Thursday, June 28, 2007

Taxing Income As Capital

The road to riches
Click on image to enlarge
The ever excellent Jeff Randall explains exactly how Brown's accelerated taper relief benefits private equity operatives:

"In a typical private-equity deal, involving the likes of Charterhouse or CVC, the firm's partners might cough up 2pc, ie £10m, of the £500m of equity funds required to pay £3bn for BusyBiz, an underperforming subsidiary of DozyCorp.

Outside investors put in the rest of the equity funds, £490m, and the balance of the purchase price, £2.5bn, comes from bank borrowings.

Having knocked the ailing BusyBiz into shape, the partners then offload it to a rival or float the company on the stock market, realising handsome gains for themselves and their backers. On a normal day, the partners will collect 20pc of the value created.

Thus, if BusyBiz is sold for £4bn, they collect 20pc of the £1bn profit (£4bn minus £3bn), ie £200m.

Under existing rules, as long as the investment had been held for a minimum of two years, all of this personal profit would attract a 10pc tax rate, not 40pc, because it counts as a capital gain, not regular income. So the partners would pay only £20m in tax, instead of £80m.

You have, I hope, spotted the anomaly. The private-equity partners put up only 2pc of the original risk money, a small fraction of the total purchase price, yet collect 20pc of the overall payback.

If their bankers and outside investors are happy with this ratio, it is because they recognise the exceptional contribution of private-equity managers in creating value where little had seemed to exist.

But it is, quite frankly, outrageous that the Inland Revenue is content to reward private-equity partners with a low tax rate for taking a large punt with OPM - Other People's Money.
It's providing reward without risk.

If the partners are prepared to inject "only" 2pc of the risk equity, they should be entitled to a special tax rate on no more than 2pc of their share of the overall profit."

Not for the first time, Randall has put his finger on the nub of the problem. Brown's taper relief has exacerbated the asymmetry of risk and reward as between the owners of the capital (such as pension funds), and their fund managers. It's not really an issue of moral "outrage". It's actually worse than that.

Private equity was always a risky business, and there were always "principal/agent" issues. But Brown's taper relief has poured petrol on the flames.

With little personal capital actually at stake, highly savvy private equity partners have been even more hugely incentivised to risk capital belonging to much less well informed punters, including pension fund members.

That's all very well so long as markets are heading North- as they have been for the last few years. In that environment, private equity, geared up to the hilt on a nice big pile of debt, performs like a train. And doubtless that's helped many final salary pension schemes to surge back into surplus over the last year.

But when the next downturn arrives, watch out. The whole process goes into reverse. And the people left holding the baby won't be those private equity partners.

PS In case you're unsure, the growth of the UK's private equity biz has been spectacular over the last decade. According to the British Venture Capital Association, the industry raised £27bn of new funding in 2005, and investments hit a record £11.7bn (in case you're wondering, their chart above only goes up to 2004). That's a threefold increase since Labour came to power, reflecting in no small measure Labour's tax changes- not just the taper relief but also the abolition of ACT refunds for pension funds (see this blog).
PPS For the avoidance of doubt, yes, we think private equity firms overall do an excellent job increasing economic efficiency, and no, we don't want tax increases. But taxes shouldn't be skewed in this way because it seriously distorts economic decision making. Low and simple is what we need.

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