Private Equity: Economic and Social Risks

Baroness Penn Excerpts

Thursday 21st July 2022 Lords Chamber

[Baroness Penn (Con)]

My Lords, I congratulate the noble Lord, Lord Sikka, on securing this debate. Private equity is a salient issue for the UK economy, and it is important for us to recognise both the benefits that private equity investment can bring and the risks that can occur alongside it. I thank the other two noble Lords for their constructive contributions to the debate.

I will politely disagree with the noble Viscount, Lord Chandos, on his remarks about the Conservative Benches. I look to the Cross Benches and the Liberal Democrat Benches; even our Green representative is not here. I agree with the noble Lord, Lord Tunnicliffe, that attendance tonight probably has more to do with the timing of the debate than other events going on at this moment. However, I welcome the noble Viscount’s glass-half-full attitude to private equity investment.

The UK is proud to be home to businesses of all shapes and sizes, in every region of the country, and across a variety of sectors. Each of those companies will require different growth strategies for their business that reflect their individual strengths. Private equity plays a valuable role in providing companies with the capital to achieve that. It can also help to ensure that innovative companies are able to weather disruption and continue their long-term growth trajectory to reach their full potential.

Private equity can unlock funding for firms that would not be able to easily access public markets, a vital source of support for both early-stage businesses and businesses that are struggling temporarily, and can enable them to grow into thriving firms. In 2021, businesses backed by private equity and venture capital directly contributed £102 billion to the UK economy, representing 5% of UK GDP. As firms thrive, that benefits the British people both as consumers and as employees of these firms. On jobs, private equity-backed businesses employed 1.9 million workers last year, meaning that 6% of the total jobs in the UK are supported by private equity-backed businesses.

The Government recognise the risks that can come with this form of financing. Private equity has a responsibility to represent the long-term interests of the businesses in which they invest. When mismanagement of a business occurs, it is important that those in the business’s senior management can be held accountable. In order to ensure that this can happen, directors of UK companies owned by private equity firms are subject to the same duties and obligations as other directors. They must comply with the duty to promote the success of their company in Section 172 of the Companies Act. They must exercise reasonable care, skill, diligence and independent judgment, and they must comply with insolvency law. To ensure that any payments to shareholders are legal and sustainable, any dividends and other distributions to shareholders of these companies can be made only out of realised profits.

[Lord Tunnicliffe (Lab)]

The argument is that there are all these laws to protect everybody. Has any action been taken against any private equity firms for disobeying any of these laws?

[Baroness Penn (Con)]

I will have to check that point for the noble Lord and get back to him in writing. From memory, action has been taken but I would want to check whether it was specifically against private equity companies or private equity-backed companies, rather than more broadly. I will also acknowledge, later in my speech, that there are instances where the laws and regulations have not always worked well, and where there is more progress to be made, such as in our audit reforms.

In addition, many private equity firms have voluntarily taken action to improve their disclosures by signing up to Sir David Walker’s Guidelines for Disclosure and Transparency in Private Equity. Private equity-backed companies above a certain size that volunteer to sign up to these guidelines agree to disclose information comparable to that published by listed companies in the FTSE 250. These regulations and guidance aim to ensure that private equity firms’ involvement in UK companies is in the best interests of the company and its employees in the long term. To further support this, the Government have reviewed the legislation on limited partnerships and intend to introduce measures in this parliamentary Session that will increase the transparency of the ownership and activities of these structures.

Transparency is important, and it is vital that investors and all those who depend on the largest companies can rely on the information they publish. That is why the Government are taking further action in this area, which aims to protect the UK economy against risks to jobs, pensions and suppliers from unexpected company collapses. Under the Government’s recently announced audit and corporate governance reform plans, the definition of a public interest entity will be expanded to cover virtually all types of company with a turnover of more than £750 million and more than 750 employees. This means that large private equity-owned companies will be subject to enhanced disclosure obligations relating to resilience and other matters. They will also be subject to stronger audit rules and the new, strengthened regulator will have powers to sanction directors for breaches of duties relating to reporting and audit.

As a result of these audit and corporate governance reforms, private equity-backed firms will have to publish information about the risks they face and the steps they have taken to prevent fraud, and disclose their realised profits and losses which are the basis for dividend payments. The Government recognise that instances of asset stripping do occur, to the detriment of creditors, employees and wider stakeholders. That is why, in 2018, the Government committed to delivering new powers to better enable insolvency practitioners to reverse transactions that have unfairly extracted value from companies prior to formal insolvency proceedings. The Government’s reforms will enhance the transparency requirements for our largest companies as well as the tools our insolvency practitioners can access. This is designed to ensure that large UK firms will not be able to dish out dividends when they are on the brink of collapse.

To address the point made by the noble Viscount, Lord Chandos, about the creditor hierarchy for small traders, the hierarchy that currently exist in insolvency law—

[Lord Sikka (Lab)]

My Lords, the Minister has referred a number of times to distributable profits. A distributable profit can be calculated only if there is a notion of capital maintenance in financial reporting. There is no clear notion of financial reporting in international accounting standards. It is a mishmash of maintenance, money capital, real capital, physical capital—any number can be dreamed up.

In addition, we do not have a central enforcer of company law in this country at all. A number of companies have paid their dividends illegally. In yesteryears, I asked questions, and I persuaded some Members of this House and the other place to ask questions as well, about this. The Government were unable to name where the buck stops. Who exactly is responsible for enforcing the part of company law relating to distributable profits and payment of legal dividends?

[Baroness Penn (Con)]

The noble Lord is right that different aspects of our company law regulation and financial services regulation belong to different regulators. The point I was trying to make to noble Lords was that the extended and enhanced obligations that public companies currently face will be extended to those large companies in private ownership. That will enhance the transparency and regulation that they are subject to and, although it does not change those existing regulations, I hope that will none the less be welcomed.

I was talking about the creditor hierarchy, which has been well established for many years and is common among most international jurisdictions. Promoting the ranking of one group of creditors will mean that other creditors get less, and it would impact the positive environment that the UK economy creates for lending to business. With that in mind, any proposed change to the creditor hierarchy should only ever be considered with the utmost care.

I understand noble Lords’ concerns about recent high-profile cases where significant losses have occurred to creditors such as employees or small traders, including cases where the taxpayer has had to fund the continuation of vital services and where losses may have resulted from misconduct by the directors of those companies. I hope noble Lords will understand that it is not appropriate or helpful for me to refer publicly to individual cases, some of which may still be under investigation by various regulators or investigatory bodies, or where proceedings may be under way or in contemplation. However, I reassure noble Lords that the Government keep the insolvency and corporate governance frameworks under constant review. This includes learning lessons from such cases and, where necessary, the Government will take action to improve or strengthen those regulatory frameworks.

The noble Lords, Lord Sikka and Lord Tunnicliffe, both raised concerns about the evidence base for private equity’s impact on our economy, specifically in relation to risks to financial stability. I agree with them on the importance of evidence and note that the Financial Policy Committee is responsible for identifying, monitoring and taking action to address systemic risks to UK financial stability. The FPC achieves this, in part, via the identification and assessment of risks and stresses in its biannual Financial Stability Report, published most recently on 5 July.

Both noble Lords also mentioned the Financial Services and Markets Bill. The noble Lord, Lord Tunnicliffe, is right about its heft and, without going into detail, I am sure the Government will welcome noble Lords’ scrutiny of the Bill when it comes to this House. They will have the opportunity to table amendments in the usual way, but perhaps I can provide some words of reassurance to your Lordships on that Bill. It aims to make the UK one of the most competitive places in the world to do financial services business. However, I think the noble Lord talked about better regulation rather than deregulation; that is the spirit and aim with which the Bill is being taken forward, and the UK has a strong record in delivering that.

Both noble Lords also raised concerns about carried interest and the tax treatment of debt compared to equity. The Government believe that the UK’s approach to the taxation of carried interest, which is comparable to that of other jurisdictions, strikes an appropriate balance. The existing rules reflect both the nature of carried interest as a reward and the importance of maintaining the UK’s competitiveness for fund management.

As with other costs in relation to debt versus equity, debt interest is generally deductible as a business expense. Again, the UK is not an outlier in allowing groups to deduct interest in the calculation of taxable profits. Meanwhile, the UK has wide-ranging interest restriction rules that ensure highly leveraged groups deduct only a proportion of their worldwide third-party net interest expenses, equal to the UK’s share of the group’s worldwide profits. There are many reasons, other than the tax deductibility of interest, why companies may favour debt over equity financing. These include lower costs, easier access, greater flexibility and non-dilution of capital.

Noble Lords asked about takeover powers and what consideration the Government have given to enhanced takeover tests for large companies. As an open economy, overall we welcome foreign trade and investment where it supports UK growth and jobs and meets our stringent legal and regulatory requirements. The details of mergers and acquisitions are primarily a commercial matter for the parties concerned. However, the Government acknowledge that there are instances where such transactions might result in concerns for consumers and the economy more broadly. That is why there are established processes for considering whether there are specific public interest reasons for Ministers to intervene in mergers under the Enterprise Act 2002. These are limited to matters relating to financial stability, media plurality and public health emergencies.

The National Security and Investment Act 2021, which came into force in full in January 2022, introduced mandatory notification and clearance requirements for certain acquisitions in 17 sectors of the economy, including parts of the UK’s critical national infrastructure and advanced technology sectors. This brought further improved security to British businesses and people.

I am conscious of the time, but I have one more point to address. The noble Lords, Lord Sikka and Lord Tunnicliffe, mentioned the establishment of ARIA. Earlier this week, the Business Secretary appointed the new CEO and chair of ARIA. These appointments will now drive forward the final steps in setting up the agency, ensuring it is best placed to fulfil its objectives of enabling exceptional scientists and researchers to identify and fund transformational research that leads to new technologies, discoveries, products and services. As part of finalising the set-up, careful consideration will be given to the most effective funding mechanisms for the agency to have at its disposal.

I close by praising the support that private equity provides to UK businesses and agreeing with the noble Lord, Lord Sikka, that we must be conscious of the economic and social risks that can arise. I emphasise that the Government understand the consequences that can arise from malpractice in private equity. The ongoing reforms and regulation involving private equity-backed businesses, alongside the upcoming audit and insolvency reforms, are designed to address these issues. In doing so, we will work to ensure that the UK economy continues to be open, competitive and above all fair to those whose jobs and livelihoods depend on it.