breakingviews.

com

Is private equity in the

public interest?

Views you can use

 Contents

1 Introduction

2 The case against private equity, part one

5 The case against private equity, part two

7 The case for private equity

10 An imbalance of greed and fear

12 Of debt and taxes

14 The real UK private equity tax loophole

17 Private to public

18 Missing the point

19 Angels or Demons?
 breakingviews.com

Introduction

The rise of private equity over the last decade has been nothing less than a
revolution. And like all revolutions, it has provoked furious debate as to what it
all means. A few facts everybody can agree on: that over the last few years, the
top private equity funds have delivered spectacular returns to investors, that
these returns have enabled buyout firms to raise ever-larger funds, and that
these huge funds have allowed buyout groups to chase even larger targets. As
a result, private equity now employs a quarter of UK private sector workers. And
this year has seen private equity bids for two FTSE 100 companies, J.
Sainsbury and Boots, with plenty of others cited as potential targets.

But then the questions begin. How has this success been achieved? How much
is due to asset-stripping? How much to cutting jobs and slashing employee pay
and benefits? How much to piling onto companies reckless quantities of debt?
Or indeed, to clever tax loopholes? And how much is due to lucky timing, thanks
to the huge rise in the stock market following the stock market crash? And how
much is due to skill, to spotting undervalued and underperforming companies,
to success in turning around struggling companies around and providing a
structure that allows companies to grow? Will private equity’s success prove a
flash in the pan? Or are we witnessing a permanent revolution? Should policy-
makers be worried?

These arguments aren’t just taking place between trade unions and bosses,
between regulators and bankers, between academics and practitioners. They
rage within the City and on Wall Street too. Nobody knows for sure where this
revolution will lead. Perhaps, like the French revolution, it is still too soon to tell.
But breakingviews.com aims to be at the forefront of the debate, analysing
deals, examining company and fund performance, probing the sources of the
industry’s returns and investigating the claims of private equity’s opponents.
This selection of recent articles, covers a range of different topics and contains
a variety of points of view. We don’t claim to have all the answers, but we hope
they will help you make up your own mind.

By Simon Nixon, Executive Editor

-1-
 breakingviews.com

The case against private equity, part one

By Edward Chancellor

The leveraged buyout industry has never been bigger or bolder. Over the last
year, private equity has both raised and spent record amounts. It plays an
increasingly prominent role in the markets for mergers and acquisitions and for
IPOs. Fees generated from buyouts have enriched commercial and investment
bankers alike, not to mention the employees of private equity firms themselves.
And let's not forget the investors in buyout funds, who have enjoyed staggering
returns over recent years.

Nevertheless, the private equity industry feels unloved. The buyout barons are
irked by those who cavil at their fees and warn of the dangers that come from
piling too much debt onto companies. In the US they've responded by setting up
a trade association, the Private Equity Council. And because returns apparently
don't speak for themselves, the top industry figures are taking time off from their
deal-making to argue the case for private equity. As we shall see, their
arguments don't stack up. No amount of propaganda can conceal the truth that
the buyout industry is a fee-devouring, asset-gathering operation which
generates returns primarily from leveraging assets. This is not just a matter of
concern for over-expectant buyout investors, known as limited partners. The
industry has become so large and borrowed so much that it poses a threat to
the financial system and the economy at large.

The case for private equity begins with returns, large and mouth-watering
returns. In the year to June 2006, the average return after fees for buyout
investors was nearly 26%, according to Cambridge Associates, roughly three
times as much as the S&P 500. Furthermore, over the past two decades there
have been only a couple of years of negative returns for private equity
investors. Institutional investors looking for high returns away from the volatile
stock market are naturally excited by these figures. According to research firm
Private Equity Intelligence, some $700bn has been invested by private equity
(including venture capital) with a further $700bn committed and awaiting
investment. The majority of buyout investors plan to increase their stake in the
coming year, says Mark O'Hare of Private Equity Intelligence.

Where do these returns come from? Well, says the buyout apologist, they're the
premium investors receive for illiquidity, that is, for locking up their money for
years at a time. Private equity managers know a thing or two about adding
value. By taking control of the whole company, they claim to have got rid of the
longstanding "agency problem." This refers to the numerous issues that arise
when the management and ownership of public companies are separated.
Furthermore, it's claimed that private equity has a longer time horizon than
stock market investors. Hedge funds, for instance, force management of public
companies to focus on their quarterly earnings figures. Private equity is not only
more far-sighted, it is prepared to take hard decisions, such as radical
restructurings and large leverage, which the managers of listed firms often
eschew. Corporate turnarounds are therefore more effective when undertaken
by private equity owners.

-2-
 breakingviews.com

After a buyout, senior management is provided with huge financial incentives to

maximise returns for investors. Besides, bosses prefer working for private
equity since this frees them from onerous reporting duties, such as those
entailed by Sarbanes-Oxley. Private equity also uses capital more efficiently.
For a start, high levels of leverage enable buyouts to take advantage of the tax
deductibility of interest payments. This lowers their cost of capital.

Private equity employs sophisticated financial engineering to mine further gains.

For example, when car-rental firm Hertz was acquired by a buyout consortium
in late 2005, the securitisation of its fleet raised some $4.5bn, reducing interest
payments by $80m a year. The larger private equity firms, such as Carlyle,
boast that their global network of portfolio companies allows them to extract
synergies by cross-marketing, joint-ventures and expansion into new
geographic regions.

These claims are not just special pleading by private equity insiders.
Institutional investors, including the largest public pension funds, make the
same argument. Even Britain's Financial Services Authority concluded in a
recent report on the industry that "private equity offers a compelling business
model with significant potential to enhance the efficiency of companies. This
has the potential to deliver substantial rewards both for the companies' owners
and for the economy as a whole."

Or not. The case against private equity begins with investment returns. These
are both exaggerated and misleading. For a start, it's mistaken to focus on
average returns since the gains from private equity are very unevenly
distributed. That means there's a very wide distribution of returns between the
best and the worst managers. Unless investors have money in the best-
performing buyout funds, they're likely to do far worse than average. Then,
there's a problem of survivorship bias in the data - the returns of the most
successful private equity firms are recorded in the performance data while poor
funds are discontinued and drop out. Furthermore, these returns aren't risk-
adjusted to account for the large levels of debt employed in LBOs.

What's more, buyout firms have developed tricks, such as paying themselves a
large dividend shortly after an acquisition, in order to boost their reported
returns. Although some private equity deals undoubtedly add value with
turnarounds and mergers ("roll-ups" in industry parlance) of their companies,
there is no evidence that this holds true in aggregate.

On the contrary, academic research has repeatedly demonstrated that the high
returns from buyouts derive solely from their use of leverage. A report by
Citigroup analyst Darren Brooks points out that private equity returns also need
to be adjusted for investment style and company size. Buyouts typically occur
among mid-size companies with 'value' characteristics, such as low price-to-
book ratios. Over the past 10 years, investors could have beaten the returns of
the best private equity funds simply by applying private equity-style leverage to
a portfolio of quoted mid-cap value stocks, says Brooks.

The other arguments put forward for private equity don't bear close
examination. Senior executives at public US companies already have huge

-3-
 breakingviews.com

incentives, through grants of stock options and deferred stock, to maximise

shareholder value. And if they're not prepared to take difficult decisions, then
directors can always fire them and find other people to run the company. The
reason that chief executives like working for private equity owners has little to
do with the short time horizons of stock market investors or the reporting
requirements of Sarbox. On this score, the buyouts provide only a brief respite
since the exit route is often back into the public markets. The real attraction for
senior managers is the huge compensation that private equity is prepared to
offer. Last August, General Electric executive David Calhoun joined the recently
privatised Dutch media firm VNU with a package reportedly worth up to $100m.

The claim that private equity is overhauling management is overdone. Many of

today's largest deals involve management buyouts, such as the $32bn
acquisition of HCA last summer - which don't involve any change at the top.
Many private equity deals nowadays involve buying companies from other
buyout firms. These so-called "sponsor-to-sponsor deals" offer little obvious
scope for operational improvement.

Besides it's wrong to suggest that equity investors in general are too myopic to
allow management to pursue long-term strategies. Several hundred years of
stock market history and industrial development suggest otherwise. For
instance, the biotech industry, whose eventual profitability lies somewhere in
the long-distant future, is largely funded in the stock market.

Hedge fund managers may have an interest in boosting short-term returns but
they're also locked in a symbiotic relationship with private equity. Activist hedge
funds put public companies in play, while other hedge funds provide equity and
debt financing for buyout deals. And although it's true that leveraged companies
with large interest payments enjoy a lower cost of capital, private equity firms
throw all this advantage away and a great deal more when they pay an average
premium of nearly 20% to acquire firms in the public market. In fact, the largest
buyout announced in 2006 - Blackstone's $36bn acquisition of Equity Office
Properties , provided no tax benefits whatsoever since the company concerned
was a tax exempt REIT.

In the second part of this essay, I will examine the conflict of interest that exists
between buyout shops and their limited partners.

Published 10 January 2007

-4-
 breakingviews.com

The case against private equity, part two

By Edward Chancellor

Although private equity disposes of the ancient division of ownership and

management of public companies, it brings a host of new agency problems.
Private equity firms have interests which are distinct from the investors in their
funds. This leads them to engage in activities to maximise their own profits at
the expense of their limited partners.

Private equity firms charge large fees for executing deals. These vary between
firms but are believed to average around 1%. They also extract annual
management fees, also of around 1.25%, for managing companies and take a
profit share, normally 20% above a hurdle rate, when a company is sold. Given
these facts, we might expect that a profit-maximising private equity firm to do
the following: grow assets under management as quickly as possible, invest
that money speedily, and look for the first opportunity to exit the investment.

The recent behaviour of the major private equity firms conforms to this pattern.
They have recently been engaged in an unparalleled spurt of asset-gathering.
Buyout firms raised nearly $240bn last year, according to Private Equity
Intelligence. Fund envy dominates the industry and several leading firms now
manage funds in excess of $10bn, Blackstone even has a $20bn fund on tap.

You might think that with the stock market at record highs and profits bloated by
a long period of expansion, private equity firms would resist spending all this
money at once. Not so. Buyout funds used to invest their funds over an average
six-year period. Yet over the last year, several of the mega funds, including
those run by Blackstone and Bain Capital, have spent their more than half their
cash piles within months of raising them. This frenzied deal-making belies the
claim that private equity acts like a value investor waiting patiently to invest in
the right companies at the right time. Because buyout firms are investing over
such a short period, their limited partners are now more exposed than before to
the danger of buying in at a cyclical top.

As private equity rushes to put money to work, they've engaged in some

questionable deals. For instance, last April Blackstone spent E2.7bn for shares
in the listed German telecoms firm, Deutsche Telekom. This stake gave
Blackstone board representation but no management control. Private equity is
also entering into volatile sectors traditionally considered too risky to carry large
amounts of debt. Of the $17.6bn acquisition of Freescale Semiconductor last
September, Fred Hickey, editor of the High Tech Strategist, observed: "hugely
cyclical, often money-losing, and usually cash-burning semis have all the
attributes that should make LBO funds steer clear." Furthermore, rising
competition among private equity firms has pushed up valuation multiples for
buyouts. That spells lower returns for their investors in the future.

Then, there's the unseemly dash to the exit. An early sale or large dividend
payments (or 'recap') allows private equity firms to boost their reported returns.
This helps them raise more money when they launch new funds. Private equity

-5-
 breakingviews.com

has come to resemble a game of hot potato in which companies are handed
from one private equity firm to another, sometimes as often as three or four
times in succession. Buyout shops also look to float their companies as soon as
possible on the stock exchange. The IPO of Hertz, for instance, occurred less
than a year after the buyout. Speedy disposals suggest that private equity is not
relying so much on its vaunted turnaround skills to generate returns and that its
investment horizon is shorter than is claimed.

There's a catch, however. As private equity firms engage in ever larger deals,
Carlyle's David Rubenstein recently suggested that the first $100bn buyout may
not be far away , there's a problem of how to exit the deal. Multibillion dollar
companies, such HCA, are unlikely to find a trade buyer and are too large to
flog to other private equity concerns. So the most likely exit is through an IPO.
Yet private equity firms could clog up the world's stock markets as they prepare
to float upwards of a trillion dollars worth of companies in the years to come.
That may not be good news for limited partners, but the private equity firms will
still harvest tens of millions of dollars in deal and management fees.

All this suggests that the buyout industry is a confidence trick played at the
expense of investors. Companies are taken from the public market, where the
investment risk is evident in the daily fluctuation of share prices, and transferred
to opaque buyout funds, where the risk is enhanced by leverage but concealed
from public view. Hiding the true risk in buyout funds serves private equity
because it makes their returns appear less volatile. It's no wonder that the
industry has been fighting a change in accounting rules which forces them to
mark the value of their investments to the market.

Since large institutional investors have interests in the stock markets as well as
private equity funds, the investor base may not change dramatically after a
buyout. Yet private equity firms, investment and commercial banks and
numerous others on Wall Street receive enormous fees for this public-to-private
"repackaging" service. As we have seen, many private equity deals amount to
little more than piling on debt. Yet sophisticated investors should be acquainted
with the Modigliani-Miller theorem which teaches that adding debt to a company
doesn't add value (leaving taxes aside). Therefore all those private equity fees
represent a net loss to the investment world. Institutional investors, who are
rushing to increase their buyout exposure, suffer from a private equity illusion.

In truth, buyout funds aren't really much different than the heavily indebted
conglomerates of the 1960s, such as LTV and ITT. In their heyday, the
conglomerates also boasted that they added value with their lower cost of
capital and superior financial skills. Private equity firms, such as Carlyle and
Blackstone, which spread their tentacles across many industries, have come to
resemble the highflying Japanese keiretsu of the 1980s. It should be
remembered that both conglomerates and the keiretsu came unstuck when
booming market conditions changed.

Buyouts have generated large returns in recent years. But this has been due to
favourable market circumstances - a combination of the very strong profits
growth in recent years and a rise in corporate valuations since the stock market
bottomed out in 2002. Extraordinarily loose credit conditions have also played

-6-
 breakingviews.com

an important role. Private equity firms have been able to finance risky deals at
very low interest rates. The credit markets have facilitated the private equity's
daisy chain, as firms are handed from one sponsor to another, and have
enabled dividend recaps. Easy money has also supported rising debt levels
(relative to operating cash flow) and higher purchase prices for buyouts.

Unfortunately, when the buyout boom ends it won't be just private equity
investors who suffer. The industry has become so large that too many people
and institutions will be involved in the debacle. The banking system has a large
and increasing exposure to leveraged buyouts. While the great majority of these
loans are parceled out in a matter of months, if the buyout party stops abruptly
some banks will surely be caught on the hook. Then there's the legacy of
excessive corporate debt to consider. This could cripple hundreds of companies
in years to come. Jon Moulton of British private equity firm Alchemy Partners
has recently warned of the prospect of rising defaults and a corporate world
filled with "headless chickens." Institutions, whether insurers and pension funds,
which have invested in buyout debt or in private equity funds are also at risk if
investment returns fall far short of expectations.

In fact, the only major financial players who stand to profit from a buyout bust
are the private equity firms themselves. Senior industry figures acknowledge
that corporate valuations are currently unattractive. Some admit, in private, to
looking forward to a downturn, which might allow them to acquire companies at
more affordable prices. Several firms, including industry titans Blackstone,
Carlyle, KKR and Texas Pacific have anticipated such an outcome by raising
distressed debt funds. Today's private equity boom is shaping up to add yet
another chapter to Wall Street's long history of cynicism and arrogance.

Published 10 January 2007

The case for private equity

By Simon Nixon

Private equity is on the receiving end of a ferocious global backlash. But then it
has never exactly been popular. It has lived with the "Barbarians at the Gate"
tag for nearly 20 years. Now it faces a new barrage. To trade unionists
protesting outside an industry gathering in Germany, buyout groups are "amoral
asset strippers" and "casino capitalists". To many politicians, they are "locusts"
and their salaries "obscene". In the UK and France, there has been talk of new
taxes targeting private equity. In the US, there have been calls for an
investigation into alleged collusion. And in South Korea, an executive from
Warburg Pincus has been sentenced to jail.

Much of this backlash is not really about private equity at all. The industry is the
latest whipping boy for opponents of globalisation. For all the talk of asset-
stripping, UK private equity-backed firms have a better record of creating new
jobs than public companies, having increased their employees by an average

-7-
 breakingviews.com

9% in the year to June 2006, compared to a 1% rise in jobs among the FTSE
All-Share according to the British Venture Capital Association. And while private
equity has certainly taken advantage of cheap debt over the last few years, it is
hardly alone in that. So too, have UK and US consumers. And why do critics
complain that private equity salaries fuel social inequalities, but not those of
footballers? Do critics believe the way to ease social tensions is for private
equity to promise to be less successful?

But some criticism cannot be dismissed so easily. The most damaging charge -
one often heard even in the City - is that private equity fails its own investors.
This view has been most pungently expressed by breakingviews.com columnist
Edward Chancellor, who recently dismissed private equity as "a confidence
trick". His argument boiled down to three criticisms. First, that private equity's
claim to superior returns is "exaggerated and misleading". Second, that those
returns are entirely due to cheap debt and rising stock markets. Third, that
private equity groups "engage in activities to maximise their own profits at the
expense of their investors".

A confidence trick?

But can all those supposedly sophisticated investors who last year poured
$432bn into private equity - and half of whom are likely to increase their
allocation this year - really be such deluded saps? Of course not. Sure,
investors know that three quarters of private equity funds fail to beat the stock
market. But they also know that the top 25% of funds do outperform the stock
market, according to a study by McKinsey - "and did so both by a considerable
margin and persistently". This variation in performance simply proves what
many in the buyout industry have always maintained: that private equity is a
tricky business, and that investors must choose their funds with care.

But why do some funds consistently outperform? Is it really just a matter of

cheap debt and lucky timing? True, both are important drivers of returns, but
that hardly amounts to a case against private equity. Most businesses use
leverage to juice up returns to some extent; private equity-owned businesses
tend to do so more than most because their shareholders accept the risk of their
equity being wiped out. As with hedge funds, leverage is part of the attraction.
Meanwhile, it would be remarkable if market timing was not an important driver
of returns - particularly three years into a bull market; after all, private equity
groups are first and foremost investors, whose job it is to spot value. That said,
at this stage in the cycle, with valuations already high, many buyout groups are
assuming no multiple expansion on current investments.

Besides, this so-called cheap debt is often not as cheap as it looks. Buyout
groups can't borrow on the same terms as central banks. Permira reckons its
blended cost of sterling debt - including racier debt instruments such as second-
lien loans and pay-in-kind notes - is over 9%, which, after allowing for the tax
benefits of debt, falls to 6.5%. If Permira relied on leverage alone, it could only
buy companies expected to deliver annual returns of more than 6.5% - hard
when this is the earnings yield of the FTSE All-Share. No buyout group would
contemplate a deal without a clear strategy for growth. For example, General
Healthcare, backed by BC Partners, bought three hospitals and built one from

-8-
 breakingviews.com

scratch in the UK. And UK retailer New Look, has added more than 1m square
foot of new space under Apax's and Permira's ownership.

Better investors, better owners

In fact, studies show that operational improvements are just as important drivers
of private equity returns as leverage and market conditions. In a study of 60
buyouts, McKinsey found that only a third was due to higher leverage and 5% to
rising stock markets. The rest reflected the focused and active involvement in
these companies by their private equity owners. A similar study by Ernst &
Young of the 100 largest private equity exits in the boom year of 2005 found
only a third of the returns were attributable to leverage and a third to multiple
expansion. The rest was due to business change. Indeed, the deals that yielded
the highest returns were those involving change.

Is private equity better at driving change than the public market? In fact, the
question is often irrelevant. Many buyouts involve companies that have never
been listed, such as subsidiaries of larger groups that may have been starved of
investment, or run with other priorities. Meanwhile, public market buyouts
typically involve companies with failed strategies, or that require major
restructuring. In these situations, private equity brings the advantages of a
single owner: rapid decision-making, clear incentives, short lines of
communication, and, increasingly, a wealth of expertise. All the big buyout
groups now employ top business leaders as advisors. Apax Partners has
recruited former BP boss John Browne; Carlyle has hired former IBM boss Lou
Gerstner.

Of course public companies can, and do change too. But often it takes the
threat of a buyout to galvanise the board, as in the case of Marks & Spencer or
Saint Gobain. Increasingly change in the public markets is driven by activist
investors, who will incur the costs of a campaign to change strategy or
management. But fighting an entrenched management is hard work for a
minority investor relying only on public information. Historically, public markets
have not been good at holding boards to account - particularly in Europe.
Shareholders often prefer to sell poor-performing investments. They don't have
the time, skill, or incentive to drive change. Private equity eliminates the so-
called principal-agency problem, whereby ownership and management are
separated. That gives it a real advantage.

Sure, this active ownership does not come cheap. In addition to high
management and performance fees, some firms - but by no means all - charge
portfolio companies management and transaction fees. These often look
outrageously high, and they do indeed line the pockets of the private equity
groups at the expense of investors. But firms know they can only get away with
these charges if they deliver on returns. If returns fall short, they will struggle
with future fund-raising.

Does the pressure to generate those returns lead to decisions that could harm
the long-term value of the business, such as taking out large cash dividends, or
selling too quickly? That's hard to judge. But private equity has little trouble
finding buyers for its assets, not least because these companies tend to perform

-9-
 breakingviews.com

well after they change hands. Initial public offerings of private equity-backed
companies outperformed other IPOs and the market as a whole between 1980
and 2002, according to a study by Jerry Cao and Josh Lerner of Harvard
University. In fact, private equity has a strong incentive not to float dog stocks:
not only do they typically retain a chunk of equity in the companies they IPO;
they also know they will need to come back to the public markets again, so they
have a reputation to uphold.

Barbarians or liberators?

That's not to deny the industry is changing. Private equity's past success may
not be a very good guide to the future. Have buyout groups become greedy,
raising mega-funds purely to pocket the management fees? Can the mega-
funds invest all this cash without sacrificing returns? Time will tell. On the other
hand, investors are piling into these mega-funds with their eyes open. The firms
raising mega-funds are those with a track record. These mega-funds also offer
other advantages, including access to the biggest deals, which is where the
biggest gains potentially can be made, since these managements are more
likely to have been shielded from their owners; and portfolio diversification,
which should lead to less volatility, since it means risk is spread more widely.
Higher returns and lower volatility: that's the Holy Grail of investment.

Like the original barbarians, private equity has succeeded because it

encountered an old order that had become complacent, ill-disciplined, fractious
and often corrupt - leaving it wide open to attack from a more focused, better
organised and more determined adversary. But whereas the barbarians left a
trail of destruction and despair, private equity has triggered an economic
renaissance in every country where it has been embraced - while countries that
have resisted private equity languish at the bottom of the growth and jobs
league. Private equity's success may be troubling for those with a stake in the
old order - mediocre managers, trade unions and traditional fund managers. But
for employees, investors and everybody else who has an interest in healthy
companies, these barbarians should be welcomed as liberators.

Additional research by Nicole Lee

Published 27 February 2007

An imbalance of greed and fear

By Hugo Dixon

The smart money knows that today's liquidity-inflated financial markets are full
of risk. That was clear from private discussions at last week's World Economic
Forum in Davos. And yet private equity houses, hedge funds and investment
banks are acting as if the good times will continue.

- 10 -
 breakingviews.com

Skewed incentives, that pump up greed and dampen fear, explain the
discrepancy. Huge fortunes will be made if the good times roll on; but the
insiders won't lose much if there is a crash because they are often playing with
other people's money.

Peer pressure at events like Davos insidiously magnifies the greed. Russian
oligarchs, mining magnates and Indian moguls rub shoulders with hedge fund
and private equity billionaires. A $50m fortune means nothing. Being a
billionaire is merely an entry ticket to the super-rich league. Even many of the
$10bn-plus guys, who are still in a class of their own, are driving hard to
increase their fortunes.

The main way to get seriously rich quickly these days is to play the hedge fund
or private equity game. The incentive system - the notorious "2 and 20" under
which managers get 2% of funds under management as an annual fee and 20%
of the profits - favours those who can scoop up the biggest pots of other
people's money.

The prime drive has become to gather assets rather than to deploy them
effectively. That's not to say the smart money likes to make bad investments.
But when things go pear-shaped - as with Amaranth last year - the managers
don't share in the losses or give back past takings.

In a well-functioning market, greed and fear are appropriately balanced. But the
"heads-I-win tails-you-lose" structures rife today have distorted the emotional
balance.

Liquidity

Hedge funds and private equity houses are only able to play this game, of
course, because the world is sloshing with liquidity. To hit the jackpot, they need
to gear up with borrowed money.

But why is there so much liquidity? Partly it's a macroeconomic story, linked to
savings gluts in China and oil-rich countries. But skewed incentives are part of
the explanation here too.

Look at leveraged loans, which are fuelling the private equity bubble. Last week
saw a new high-water mark when Blackstone upped its bid for Equity Office
Properties to $38bn.

Leverage multiples have reached levels that many banks think excessive. But
they are still lending. They are doing so because they have become skilled at
passing the parcel. Banks originate the deals, take fat fees, then syndicate the
loans onto others. At Davos, bosses of two big players in the leveraged loans
businesses privately boasted at how they had cut their risk exposure in recent
years while maintaining or even increasing the amount of new loans they were
making.

What's worrying them, though, is that playing pass the parcel is becoming
harder. Private equity houses are using their position as favoured clients to

- 11 -
 breakingviews.com

make demands that banks feel queasy about but unable to deny. The LBO
houses don't just want higher leverage multiples. They are increasingly asking
banks not to syndicate the loans immediately but to hang onto them for six
months. And they sometimes also want them to put in temporary equity - so-
called equity bridges.

What this means is that, if there is a crash, banks could be left holding some
pretty hot potatoes. If that happens, it won't just be bad for the afflicted banks.
Liquidity could dry up suddenly, causing a generalised financial panic.

The smart operators are aware that the party can't go on forever. But the longer
it continues, the more money they'll make. What's more, there's no obvious
reason why it has to end now. There may be kindling on the forest floor, but
where's the spark that's going to ignite it? The snag, of course, is that as time
passes, more kindling accumulates. When the conflagration comes, it could be
dramatic.

Published 29 January 2007

Of debt and taxes

By Edward Hadas

There is a spectre haunting the private equity industry: tax. As the industry's
leaders talk over the issues at their annual festival in Frankfurt, they are likely to
shrug off accusations of being locusts and asset-strippers. An end to the tax-
deductibility of interest payments, on the other hand, would hit them where it
really hurts: in their wallets. Germany and Denmark have already made moves
in this direction. Other countries could, and should, follow suit.

The case against interest deductibility is clear. It gives companies an artificial

incentive to pile on debt. Despite that, most public companies have tended to
operate with reasonably conservative balance sheets. But the charge of the
private equity brigade in recent years has changed all that. Not only are more
and more companies being leveraged to the gills by buyout groups; an
increasing number of public companies are mimicking them.

While it is perfectly logical for smart financiers to exploit the tax system, there
are two worrying macroeconomic consequences. First, the corporate tax base
of many countries could be eroded. For example, five of the top ten UK
companies owned by private equity paid no corporation tax last year, according
to the Daily Telegraph. Second, if there is a downturn, more companies are
likely to go belly up.

For these reasons, the tax deduction ought to be eliminated. But it would be
wrong not to make a compensating adjustment. The neatest way to do this
would be simultaneously to cut the rate of tax on profits. The numbers in every

- 12 -
 breakingviews.com

country would be different. But, in the UK, tax experts estimate that a "neutral"
proposal would be to cut the corporation tax rate from 30% to 25%.

Of course, what is neutral for the government and for the corporate sector as a
whole wouldn't be neutral for every single company. There would be winners
and losers. Companies with no debt would come out ahead because they'd be
paying a lot less tax. But businesses with lots of debt - especially LBOs - would
end up paying more.

Think of a typical LBO whose operating profit is £100m. Imagine it is financed

with £750m of debt, on which it pays £50m of interest. Under the current
system, its pre-tax profit would be £50m, its tax bill £15m and its earnings
£35m. But, if the tax deductibility of interest was abolished and the tax rate cut
to 25%, tax would rise by £10m to £25m and earnings would fall to £25m.

For some companies, a sudden change in the tax system wouldn't just clobber
profits; it might tip them into bankruptcy. That, though, isn't a reason not to
change the system. It is a bit like saying that it is dangerous to take away a drug
addict's supply. The answer is neither to keep plying him with drugs nor to go
cold turkey, but to phase in the change. Five years would be ample time for
companies to recapitalise.

The case for the defence

As they nibble their canapes in Frankfurt, the private equity executives will be
justifying this tax break to each other. But their arguments aren't very strong.

One will be that this isn't a break that just benefits private equity. True, but
irrelevant. The tax break should be eliminated for all companies.

Another claim will be that no single country can afford to act unilaterally,
otherwise it will see capital flowing away. That scare tactic doesn't seem right.
Countries implementing such a change might well see fewer LBOs. But the
lower rate of tax on profits ought to attract other types of investment. A similar
rogue argument is that such a tax change would be bad for share prices. It
would only be bad for the share prices of highly-geared companies.

A final claim is that changing the tax system would undermine the private equity
industry which has been such a vibrant sector of the economy. Well, the titans
of the LBO world would think that. But frankly if they are really good at creating
value by taking companies private, they don't need a tax subsidy to do it.

Some countries have already started to act. The latest German government
proposal is to limit the tax deductibility of interest expense to 30% of pre-tax
earnings, compared to the 50%-plus in typical LBOs. Denmark is planning to be
even tougher.

What about the two biggest western capital markets? Well, the US isn't likely to
follow suit. After all, the concept of tax-deductibility of interest is deeply
ingrained in the nation's psyche. It applies not just to companies but to
individuals' payments on their mortgages.

- 13 -
 breakingviews.com

The question is a little more open in the UK. As yet, the government has shown
more interest in protecting the flourishing private equity industry than in
changing the tax law. But it might see the situation differently if the current
uproar over private equity persists.

Published 27 February 2007

The real UK private equity tax loophole

By Simon Nixon

What is the best kept secret in UK private equity? That partners in buy-out
funds pay as little as 5% tax on their performance fees. This tax break is now
costing the UK taxpayer several billions of pounds a year. One can understand
why the buy-out prince-lings are exploiting this break for all it is worth. But it is
hard to see how it is in the public interest.

How, though, does the industry get away with such low taxes on performance
fees? After all, the normal tax rate for people above a certain income in the UK
is 41%. The answer is that this bonanza is the unintended consequence of
three changes in the tax code over the past two decades plus a special deal
cleverly negotiated by the industry four years ago. With buyout funds getting
bigger, the lost tax revenue looks set to shoot up.

The origins of the tax break date back to 1987 when the government, in an
effort to encourage more venture capital funding for small companies, agreed to
allow performance fees to be taxed as capital, rather than income. In those
days, capital gains tax was 40%. So the treatment afforded private equity only a
modest advantage, allowing investors to net any gains off against prior year
losses.

But in 1998, this innocuous-looking loophole became much more attractive,

thanks to the introduction of "taper relief" on capital gains. Hoping to boost
entrepreneurship, the government slashed capital gains tax for people owning
shares in their own companies or in unlisted businesses from 40% to just 10% -
providing they had owned the asset for 10 years.

The real bonanza, though, started in 2002, when the government changed the
rules again. People only needed to own shares for two years to qualify for 10%
tax. With the help of some creative accountancy - including wheezes such as
artificially inflating the base cost of the original investment to account for the
"sweat equity" or hard work provided by the working partners - it wasn't long
before the industry had got the effective tax rate on their performance fees to
somewhere between 5% and 10%.

- 14 -
 breakingviews.com

How the maths works

To understand how the industry gets away with this treatment, it is necessary to
look at how a typical private equity fund is structured. Normally it is an 80:20
partnership between investors (limited partners) and the buyout group (general
partner). Both sides supply a tiny slither of equity - perhaps 0.01% of the total
funds, according to a British Venture Capital Association document. The bulk of
the fund's capital is supplied by investors in the form of loans. (Note that these
loans are quite separate from the leverage that buyout groups load onto the
companies they buy).

At the end of the fund's life, the profits, after repayment of the loans, are split
80:20 between the investors and the buyout group. The 20% that the buyout
fund receives is its performance fee or "carry". But because it is technically a
return on an investment of equity, it is taxed as if it was a capital gain.

To see just how big a bonanza this is, consider the impact on a £10bn mega-
fund of the sort now being raised by industry. The actual partnership equity
could be as little as £1m. The buyout group itself would put up only £200,000.
The rest of the £9.999bn would be supplied by investors in the form of loans.

Finally assume the fund closes after six years, having achieved its target 20%
annualised return. The initial £10bn would be worth £30bn. The partnership first
has to pay back the loan. Say the interest rate was 8%, that would come to
£16bn. That leaves a £14bn pot - of which the working partners get 20% or
£2.8bn.

Now, if that performance fee had been taxed as income, the government would
receive a cheque for £1.1bn. But taxed as a capital gain, the effective tax rate
might be as low as 7.5% - or just £210m. In other words, the Treasury loses out
£900m.

Special deal

In 2003, this gravy train nearly ground to a halt. The new taper relief rules had
proved a bonanza not just for private equity but for any company with highly-
paid employees. Suddenly, everyone was setting up elaborate "share-based"
pay schemes designed to disguise income as capital gains. So the government
introduced new rules requiring employees to declare shares received as part of
their pay package as income.

On the face of it, these rules seemed to apply to private equity performance
fees too. Indeed, many accountants and lawyers warned their clients that this
was likely to be the case. Yet remarkably, the BVCA negotiated a special deal
with the government, exempting private equity from the new rules and
preserving its 1987 loophole. Perhaps understandably, the BVCA has not
published the Memorandum of Understanding that spells out this deal on the
public areas of its website.

Having sold the pass, the UK tax authorities seem to have been regretting this
deal. They have been continually looking for ways to wriggle out of it. And so

- 15 -
 breakingviews.com

they should. Sure, changing the rules would not be easy. It might involve
primary legislation since the industry could challenge any move to tear up of the
current deal via the courts.

But the government should push ahead for two reasons. First, it should never
have agreed the 2003 Memorandum of Understanding. The working partners'
equity in a buyout fund is not risk capital in any common understanding of the
word. Hedge fund performance fees, in contrast, are treated as employment
income and taxed at the full 41%.

Second, this loophole is costing the Treasury a fortune. Official figures show
that taper relief will cost the government £4.5bn this year, up from £550m in
1998. A good deal of this is likely to be going to the private equity industry,
according to someone familiar with the situation.

No one is going to complain if buyout groups put their own money into the fund
on the same terms as the limited partners, or co-invest with the fund on
individual deals. In those cases, any gains should be treated as capital. But
carried interest is a different matter.

Of course, the private equity rejects any suggestion its tax treatment should
change, raising the familiar cry that it would trigger an exodus of people and
capital from the UK. But this is nonsense. The tax affairs of individual buyout
group employees have no bearing on the economics of private equity deals in
the UK, any more than they do on deals in France or Germany.

True, a few private equity employees may be tempted to leave the UK. For
them, Ireland, Luxembourg and Jersey await. But London would still remain the
European centre for sourcing, arranging, financing and advising on private
equity deals. Indeed, it cannot be said often enough that London's status as the
world's leading financial centre does not and should not depend on it being a
tax haven for the international super-rich.

Published 5 March 2007

- 16 -
 breakingviews.com

Private to public

By Nicole Lee and Hugo Dixon

The private equity industry has long avoided public scrutiny. But a new
consensus is emerging among the industry's top brass. Blackstone's Stephen
Schwarzman, Carlyle's David Rubenstein, and Permira's Damon Buffini all
agree that the buyout business has to embrace openness.

But what exactly should LBO houses to disclose - and why? The starting point
is to realise that there are several constituencies that have a legitimate interest
in the industry's activities: investors; employees in the companies they buy; and
the general public.

The latter was not a constituency that mattered much in the past because
private equity was mostly involved in smallish companies. But now it is involved
in bigger companies and so many more deals, it has impinged on the public
consciousness. This has stirred up debates about public policy, including
whether LBOs houses strip assets and don't pay enough taxes. It is to address
these public interest questions that private equity has to become less private.
This is not a matter of ethics but rather one of enlightened self-interest.

There are three practical things the LBO houses should do. First, they should
disclose industrial plans for the companies they buy. With small companies,
they only need to communicate with their workforces and investors. But with big
companies like TXU or, potentially, the UK's J. Sainsbury, disclosure means
public disclosure.

Second, they should reveal more about how they finance their companies.
Employees have a legitimate concern that excess debt could undermine job
security. It makes sense to allay that concern. Again, there has to be a
differential approach between small and big companies - with public disclosure
only needed for the big ones.

Finally, the industry should reveal more about how they achieve their returns.
One could say this is a matter just for private equity houses and their investors.
But, again, as the industry gets so big, it has a public dimension. Outsiders
worry whether the returns are really the result of smart decisions and hard work
- or the product of rising markets, leverage and tax optimisation. It won't come
naturally to many in the industry to share this information. But, if they are
making good returns as a result of hard work, they have something to be proud
of. If not, hiding in the shadows won't help.

Published 1 March 2007

- 17 -
 breakingviews.com

Missing the point

By Simon Nixon

Context News: Trade unions from across the developed world are gathering in
Paris today for a conference to discuss the private equity and hedge fund
industries. The unions want G8 leaders to take "rapid international action" to
tackle the rise of debt-financed investment, Brendan Barber, general secretary
of Britain's Trades Union Congress, wrote in the Financial Times.

Considered view: Private equity/Unions: Trade unions are invariably wrong in

matters of economics. And they are wrong now about private equity. Unions
from across the developed world are gathering today in Paris to vent their
spleen against the buyout industry, citing the usual charges: asset stripping,
excessive borrowing and failing to pay enough tax. They want "rapid
international action" against the industry. But as usual, the unions miss the
point.

That's because they are asking themselves the wrong question. There is
nothing very mysterious about the rise of private equity. A host of studies show
that the best buyout groups deliver consistently impressive returns - and do so
not just by piling on debt but by growing earnings. SVG, a UK company that
invests in Permira's private equity funds, has outperformed the UK stock market
by 10% a year over the last 11 years. And it reckons that only 20% of its returns
are due to leverage.

The unions would do better to ask what has gone wrong with public companies.
Why do they tend to under-perform compared to private ones? The fault lies
with public market shareholders. Their historic failure to exercise effective
ownership has left boards free to run companies in the interests of management
and employees. As a result, many companies became inefficient, bureaucratic
and resistant to innovation and change.

It's not at all clear why unions care so much who provides the capital, or
whether companies pay dividends or interest. In fact, the biggest private equity
investors are the same pension funds that pay the retirement incomes of
millions of trade union members. But if unions really want to keep companies in
public ownership, they should focus on finding ways to improve public company
performance.

In fact, the answer may be staring them in the face. In the US and Britain, a new
breed of activist investor is forcing public companies to shape up. US investor
Nelson Peltz this week persuaded Cadbury Schweppes to split itself in two;
London-based Hanover Investors recently replaced half the board at UK media
group SMG. By rights, trade unions should applaud these moves. But alas,
many prominent activists are hedge funds. And attacking hedge funds is the
other item on the agenda in Paris.

Published 16 March 2007

- 18 -
 breakingviews.com

Angels or Demons?

By Hugo Dixon, Editor-in-Chief, breakingviews.com

Are private equity houses demons or angels? Reading breakingviews.com over

recent months, you could have come away with both points of view. Two of our
most senior columnists, Edward Chancellor and Simon Nixon, have respectively
argued the “Case Against Private Equity” and the “Case For Private Equity”.

Such vigorous internal debate is healthy. It helps define the public debate on
the topic. But these opposing views are personal views. The following is an
attempt to summarise our overall house view on the matter. This is more
nuanced: private equity has strengths but also weaknesses. Mind you, so does
public equity. There are really no demons nor angels here – just ordinary
human institutions that can and should be improved.

More specifically:

• Private equity can, and often does add value to companies. That’s what
Texas Pacific did with Continental Airlines and Apax and Permira have
done with New Look, the UK retailer. Private equity can add value, partly
because the owners are not fragmented, as they are in public
companies, and the managers are highly incentivised to perform.
Equally, LBO houses sometimes do well because they buy Cinderella
assets from big public companies that can’t focus on them. That’s what
seems to be happening with Dunkin Brands, which was bought from
Allied Domecq by a group led by Bain Capital.

• But most of the huge profits that private equity houses have made in
recent years have been the result of the liquidity boom. Leverage
multiples have been rising. This has often allowed them to sell out at
higher multiples than they buy. And, because their investments are
leveraged, the returns on their equity can sometimes be staggering.

• Private equity has also benefited from exploiting the tax deductibility of
interest payments with great effect. It is wrong to describe this as a tax
break for private equity as it is something which applies to all companies.
That said, it is undeniable that private equity has exploited this more
effectively than public equity. This distortion to the tax system should be
remedied. Interest payments should no longer be tax deductible but there
should be compensating cuts in company taxes so that the overall
burden on industry is unchanged.

• Private equity principals have also benefited from another tax quirk
which, on both sides of the Atlantic, allows performance fees to be
treated as capital gains rather than income. The benefit is more extreme
in the UK than the US. But, in both countries, the tax treatment should be
changed. It is not obvious that giving tax breaks to people
who are already extremely rich fulfils any particularly useful public policy
purpose.

- 19 -
 breakingviews.com

• The incentive structure of private equity houses is skewed. The typical

reward system gives the LBO houses an annual management fee of
1.5%-2% a year and 20% of the profits above certain hurdles. This is a
type of “heads-I-win tails-you-lose” structure. The private equity bosses
get a big slice of any gains but don’t share in any losses. This is
encouraging private equity houses to raise bigger and bigger funds - the
latest crop are about $20bn in size - and invest them rapidly, even if that
means taking bigger risks. While markets are booming and liquidity is
sloshing around, end-investors may not worry too much about the
downside scenario. But when the markets turn, there could be some
nasty accidents. The private equity bosses themselves, though, will still
be sitting pretty.

• Public companies often suffer from a principal-agent problem: the owners

are so fragmented that they do not hold the managers properly to
account. The link between owners and managers is the board of
directors. But often boards are not properly informed, professional or
incentivised – and sometimes they are not adequately independent from
management. Corporate governance on both sides of the Atlantic can
therefore be weak.

• But the weaknesses of corporate governance don’t mean that the public
company model is dead. Corporate governance can, and in some cases
is being improved – as recent moves by US companies to institute
majority votes for directors and non-binding votes on executive
compensation suggest. The biggest needs are: stronger, more
independent boards; and incentive structures that align managers’
compensation to the achievement of good shareholder returns and don’t
give fat rewards for failure.

• The public company model can also improve as a result of more

engaged shareholders. The growth of shareholder activism,
spearheaded by the hedge funds - like Atticus when it hounded Phelps
Dodge or TCI with its prodding of ABN Amro - is largely a welcome
development. The activists are helping to remedy the principal-agent
problem.

• Public equity has one big advantage compared to private equity: liquidity.
At a time of rising markets, investors may not rate that so highly. But, in a
downturn – when liquidity in general could drain away – the ability to sell
shares will seem a lot more valuable than it does now. Being locked up
for years in a private equity fund could be the source of massive
frustration.

In summary, there is room in modern capital markets for both public companies
and private companies. Even private equity houses acknowledge that the public
markets are a useful exit route. And Blackstone has embarked on its own IPO.

Published 8 May 2007

- 20 -
 breakingviews.com

About us
Breakingviews is the leading international source of online financial
commentary. We deliver real-time views on companies, markets and trends,
giving clients clear insight into what’s happening in business and finance. From
punchy opinion on company events to analysis of big deals, our award-winning
journalists consistently set the agenda.

Founded in 2000, breakingviews is now read daily by the world's leading

investment banks, institutional investors, hedge fund managers, corporations,
law firms, public relations advisors and media outlets. A selection of
breakingviews commentary also appears in major US and European media,
reaching nearly four million readers.

Key features

Daily email alerts

Each day readers receive an email edition with links to the day’s top stories.
New views are published throughout the day – and users can request instant
notification on the stories of their choice with just one click.

Archive search
No-one likes searching for needles in haystacks. Our comprehensive online
search engine makes it easy to get a briefing on companies and markets
without sifting through junk.

Interactive calculators
From sizing up a leveraged buyout to valuing a dividend flow, our sophisticated
online calculators crunch the numbers so readers don’t have to.

Weekly PDF round-up

Each Friday readers can receive ready-to-print PDFs containing the week’s top
stories, delivered electronically. Topics include Money & Markets, Stocks &
Funds and Bids & Buyouts.

Blackberry support
Both the site and daily email alerts are Blackberry compatible, so readers can
be first with the views even when they’re away from the office.

If you would like more information on breakingviews.com you can contact:

(UK) Paul Pratt, Head of Sales on + 44 (0) 207 496 1873 or at

Paul.Pratt@breakingviews.com

(US) Ken Byrne, Executive Vice President on + (1) 646 467 5548 or at
Ken.Byrne@breakingviews.com

- 21 -