Lord Sikka
Main Page: Lord Sikka (Labour - Life peer)Private Equity: Economic and Social Risks
Lord Sikka Excerpts
Lord Sikka
That this House takes note of the economic and social risks created by the regulation and practices of private equity.
Lord Sikka (Lab)
I am grateful for an opportunity to exchange some thoughts about private equity, a subject that should really concern us all. In my view, it is likely to be the location of the next major financial crash, and there will not be enough money to bail out the affected entities. Private equity is enmeshed with numerous other parts of the economy. It gets its cash from insurance companies, pension funds, banks, local authorities, trusts and wealthy individuals. The Government’s quantitative easing of £895 billion has also provided vast amounts of resources to these firms.
Private equity consortiums function as banks but are not actually regulated as banks. There is no minimum capital requirement, no control on leverage and no stress tests, even though the collapse of a private equity firm can destabilise all other sectors. The recent collapse of the US-based Archegos Capital Management shows how quickly the domino effects spread. It very quickly depleted the capital buffers of Goldman Sachs, Morgan Stanley, UBS and Credit Suisse. My first question is: can the Minister publish the Government’s assessment of the possible domino effects which may arise from the collapse of a UK-based private equity firm?
In a light-touch environment, private equity has been cooking its books. Recently, the Financial Times reported that parts of the private equity market resemble Ponzi and pyramid schemes. Private equity firms are transferring assets between each other at knowingly inflated prices to bump up profits, balance sheets and returns. My second question is: can the Minister explain what estimate has been made of balance sheet and profit inflation by the UK-based private equity firms, and what are the Government going to do about it?
In 2021, 803 private equity buy-out deals, worth some £46.8 billion, were completed. This investment is welcome, but private equity also poses threats to jobs, pensions, the country’s tax base and the wider economy. On average, private equity retains its interest in a company for 5.9 years, sometimes a lot less. There is no long-term commitment to any place, product, workers or customers. We all know that short-termism has been holding this country back for years. Financial engineering, tax avoidance and opacity are key parts of the private equity business model. Short-term returns are extracted through related party transactions in the form of rental payments, management fees, royalties and much more.
Private equity eliminates the downside risk of bankruptcy by injecting finance not as equity but as secured debt. This means that, in the event of bankruptcy, private equity needs to be paid first. Inevitably, unsecured creditors recover little, if anything, of the amount due to them. I give some examples. Bernard Matthews, Bon Marché, Cath Kidston, Comet, Debenhams, Flybe, Maplin, Monarch Airlines, Payless Shoes, TM Lewin and Toys “R” Us are just some of the monuments to the predatory practices of private equity are just some of the monuments to the predatory practices of private equity. All too often, wages are pushed down, jobs lost and pension schemes looted to generate short-term returns for private equity.
In September 2013, private equity firm Rutland Partners acquired a £25 million stake in Bernard Matthews. The company was then loaded with bank borrowing and a secured loan from Rutland, which carried an interest rate of 20% per annum. Asset stripping began straightaway. In 2016, the assets of Bernard Matthews, but not the whole business, were sold off for £87.5 million to Boparan Private Office. Rutland made a quick profit of £13.9 million. The key was dumping the amount owed to unsecured creditors and the £75 million deficit on the employee pension scheme, which eventually resulted in 700 employees losing some of their pension rights. At the time, I was advising the House of Commons Work and Pensions Committee on the case and, on 3 March 2017, the committee wrote to Boparan to ask why it bought only the assets, not the entire business, including liabilities to unsecured creditors and the pension scheme. Boparan replied that it had offered to buy the whole company, including its liabilities, but the offer was rejected by Rutland because, by dumping liabilities and the pension scheme deficit, it stood to make a bigger profit.
The business model of private equity is all about asset stripping and dumping pension obligations. This pattern is visible across many private equity businesses. Silentnight appointed KPMG as administrator to enable its rescue but the firm did not actually do that. KPMG and its insolvency partner deliberately pushed Silentnight into insolvency, so that private equity firm HIG, a client coveted by KPMG, could buy the company out of administration at a lower price by dumping pension obligations to employees. About 1,200 workers lost some of their pension rights. That is a criminal act. The partner of KPMG lied—he has been found to have lied by the regulators—but the Insolvency Service has not mounted any criminal prosecution. Indeed, the Government have rewarded KPMG by giving it lots of public contracts.
Water companies have long been exploited by private equity. From 2006 to 2017, Thames Water was owned by a private equity consortium fronted by Macquarie Bank. During this period, Thames Water’s debt ballooned from £2.4 billion to £10 billion, mostly from tax haven affiliates, and interest payments paid to the group itself swelled the charges for customers. For the period of its ownership, private equity extracted £1.2 billion in dividends, plus £3.186 billion in interest payments. The company’s tax liability for the years from 2007 to 2016 totalled only £100,000, but we know that billions of litres of water leaked away and the company dumped raw sewage into the rivers. Meanwhile, the private equity investors got a return of between 15.5% and 19% a year.
In 2007, Alliance Boots was bought by a private equity firm, Kohlberg Kravis Roberts. The company’s control immediately shifted from Nottingham to Zug in Switzerland. The buyout was financed by the borrowing of £9 billion and loaded on to the company. This enabled the extraction of profits and profit shifting; and Alliance Boots engaged in a series of transactions through entities in Luxembourg, the Cayman Islands and Gibraltar to transfer profits. The net result was that Alliance Boots, which relied heavily on revenue from NHS prescriptions, dodged taxes in this country of £1.28 billion.
Asda has been bought by private equity firm TDR Capital, in conjunction with the billionaire Issa brothers. What was the company’s first step? To set up a parent company in Jersey. We know what will follow: a lot of financial engineering and tax avoidance.
Morrisons has been bought by Clayton, Dubilier and Rice’s offshore vehicle, Market21 GP Holdings, which is registered in the Caribbean. The supermarket is now controlled by a newly created entity in the Cayman Islands. We know the next step: asset stripping, profit shifting and tax avoidance.
The involvement of private equity in social care is a source of crisis. Private equity firms own one in eight care home beds in England. They typically load debts of around £35,072 for each care bed with an interest charge of £102 per bed per week. This roughly amounts to an average of 16% of the weekly cost of a bed, leaving little for staff and front-line services. Staff are poorly paid, which is one reason there is high turnover. They cannot provide the promised levels of service. Too many private equity-owned care homes, especially those owned by HC-One, are regularly sanctioned by the regulator for failing to meet the minimum standards.
At the time of its collapse in 2011, Southern Cross was owned by a private equity firm called Blackstone. Many of its care homes were sold to Four Seasons Health Care, another private equity-owned firm—this time, owned by a company based in Guernsey. In 2017, with 220 care homes and 17,000 residents, it became bankrupt because it had extracted high returns and did not provide the required level of service. Again, it made billions in profit.
In the time available, I have provided a glimpse into some of the predatory practices of private equity. The Bank for International Settlements has now warned that excessive leverage is a danger as private equity firms will struggle to meet the higher borrowing costs imposed by rising interest rates. The Government can of course stop the dangers of high leverage by abolishing the tax relief on interest payments. It is not a business cost. Why on earth is tax relief being given? Whether an investment is funded by equity or debt has absolutely no impact on the systemic or business risk of the project concerned. Therefore, there is no case whatever for allowing tax relief on interest payments by corporations. Tax relief on mortgage interest payments made by individuals was abolished long ago on the grounds that it encouraged excessive borrowing, distorted markets and created new risks. That is even more applicable to private equity entities, which can drag the whole economy down.
I remind noble Lords that the previous financial crash was caused not by people rushing to banks to withdraw their funds but by excessive leverage. Lehman Brothers and Bear Stearns had leverage ratios of 30:1 and 33:1. Private equity has even higher ratios yet we seem to be oblivious to that. There is nothing in the 330-page Financial Services and Markets Bill, published yesterday, to address any of the concerns I have raised. I hope we do not live to regret that. I beg to move.
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.
Lord Sikka (Lab)
I thank noble Lords for a very interesting debate. Although we had relatively few speakers, the quality of comments presented by all noble Lords was very high. I am especially grateful to the Minister, who has had a very long day today; I am sure she is looking forward to the end of it, so I will not hold her for too long.
It was said that private equity earns “superior” returns. As noble Lords who are familiar with efficient market hypotheses will know, if markets are efficient, there can be no such thing as a superior return; there may be a higher return, but that is something entirely different. Private equity has frequently secured this with low wages—as evidenced by Bernard Matthews, Debenhams, Maplin and care homes—and uses tax avoidance techniques ferociously and seems to get away with it. It is subsidised by the tax system. However, it was only in the early 20th century that the tax relief on interest payments began to be given; before that the courts had specifically refused that it was a cost. The change was due to lobbying by the finance industry, which obviously then makes money by asset stripping, examples of which I gave previously. On private equity, we all welcome the investment, jobs and business rescues, but the downside risks are too high.
As I have already referred to, the US regulators have recently expressed grave concerns about the operation of pyramid schemes and Ponzi schemes, but we have not heard anything from the UK regulators about what they are going to do. I believe that the SEC in the US is looking at it.
The Minister referred to transparency, but I do not see transparency in the accounts of private equity companies. One reason for this is that the entity at the apex is in a tax haven, and you cannot see the accounts or any details about them. The entities underneath do not provide full details of the corporate structures in which they are enmeshed. They will tell you what the immediate parent company is, but this is just one cog in a giant wheel. Therefore, it becomes very difficult to see any transparency.
The Minister also referred to the audit Bill. From what I have seen, I do not have any faith in it, but we will leave that for debate on another day.
I thank all noble Lords for staying behind and wish them a very happy and relaxing summer.