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The Sins Of PE Funds
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Amongst the greatest beneficiaries of the boom that has just passed in the West were private equity funds and their managers; amongst the worst victims of the bust that has followed will be their clients. Neither has figured amongst the characters that have emerged on the stage of distress and baleouts till now; most of those have been banks and real estate financiers. But as the pain spreads, PE funds will also come into the limelight. And when industrial countries come to write new regulations, they will need to write some for PE funds as well.
A major problem at that stage will be how to define a private equity fund. The name itself denotes the fact that the funds did not raise funds by going to the market. They courted rich corporates and high-net-worth individuals, and essentially acted as investment managers for a select group of investors. It should be legal for a set of like-minded people to get together and coordinate their investments. If it is their own money they are putting at risk, it would be wrong to introduce bureaucratic requirements of registration and reporting on them.
But the art of PE funds lay precisely in the fact that they were not private investors’ clubs investing their money; they were generally extremely dependent on borrowed money. Worse, it was not PE funds that borrowed money. They targeted companies with low debt and high profits and hence with high borrowing capacity, borrowed money in the name of those companies, and then used the money to buy off outside shareholders in those companies. This artifice was lucrative because profits are taxed in the hands of the companies whereas the interest they pay is not; in other words, the after-tax cost of borrowed funds to PE funds was lower than of funds from their equity investors.
So the first thing to do does not refer to PE funds, but to taxation: taxation of profits and interest must be made more equitable. One way would be to tax both in the hands of the paying company at the same rate; then where appropriate, the creditor can claim a refund of the tax or write it off against the tax he has to pay on his income. But there is also another way, namely to tax neither. Profits have been taxed for a long time; the original justification was that they went to the rich. But today, a large proportion of them go to old people, widows and orphans; the equity argument for taxing them is no longer relevant. If they go to a rich man, they should be taxed as part of his total income; but there is no reason to tax profits as such.
However, taxes on business profits form such a large proportion of governments’ revenue that abandoning their taxation is not practicable. If they are not taxed, something else must be taxed to replace the revenue. But there is a case for expanding the revenue base — from profits to value added. Many countries already impose a value-added tax. It is a tax on wages and profits together; it can be increased as the tax on profits alone is abolished. There would eventually be two principal taxes. One would be on value added by businesses. The other would be on total income of individuals.
If this new scheme of taxation is adopted, a major incentive for the setting up of PE funds will be removed; they will no longer be an instrument for tax avoidance. But it would still be possible to use debt to buy equity; PE funds would still be used to wrest control of companies with borrowed money. In theory, this should be all right; if someone thinks that he can manage a company better than the incumbent management, he should be able to contest its ownership and change the management.
But one major charge against PE funds has been that they have not offered better management, but simply taken a shorter-term view. They have got control of companies with valuable assets, sold them off, and left shells behind or closed down the companies. And since the value of real estate normally rises faster than corporate income, property-rich companies will continue to be targets of PE sharks.
However, property too should be subject to competition amongst bidders who may have ideas about how to put it to better or more profitable use; PE funds cannot be faulted simply because they participate in this competition for value addition. Profitable uses of property may be undesirable; for instance, they may lead to overdevelopment and congestion.
But the remedy for that is not to regulate investors, but to regulate the use of land — to control density and to legislate minimum allocation of land for desirable uses such as transport networks and green belts.
(Businessworld Issue Dated 21-27 April 2009)