (b) are capable of dealing with evolution in private equity structures as a means of avoiding such legal provisions. It remains, however, to be seen what the Treasury review will conclude on this issue. Another contentious issue has been the tax status of 'carried interest' earned by the partners in private equity firms. This term describes the type of performance fee that is typically paid to the general partners in a private equity partnership and calculated as a percentage of the capital gains realized by the fund. The designation 'carried' refers to the fact that payment is normally deferred until limited partners' (the investors in the fund) capital has been returned and in internal hurdle rate of return has been met. It is argued that such payments are better characterized as remuneration rather than capital gain and should therefore be subject to income tax rather than capital gains tax. That argument is reinforced by the fact that such gains may be taxed at a rate as low as 10% when 'taper relief' is available. It was this feature that prompted one prominent participant in the private equity market to observe that private equity partners were paying a lower rate of tax on their remuneration than their office cleaners. While that comment focuses on private equity buyouts, there has been less opposition to the application of the same tax treatment in respect of 'carried interest' in venture capital firms operating at the start-up and development finance end of the market, where the {tax.

[Audio] obviously viewed as an incentive to entrepreneurship and the growth of small companies. Once again this matter falls within the remit of the Treasury review and further developments are likely to be largely driven by its conclusions. Pension funds have also entered the fray. Their focus has not been so much on regulation as on negotiating contributions to pension schemes from private equity bidders as a way of compensating for the (perceived) increased risk to job and pension security arising from private-equity ownership. While any such individually negotiated contributions made by private equity purchasers do not carry direct consequences for regulation, there may be some indirect effect if the effect of private equity buyouts across the board is to erode pension benefits and their security over time. In that scenario, there might well be calls for regulatory intervention to reinforce the security of pensions in the context of all forms of takeovers, including private equity buyouts. The Work and Pensions Select Committee has already raised this issue with the government, and it could well develop political traction as a means of strengthening the position of employees in private-equity owned firms, especially if it became clear that more direct forms of regulation of private equity were problematic. This might lead, for example, to some extension of the scope of the Transfer of Undertakings–Protection of Employment (TUPE) Regulations so as to make them bite on a wider range of restructuring transactions than is currently the case. However, any shift in policy in that direction would represent a recalibration of the takeovers regime in the UK, which has deliberately positioned itself in global terms as a jurisdiction that is amenable to takeovers and has exerted substantial influence worldwide in the development of regulatory regimes that aim both to facilitate and control the takeover process. Finally the public debate has focused on governance and disclosure within privateequity owned companies. As private companies, they benefit from the limited disclosure regime applicable to such companies by comparison with public and listed companies as well as exemption from some statutory governance requirements and the Combined Code of Corporate Governance. The public concern in this field reflects the view that governance and disclosure (at least in major enterprises) should be based on the needs of all stakeholders and should not simply be the outcome of (private) contractual negotiations between private equity firms, their investors and lenders. Underlying this viewpoint is the perspective that there is an inevitable public dimension to the activities of major enterprises that should not be capable of removal by alteration of the legal structure under which they operate. The argument is not so much that the private company status of private equity-owned enterprises is a bad thing for a single (even large) enterprise, but that it is inappropriate to envisage that it should displace the public company as the standard model for large enterprises. 3. The FSA response—risk The FSA's response to the recent rapid growth in private equity 'buyouts' is best assessed by reference to the statutory objectives according to which the FSA operates. Those objectives are: maintaining market confidence, promoting public understanding of the 20 Capital Markets Law Journal, 2008, Vol. 3, No. 1 Downloaded from https://academic.oup.com/cmlj/article/3/1/18/337243 by King's College London user on 11 February 2023.

[Audio] financial system, protecting consumers of financial services, and reducing financial crime. The effect of the statutory objectives and the associated powers given to the FSA is that its regulatory remit is limited in terms of the both scope of regulation and (to a lesser extent) regulatory technique. Thus, the FSA may not be capable of responding to all the possible types of regulatory intervention that have recently been linked with private equity. As is has stressed many times in recent years, the FSA operates a form of risk-based regulation. Its focus on risk, however, is different from that of an authorized firm in the sense that the FSA focuses on risks to its regulatory objectives rather than on the direct control or mitigation of risks faced by authorized firms. In that sense, the FSA concept of risk is that it may fail in the performance of its statutory duties. There is, of course, an overlap between the two concepts of risk because to perform its statutory duties the FSA must create a regulatory system under which firms can effectively control and manage the risks that arise in their business. But that is not to say that the role of the FSA is to prevent the failure of authorized firms since it is clear that the FSA can meet its statutory objectives even when compliant firms become insolvent. The risks identified by the FSA in private equity are as follows:1 (i) Excessive leverage. Concern in this area reflects recent trends in lending to fund private equity transactions: as the FSA notes 'Lending limits are increasing, multiples are rising, transaction structures are being extended and covenants are weakening.' The risk is that if credit markets remain tight, there could be a period of corporate distress that would have an impact on the debt market in general and possibly even on the equity market. Employees would also feel the effect as the collapse of privateequity owned firms led to job losses. Individual lenders with a large or badly timed exposure to highly leveraged transactions would also face the risk of serious losses. (ii) Unclear ownership of economic risk. Market practice in the transfer of credit risk associated with lending to fund private equity transactions has become increasingly complicated in recent years. This has resulted from longer chains down which the risk is transferred and increasing complexity in the mechanisms of risk transfer, such as, for example, the use of credit derivatives. The result is that the exposure of the holders of the relevant instruments to a credit event (eg default) may not be clear. A further complication is that different insolvency regimes in different countries (even within the EU) may result in creditors having different rights on the occurrence of different events, thus complicating the possibility of a negotiated solution outside the formal insolvency regimes. (iii) Reduction in overall capital market efficiency. The recent rapid growth in private equity buyouts of public companies may carry negative implications for the public equity markets. If the more attractive high-growth companies were over time to migrate to private equity ownership and public markets were left with low-growth 1 Financial Services Authority (Discussion Paper 06/6, 2006) Private Equity: A Discussion of Risk and Regulatory Engagement, available at www.fsa.gov.uk. Iain MacNeil � Private equity 21 Downloaded from https://academic.oup.com/cmlj/article/3/1/18/337243 by King's College London user on 11 February 2023.

[Audio] companies, retail investors and some institutional investors would suffer in terms of available investment opportunities and prices for the few accessible forms of private equity (eg Private Equity Investment Trusts) might be bid up excessively. (iv) Market abuse. The risk of market abuse arises primarily from the wide dissemination of information associated with the structuring and negotiation of a private equity buyout. This gives rise to the possibility that inside information may either be leaked (inadvertently or deliberately) or be used for trading purposes. The risk is particularly great where firms are engaged in both proprietary trading (eg of Leveraged Buyout, LBO, debt) and private equity as even the presence of 'Chinese Walls' may not be adequate to prevent the transmission of some forms of inside information. (v) Conflicts of interest. Two forms of conflict of interest were identified by the FSA. The first was the conflict between private equity fund managers and investors. This is evident in the process according to which the managers are able to participate in transactions entered into by a private equity fund, the risk being that managers will be able to engage in 'cherry picking'. It is also evident when a fund manager acts as a director of a company owned by the fund, as the director will owe legal duties (of the same nature and standard) to both companies at the same time: in that scenario, it is clear that financial incentives may well influence the balancing and discharge of those duties. Conflicts of interest may also arise in leveraged finance providers who may find themselves providing finance to acquire a long-standing client or providing finance to multiple private equity clients. (vi) Market access constraints. Retail investors have only limited access to private equity investment via venture capital trusts or private equity investment trusts. Pension fund managers, according to the FSA, would prefer access to private equity via liquid-listed entities as they find the structure of private equity funds burdensome. In both instances there is a risk of limited access to an asset class that may (or even must to sustain its existence) offer better returns over the long term than other asset classes, especially those that are accessible through lower-cost structures. (vii)Market opacity. As noted by the FSA 'the methodologies for disclosure, valuation and performance reporting used in practice in the private equity market are far from standardised.' This poses the risk that less well-experienced and resourced investors will make poorly informed investment decisions and will be unable to effectively monitor performance once their money is committed. More recent comments from the FSA indicate, however, that the risks in this area were initially overstated as the market has moved forward considerably in developing standard methodologies. These risks have been categorized by the FSA using its standardized impact scoring mechanism as being either high, medium high, medium low or low. They are not, however, evenly spread across participants in the private equity market as the nature of 22 Capital Markets Law Journal, 2008, Vol. 3, No. 1 Downloaded from https://academic.oup.com/cmlj/article/3/1/18/337243 by King's College London user on 11 February 2023.

[Audio] the risks mean that particular participants are at risk in different ways. The relationship between risk and participants is mapped out in Table 1 below. It is clear from this exercise that the FSA's priorities lie in regulatory action to address the risk of market abuse and conflicts of interest in private equity firms and lenders. Regulatory intervention in respect of other combinations of participants and risks cannot be ruled out, but seems less likely in a risk-based regulatory environment. 4. The FSA response—regulation? It is sometimes said that private equity transactions are already regulated. It has even been said that they are 'fully regulated', whatever that means. On the other side of the debate, it has been argued that private equity is unregulated with participants being compared to 'barbarians' or 'locusts', free to roam and ravage outside the regulatory remit of the world's financial regulators. The FSA's response recognizes that significant parts of private equity are already regulated but that there are some risks that are not fully addressed. The FSA's response to the regulatory risks posed by private equity can best be described as low key or non-interventionist.2 That outcome has resulted largely from three considerations. The first is that the forms of regulation that are being considered as part of the broad regulatory debate lie outside the FSA's remit. Taxation is the responsibility of the Treasury, the DTI is responsible for company law and the Financial Reporting Council is the main driver of policy for (non-statutory) governance requirements (primarily the Combined Code) and the disclosure regime. The FSA does have a potential role in enforcement of the Combined Code as companies are bound by the 'comply or explain' obligation in the listing rules, but it has shown little inclination to take enforcement action even in those instances where listed companies have neither Table 1. Risk assessment and private equity participants Risk Participants High Medium High Medium Low Low Private equity Market abuse Firms Conflicts of interest Lenders Market abuse Conflicts of interest Excessive leverage Investors Market access Unclear ownership of economic risk Market opacity Reduction in overall market efficiency PE-owned companies Excessive leverage 2 Financial Services Authority (Feedback Statement 07/3, 2007) Private Equity: A Discussion of Risk and Regulatory Engagement, available at www.fsa.gov.uk. Iain MacNeil � Private equity 23 Downloaded from https://academic.oup.com/cmlj/article/3/1/18/337243 by King's College London user on 11 February 2023.

[Audio] complied nor adequately explained non-compliance. The second consideration is that the FSA regulatory regime already regulates private equity participants to some degree. A third reason that seems to emergence from the approach of the FSA, even if not expressly stated, is that new rules are not always the best way to address risk. This can be seen as a reflection of two established aspects of the FSA's modus operandi. One is the move to more principles-based regulation that favours the formulation of regulatory obligations at a high level of generality, leaving authorized firms to determine their application to specific activities such as private equity. Another is that regulation is viewed as much more than the aggregate of rule making and enforcement: supervision and related thematic work focusing on particular risks or firms are, for example, seen as regulatory techniques with a proven record of success. As regards the second reason – the adequacy of the current regulatory regime – some expansion is required to set out the framework. A brief reprise of the current regulatory regime for transactions and participants in the private equity market may be useful in this regard. Buyout transactions will often (and always in the case of buyouts of public-listed companies) be subject to statutory regulation under the Companies Act 2006 and the Takeover Code. This regulatory regime controls the bidding process, in some instances controls the price that must be paid (eg when a mandatory bid is required) and also constrains the defensive measures that can be adopted by a target board in response to a bid. In that sense, the manner in which a private equity buyout of a public company is conducted mirrors exactly the manner in which any bid for a public-listed company is conducted. Moreover, when a bid is structured as a statutory 'scheme of arrangement' (eg the Alliance Boots buyout), it will be subject to further scrutiny by the court before approval may be given. A similar view can be taken of the company law provisions that are intended to protect shareholders when a buyout takes the form of a management buyout (MBO). The risk in an MBO is that the directors who collaborate to make a bid will prioritize their own interests over those of the company. The primary technique employed by company law is the fiduciary duty to avoid or alternatively to disclose conflicts of interest. Such disclosure permits the company to adapt its decision-making process so as to respond to the conflicted position of the relevant directors. Regardless of how effectively one views the operation of this mechanism in the case of MBOs, the important point is that all companies (whether or not listed) are subject to the same rule. In that sense, private equity-backed MBOs are no different to others. As far as regulation of participants in the private equity market is concerned, 'private equity' is not currently one of the activities defined by the FSA to control the permitted activities of an authorized firm. Thus, there is no easily defined set of authorized firms that can be defined as being engaged in 'private equity' and even if that were possible it would not capture the broader range of participants such as lenders and advisers who fall into different categories and in some cases fall outside FSA regulation altogether. 24 Capital Markets Law Journal, 2008, Vol. 3, No. 1 Downloaded from https://academic.oup.com/cmlj/article/3/1/18/337243 by King's College London user on 11 February 2023.

[Audio] Under the existing regulatory regime a private equity firm that is engaged in buyouts will be subject to relatively 'light-touch' regulation. This reflects the fact that such firms are generally dealing with clients who are sophisticated investors (intermediate customers or market counterparties in FSA terms). Implementation of the EC Markets in Financial Instruments Directive (MiFID) is likely to have the effect that 'light-touch' becomes a little heavier in some areas, but in broad terms the descriptor will remain accurate. Moreover, as the vast majority of private equity firms have been assessed as 'Low Impact' by the FSA using its standardized impact scoring mechanism, they are not, as entities, regarded as posing significant risk and, therefore, no specific regulatory response has been triggered. The FSA has recently indicated that lenders will be subject to more frequent (six-monthly) reporting of their exposures to private equity but that is only an expanded disclosure obligation, not a substantive control over lending, and does not alter the view of regulation as being 'light-touch'. Given its emphasis on risk-based regulation, it is hardly surprising that the FSA response to private equity should focus on risk because it is risk that provides the rationale for regulatory intervention. A consequence of this approach is that the FSA does not intend to develop a distinct regulatory regime for 'private equity', however that term might be defined. Instead, its approach is largely to fill the gaps in the regulatory regime that have been exposed by the growth of private equity. However, as shown in Table 2 below, that process of gap filling is quite limited. In those areas where action is envisaged there are unlikely to be new rules, the focus being instead on supervision of firms and the monitoring of further developments. 5. The industry response The private equity industry body, the British Venture Capital Association (BVCA), responded to public concern over private equity by commissioning Sir David Walker to undertake a review of the adequacy of disclosure and transparency in private equity with a view to recommending a set of guidelines for conformity by the industry on a voluntary basis. The review, 'Disclosure and Transparency in Private Equity', was published Table 2. Risks in private equity and the FSA response Risk Response Market abuse Supervision, transaction monitoring Conflicts of interest Thematic work in alternative investments centre Excessive leverage Enhanced disclosure of PE exposure Unclear ownership of economic risk Further investigation Market access Keep under review; link with listing regime for investment entities Market opacity No action Reduction in overall market efficiency Watching brief with respect to listing rules; no action Iain MacNeil � Private equity 25 Downloaded from https://academic.oup.com/cmlj/article/3/1/18/337243 by King's College London user on 11 February 2023.

[Audio] as a BVCA Consultation Document in July 2007.3 The final guidelines were published in November 2007.4 They provide for enhanced disclosure by some portfolio companies and private equity firms and will operate on a 'comply or explain' basis, leaving open the possibility of conformity through explanation (eg where compliance might risk competitive disadvantage). The BVCA will be responsible for monitoring compliance and for review of the guidelines. The definition of a portfolio company covered by the enhanced reporting guideline is a UK company: (a) acquired by one or more private equity firms in a public-to-private transaction where the market capitalization together with the premium for acquisition of control was in excess of £300 million,450% of revenues were generated in the UK and UK employees totalled in excess of 1000 full-time equivalents; or (b) acquired by one or more private equity firms in a secondary or other non-market transaction where enterprise value at the time of the transaction is in excess of £500 million,450% of revenues were generated in the UK and UK employees totalled in excess of 1000 full-time equivalents. Around 65 companies are expected to fall within the scope of the enhanced reporting coverage, which comprises the following elements. (a) The report should identify the private equity fund or funds that own the company and the senior executives or advisers of the private equity firm in the UK who have oversight of the company on behalf of the fund or funds. (b) The report should give detail on the composition of the board, identifying separately executives of the company, directors who are executives or representatives of the private equity firm and directors brought in from outside to add relevant industry or other experience. (c) The report should include a business review that substantially conforms to the provisions of Section 417 of the Companies Act 2006 including sub-section 5 (which is ordinarily applicable only to quoted companies). (d) The financial review should cover risk management objectives and policies in the light of the principal financial risks and uncertainties facing the company, including those relating to leverage, with links to appropriate detail in the footnotes to the balance sheet and cash-flow section of the financial statements. (e) To the extent that the guidelines at (b) and (c) above are met by existing market disclosures in respect of debt or equity issuance on public markets, this should be explained with the relevant material made accessible on the company's website; and where compliance with these guidelines, in particular in respect of any forward-looking statement, might involve conflict with other regulatory 3 British Venture Capital Association, Disclosure and Transparency in Private Equity, Consultation Document, July 2007, available at http://www.walkerworkinggroup.com/. 4 British Venture Capital Association, Guidelines for Disclosure and Transparency in Private Equity, November 2007, available at http://www.walkerworkinggroup.com/. 26 Capital Markets Law Journal, 2008, Vol. 3, No. 1 Downloaded from https://academic.oup.com/cmlj/article/3/1/18/337243 by King's College London user on 11 February 2023.

[Audio] obligations, the reason for non-compliance should similarly be explained on the company website. As regards the form and timing of public reporting by a portfolio company the guidelines suggest that (a) The audited report and accounts should be readily accessible on the company website; (b) The report and accounts should be made available no more than 6 months after the company year-end;5 (c) A summary mid-year update giving a brief account of major developments in the company (but not requiring updated financial statements) to be placed on the website no more than 3 months after mid-year.6 The guidelines suggest that private equity firms should publish an annual review on their website, focusing on their general approach and attentive to wider stakeholder interests. Its content should include (a) a description of the way in which the FSA-authorized entity fits into the firm of which it is a part with an indication of the firm's history and investment approach, including investment holding periods, where possible illustrated with case studies; (b) a commitment to conform to the guidelines on a comply or explain basis and to promote conformity on the part of the portfolio companies owned by its fund or funds; (c) an indication of the leadership of the UK element of the firm, identifying the most senior members of the management or advisory team and confirmation that arrangements are in place to deal appropriately with conflicts of interest, in particular where it has a corporate advisory capability alongside its fiduciary responsibility for management of the fund or funds; (d) a description of UK portfolio companies in the private equity firm's portfolio; (e) a categorization of the limited partners in the funds or funds that invest or have a designated capability to invest in companies that would be UK portfolio companies for the purposes of these guidelines, indicating separately a geographic breakdown between UK and overseas sources and a breakdown by type of investor, typically including pension funds, insurance companies, corporate investors, funds of funds, banks, government agencies, endowments of academic and other institutions, private individuals, and others. As regards reporting to limited partners on their interests in existing funds and for incorporation in partnership agreements for new funds, the guidelines suggest that private equity firms should: (a) follow established guidelines such as those published by the European Venture Capital Association (EVCA) (or otherwise provide the coverage set out in such 5 Compared with 4 months in the consultation document, but in line with the provision for AIM companies. 6 Compared with 2 months in the consultation document. Iain MacNeil � Private equity 27 Downloaded from https://academic.oup.com/cmlj/article/3/1/18/337243 by King's College London user on 11 February 2023.

[Audio] guidelines) for the reporting on and monitoring of existing investments in their funds, as to the frequency and form of reports covering fund reporting, a summary of each investment by the fund, detail of the limited partner's interest in the fund and details of management and other fees attributable to the general partner. (b) value investments in their funds using valuation guidelines published by either the International Private Equity and Venture Capital Board (IPEV) or the Private Equity Industry Guidelines Group (PEIGG) or such other standardized guidelines as may be developed in future. Another aspect of the guidelines is the plan for industry-wide collection and dissemination of authoritative data on private equity, with a view to informing government, the media, unions and other stakeholders about the economic context and performance of private equity. The guidelines encourage portfolio companies to supply to the BVCA data for the previous calendar or company accounting year on: (a) trading performance, including revenue and operating earnings; (b) employment; (c) capital structure; (d) investment in working and fixed capital and expenditure on research and development; (e) such other data as may be requested by the BVCA after due consultation and where this can be made available without imposing material further cost on the company. Similarly, it is suggested that private equity funds input data on a confidential basis to an accounting firm (or other independent third party) appointed by the BVCA to cover: (i) In respect of the previous calendar year (a) the amounts raised in funds with a designated capability to invest in UK portfolio companies; (b) acquisitions and disposals of portfolio companies and other UK companies by transaction value; (c) estimates of aggregate fee payments to other financial institutions and for legal, accounting, audit and other advisory services associated with the establishment and management of their funds; (d) such other data as the BVCA may require for the purposes of assessment of performance on an industry-wide basis, for example, to capture any material change over time in the terms of trade between general partners and limited partners in their funds. (ii) In respect of exits from UK portfolio companies over at least the previous calendar year to support the preparation on an aggregate industry-wide basis of an attribution analysis designed to indicate the major sources of the returns generated by private equity. In broad terms, these are the ingredients in the total return 28 Capital Markets Law Journal, 2008, Vol. 3, No. 1 Downloaded from https://academic.oup.com/cmlj/article/3/1/18/337243 by King's College London user on 11 February 2023.

[Audio] attributable, respectively, to leverage and financial structuring, to growth in market multiples and market earnings in the relevant industry sector, and to strategic direction and operational management of the business. The relevant data, which will unavoidably involve important subjective assessment, will involve content and format at the outset as in Annex F to the guidelines, to be reviewed and refined as appropriate in the light of initial experience and discussion between the BVCA, with the third-party professional firm engaged for this, and related analysis, and the relevant private equity firms. Finally the guidelines also deal with the responsibilty of a private equity firm at a time of strategic change. They suggest that: A private equity firm should commit to ensure timely and effective communication with employees, either directly or through its portfolio company, in particular at the time of a strategic initiative or a transaction involving a portfolio company as soon as confidentiality constraints cease to be applicable. In the event that a portfolio company encounters difficulties that leave the equity with little or no value, the private equity firm should be attentive not only to full discharge of its fiduciary obligation to the limited partners but also to facilitating the process of transition as far as it is practicable to do so. Perhaps just as important are those issues that the review considered but ultimately excluded from its recommendations. One was the composition of the Board of portfolio companies and the potential role of 'outside' directors. The Combined Code contains guidelines for listed companies on this issue, but it does not extend to private equity portfolio companies. While the review recognized the potential benefits for private equity portfolio companies in having 'outside' directors, it did not consider that the rationale applicable to listed companies (primarily the alignment of interests of shareholders and the board) was applicable in all cases in private equity. Hence, it limited its recommendations on board composition to disclosure of the background and capabilities of the board through the annual review (above). Another area excluded from the review was the issue of remuneration in portfolio companies, which was viewed essentially as a matter for agreement between the general and the limited partners rather than an issue of broader 'stakeholder' concern. The consultation process following the review generally supported this approach and therefore the guidelines do not impinge on this matter. 6. The Treasury Select Committee Report The Treasury Select Committee Report stands out from the other reviews mentioned above in that it adopted an over-arching approach to private equity. The other reviews have been limited by either their terms of reference (the BVCA) or the scope of the relevant body's regulatory authority (the FSA and the Treasury). While the Select Committee Report was, therefore, able to look at the broad picture, it made few firm proposals.7 Indeed it was surprisingly non-committal on the issue of a legislative (as opposed to a self-regulatory) response in the field of disclosure and transparency, 7 Treasury Select Committee 10th Report Session 2006–07, 24 July 2007, available at http://www.publications.parliament.uk/pa/ cm/cmtreasy.htm. Iain MacNeil � Private equity 29 Downloaded from https://academic.oup.com/cmlj/article/3/1/18/337243 by King's College London user on 11 February 2023.

[Audio] commenting rather cryptically that 'We will certainly be willing to use our influence to help to ensure that any guidance drawn up by Sir David Walker is implemented.' It did, however, call for an extension of the Walker Review proposals to provide more guidance on: (a) board statements by relevant portfolio companies setting out their approach to their stakeholders, together with information on their strategy for the company; (b) annual reviews by general partners, including the information on how value has been created; (c) reports on the level, structure and conditionality of debt. The Select Committee also proposed the establishment of arrangements for additional independent monitoring of the industry's conformity with this code over and above the expected scrutiny by unions, politicians and the media, to provide greater assurance that compliance will not fall short of the desired level. This suggestion was taken up by Sir David Walker in the guidelines. His recommendation is for the BVCA to set up a Guidelines Review and Monitoring Group. Its terms of reference would be: (a) to keep the guidelines under review and to make recommendations for changes when necessary to be implemented by the BVCA after due consultation to ensure that the guidelines remain appropriate in changing market and industry circumstances; (b) to review the extent of conformity with the guidelines, through compliance or explanation, on an ongoing basis; (c) to publish a brief annual report on the work of the Group. The protection of employees through the TUPE Regulations attracted the interest of the Select Committee. It called for clarification over the application of the TUPE Regulations to private equity buyouts. While the regulations do not normally apply to takeovers that are structured in the form of acquisitions of shares (as opposed to acquisitions of assets), there was some evidence presented to the Select Committee indicating that TUPE could apply in those circumstances. The Committee therefore called for more evidence before taking a view on this issue. This is a matter that carries implications not just for private equity buyouts but for all forms of takeovers funded by shares. As regards the tax issues relating to 'carried interest' and the broader issue of the taxfavoured status of debt as compared with equity, the Select Committee simply noted that these matters were already the subject of Treasury and Revenue investigations and did not make any specific proposals. The Committee also deferred consideration of why Public Limited Company (PLC) status has become less attractive from the perspective of institutional investors. The conundrum apparent here is that while much of the case against PLC status is attributed to the short-term focus of institutional investors, it is largely the same set of investors who back private equity firms as limited partners. It seems quite likely that this line of enquiry will take the Select Committee down the route of enquiring into the mandates under which portfolio managers handle different asset classes and the time-frames around which their remuneration is structured. 30 Capital Markets Law Journal, 2008, Vol. 3, No. 1 Downloaded from https://academic.oup.com/cmlj/article/3/1/18/337243 by King's College London user on 11 February 2023.

[Audio] The tax treatment of 'carried interest' was subsequently clarified by the 'Pre-Budget Report' of the Chancellor.8 As from 6 April 2008 capital gains tax will be levied at a single rate of 18 per cent and both taper relief and indexation9 will be withdrawn. This change carries implications for all capital gains and not just 'carried interest' earned by the general partner in private equity funds. It represents an 80 per cent increase in the marginal tax rate applicable to gains on (unquoted) investments held for 42 years and was introduced partly in response to public disquiet over the level of tax paid by general partners in private equity firms. However, to the extent that there has been no attempt as yet to categorize 'carried interest' as income (comparable to a performance-related fee), the private equity industry has fared well as that would have resulted in tax rates of up to 40 per cent being applied. 7. Conclusion The regulatory debate in respect of private equity has moved forward considerably during the current year. The BVCA has moved quickly to put in place an enhanced disclosure framework that will operate on a 'comply or explain' basis. The FSA's response has been more limited, focusing on the application of the existing regulatory framework to private equity transactions rather than its expansion. The Treasury has already taken some action in the sphere of capital gains tax by announcing an end to taper relief and indexation and may have further proposals to make on the treatment of debt once its review has been completed. The onset of the credit crunch since mid-August may also prove to be a significant factor in the dynamics of the regulatory debate. To the extent that it limits the possibility of completing buyouts or the degree to which deals can be leveraged, it may be that private equity may be perceived as less of a threat than it was in some quarters earlier in the year. Taken together with the BVCA's framework for enhanced disclosure and the FSA's heightened focus on the transactional aspects of private equity, the impetus for a broader regulatory response may well have been lost. Even so, it remains difficult to predict how the political dimension of private equity regulation will shift as more information enters the public domain. The standpoints of the opposing camps are well known: on the one hand, private equity is seen as having a short-term focus on asset stripping and re-structuring without proper regard to the interests of employees, and on the other it is viewed as a means of transforming corporate governance, creating jobs and enhancing overall economic performance. The potential for public opinion and political traction to move between these two diametrically opposed views is considerable and may well be influenced to a greater extent by experience derived from the operation of privateequity owned companies rather than being dominated, as is currently the case, by the buyout process. 8 See http://www.hm-treasury.gov.uk/pbr_csr/pbr_csr07_index.cfm. 9 Indexation permits the acquisition cost of assets to be adjusted in line with inflation when calculating a realised gain for the purposes of capital gains tax. Iain MacNeil � Private equity 31 Downloaded from https://academic.oup.com/cmlj/article/3/1/18/337243 by King's College London user on 11 February 2023.