Friday Letter Babies and bathwater

The UK’s legislative should watch what it wishes for when it addresses the tax burden on Europe’s private equity firms, because the law of unintended consequences could easily leave the Chancellor with less in his coffers than today, if he drives away the most successful firms.  

Finally another heavyweight investor in private equity has joined the fray and taken the message to the mainstream media that private equity is not the devil’s work. But the headlines were not perhaps those hoped for.

In a wide-ranging recent interview published on Monday in the Financial Times, Nick Ferguson, chairman of UK private equity investor SVG Capital, covered a lot of ground. But his criticism of the tax relief on carried interest that allows buyout executives to pay “less tax than a cleaning lady” showed the power of a graphic image, dominated the story, and was splashed all over the newspaper’s front page.

UK union leaders hailed Ferguson’s apparent Damascene conversion. It was a gift to them that Permira’s biggest investor was on the record saying: “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.”

Under the current rules, the money that private equity executives earn from carried interest – the portion of profit they receive from buyout deals, normally about 20 percent once certain thresholds have been passed – is treated as capital gains. Taper relief rules allow the tax on this to be reduced from the top rate of 40 percent to as little as 10 percent, while any investment losses can also be offset against this rate.

Damon Buffini, Permira’s managing partner, might wish for a lower profile from his cornerstone investor until after UK premier-in-waiting Gordon Brown has finished his pending review of the industry’s tax treatment. Brown, in an apparent reference to private equity tax, has promised “justice and integrity” in the review.

Ferguson himself was sceptical about arguments put forward by the Confederation of British Industry and the British Venture Capital Association, among others, that increasing the current rate of capital gains tax would cause firms to move offshore. “Anyone who wants to live in Guernsey can do so already,” he said.

But this threat is real, although it is unlikely to involve a move to the Channel Islands.

An exchange during a panel discussion between financial services grandee Paul Myners and Kohlberg Kravis Roberts’ European head Johannes Huth at a conference in London one day after the Ferguson story appeared underlined how important the tax break is in putting London at the heart of Europe’s buyout business.

Myners said it was indefensible that Huth might pay a lower rate of tax on his capital gains than a London policeman earning enough to trigger the 40 percent rate. Huth said it was not his position to comment on a police constable’s tax bill, but he emphasised the importance of optimising his firm’s tax liability. If one jurisdiction offers a particular advantage, then it will win the battle for business. Or as Huth put it, that is why there are so few private equity firms incorporated in his German homeland. The threat was implicit, but clear.

However, can there be really that much argument that carried interest looks like income, not equity, and should therefore be treated as a performance bonus? In effect, carry works much as share options awarded to company managers do. They are taxed as income.

Private equity managers should be careful not to fight what seems increasingly inevitable. But Gordon Brown would also do well to remember what makes London such an attractive destination for the globe’s private equity elite.

Otherwise the baby will be thrown out with the bathwater, leaving the Exchequer with nothing but memories.