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The Bottom Line

Evan Davis gets to the heart of the big finance stories at The Bottom Line.

"It was the best of times, it was the worst of times, it was the age of wisdom, it was the age of foolishness, it was the epoch of belief, it was the epoch of incredulity, it was the season of Light, it was the season of Darkness, it was the spring of hope, it was the winter of despair, we had everything before us, we had nothing before us, we were all going direct to heaven, we were all going direct the other way."

The most well-known passage of Charles Dickens’s novel, A Tale of Two Cities, seems an appropriate starting point to discuss private equity, one of the topics of the latest BBC/Open University The Bottom Line broadcast. Belief and incredulity appear to characterise our present epoch of financial booms and crashes, during which private equity firms are painted as the pantomime villain in capitalism’s triumph and fall: asset strippers in name and deed.

The relationship of Dickens’s tale of London and Paris, at the time of the French Revolution, to the financial centre of the City of London seems metaphorical and real. Joseph Addison had described London as an “Emporium for the whole earth” a century earlier, and in the emporium that is the global financial entrepôt of today, private equity firms are as much a part of its landscape as the trader of the 17th century. In the late 20th century, the leitmotif of the City of the furled umbrella and the bowler hat gave way to the yuppie and the mobile phone; the gentleman giving way to the player. For some commentators, these changes represented a revolution whose genesis rested on private equity firms and their ilk.

Businessmen shaking hands.
photo © copyright Jupiterimages Corporation

Private equity firms operate on the basis of buying and selling a portfolio of companies to extract returns of 20 per cent on their investment over a three-to-seven-year period. They institute cost cutting and disposal of parts of companies in order to sweat the assets they have invested in. For defenders of private equity firms, they create long-term value. For critics, they are the manifestation of the UK-based asset strippers of the 1970s; Jim Slater, John Bentley and ‘Tiny’ Rowland amongst others, whose activities were called the “unpleasant and unacceptable face of capitalism” by the then Prime Minister, Edward Heath. The language of private equity activities are, in this view: a climate of fear; downsizing; the casualisation of work and so on. This litany is universal to these firms, whether expressed in the English or any other linguistic form. For the famous economist Joseph Schumpeter, entrepreneurship represents the revolutionising of the economic structure which enables new activities to be born, phoenix-like, from the ashes through the process of “creative destruction”.

It is the important question of language that formed the second topic of The Bottom Line discussion. English is claimed to be the universal language of business, with its own cross–national dialects, so that knowledge of other languages is deemed not to be as important as it once was. But language is like football, the rules of the game may be pretty much the same but the variants are as numerous as the array of cities in the world. It is a linguistic truism to say that language affects the way in which one thinks. Knowledge of local customs may be useful upon introduction to a client, but knowledge of the rudiments of the local language is an important part of business engagement and sustainability. For example, in China, saying yes to a question does not signal agreement but rather that the speaker has been heard. These are important considerations for companies that engage in international transactions. It can be argued that globalisation will only be completed if the law of one price operates. That is, all prices in the world converge with the only differences being accounted for by transport and administration costs. Similarly, if English became the first language of everyone in the world it would become truly global.

Capitalism, as Schumpeter and others remind us, is a revolutionary system in which “all that is solid melts into air, all that is holy is profaned…” Private equity is part of that system and provides a vehicle for “revolutionising the conditions of production.” A single global language would be part of that revolution, and if that is not generally understood then change does need to be made. Blaming private equity firms and hedge funds for the financial crisis is a bit like Canute blaming the Moon for his failure to control the tides. There are compensations with more than two cities and more than one language in the world which makes us all richer, whether materially or culturally. The globalists, in whatever guise, make us all poorer as heterogeneity is sacrificed for homogeneity.

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About the author

Leslie Budd is Reader in social enterprise at The Open University Business School. He is an economist and has written extensively on the relationship between regional and urban economics, and international financial markets.

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Money Programme

Get the facts behind the big business and finance stories from around the world – and down your street, in The Money Programme.

'The AA; Rescue or Wrong Turn?' highlights the advantages of private equity to at least some stakeholders. Whilst the private equity takeover of the AA has not been a good experience for all employees, or even customers, private equity investors have already got their investment capital back, and are looking forward to billions of pounds of profit when they sell the AA on. How did they do it?

Firstly, by taking advantage of the glut of money around the world. Banks are falling over themselves to lend money, at ultra-low interest rates and with no strings attached. And the private equity firms do not even need to have a good credit rating. They secure the debt they borrow on the assets of the companies they buy. With pre-determined debt interest costs, any increase in profits from reducing staff numbers, for example, goes straight to the private equity investors.

But there is another reason why private equity is a ‘no brainer’. Debt interest payments, and not equity dividends, are tax deductible for corporation tax purposes. All private equity investors have to do is to buy a company, load it with debt, and benefit from reduced tax bills. The stakeholders who pay for this are a country’s taxpayers. Lower corporation tax receipts usually mean higher taxes elsewhere. This has had such a major impact that some countries have changed their tax laws.

For example, the private equity purchase of the main Danish telecoms operator, TDC, in early 2006 for 13bn euros (with a special dividend of nearly half that paid to private equity investors less than six months later) was 90% debt funded. It is estimated that this private equity financing alone has reduced Danish corporation tax revenues by more than 12%, and the recent private equity takeover of Danish cleaning company, ISS, will have made matters even worse for the Danish government – and for Danish taxpayers. The Danes are currently conducting a review of the tax deductibility of debt payments. And the German government is reforming its corporation tax rules, also with a view to limiting the tax deductibility of debt. However, Ed Balls, Economic Secretary to the UK Treasury, said recently that the government had no plans to review the tax deductibility of debt principle as far as UK-based firms were concerned.

This tax game is nothing new. Leveraged buyouts in the 1980s aimed to exploit exactly the same tax relief. That boom ended when interest rates went sky high, and a recession meant interest payments had no profits against which to be offset. If interest rates go up this time, or if there is a recession, we will experience a sense of déjà vu. But the secretive nature of private equity companies will make it much harder to find out exactly who is bearing the pain this time around.

Further reading

•  
• The AA: rescue or wrong turn? - are private equity investors saving or savaging The AA? The Money Programme investigates.
• The private equity rollercoaster - 2005 was a record year for UK private equity deals, but many in the industry see dark clouds on the horizon.
• Corporate accountability and ethics - a disregard for ethics can lead to trouble: remember the Enron saga.
• Tax shelters - nobody likes paying tax, but how far would you go to avoid it? Liberia? Monaco?
• Is tax avoidance only for the rich? - can everyone pay less tax? Or is it a rich man's game?

About the author

Janette Rutterford is Professor of Financial Management at the OU Business School, having previously worked in corporate finance and investment. Jannette's research includes pension funds, equity valuation and investment history, in particular the history of women and wealth.

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