Jeremy Warner's Outlook: Private equity is a British success. It wouldn't pay for the FSA to regulate it out of existence

Executive pay: it just keeps on rising
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The Independent Online

The Financial Services Authority sounds a timely reminder about the dangers inherent in the present explosive growth in private equity with its drearily named discussion document, "Private Equity: a discussion of risk and regulatory engagement". Its warning that "the default of a large private equity-backed company, or a cluster of smaller private equity-backed companies, seems inevitable" follows hard on the heels of news that the American private-equity house KKR came within a whisker of launching a €40bn buyout of Vivendi, the French media giant. Though that bid failed, no company, it seems, is too large a prey for private equity to be able to swallow whole.

Yet other than declaring that it is on the case, the FSA doesn't seem to know quite what to do about it. This may be a good thing, for private-equity houses are already more highly regulated in the UK than they are in the US, or even some other parts of Europe. The dangers of regulatory overkill for an industry which has been one of London's key strengths as a financial centre are all too apparent. Reassuringly, the FSA has no intention of upsetting the apple cart. Only in extreme circumstances, it thinks, does private equity pose systemic risks to the markets as a whole. For a big private-equity deal to go wrong may be a positive boon, as it would provide a moral hazard for the rest of the market.

Yet private equity is plainly something a financial regulator has to be interested in to some degree. Along with the related growth in hedge funds and credit-derivative markets, the explosion in private-equity transactions is one of the seismic changes to have occurred in capital markets over the past 20 years. Unlike more traditional areas of the financial markets, it is comparatively unregulated, and therefore alive with potential for abuse.

Still, there's no stopping it now, even if the FSA wanted to. More and more money is pouring into private equity by the day. As the size of the deals grow, so does the degree of leverage. In order to generate promised high rates of return for their investors, private-equity houses must apply ever-more heroic levels of debt.

As the discussion document points out, some of this leveraging up of British industry is indeed quite worrying. The greater the leverage, the higher the risk of default. In some cases, the coupon on the debt ratchets up with the passage of time to take account of the presumed abilities of the private equity managers to extract ever higher levels of profit from the asset. That sounds to me like an accident waiting to happen if ever there was one.

The present craze for private equity relies crucially on the fact that the cost of borrowing is a great deal lower than the profits that can be generated from equity. With the world still awash with liquidity, it makes sense to borrow cheaply in debt markets to buy high-yielding equity.

What happens when this happy coincidence of circumstances changes is an interesting question. In some cases, banks will fail to syndicate the loans they have extended to finance private equity transactions, and will be left with the bad debt exposure.

Where the debt has been securitised, it is often impossible to know where the risk of default lies. Bankers have become masters of slicing and dicing up debt, packaging different types of debt together, and then selling them on as collateralised debt obligations (CDOs).

The world used to be so much more simple. Bankers lent and corporations borrowed. Bankers made their money on the interest they earned from lending their deposits. Today's markets are infinitely more complex and obfuscated. Bankers make a great deal more money out of the fees they earn facilitating such transactions than they do out of conventional lending.

Is it all just a giant ponzi scheme waiting to collapse? The FSA doesn't think it is. This is probably correct, though all credit that goes wrong ultimately comes bouncing back on the banks, however much they try to securitise their way out of the liability. After all, some of the biggest buyers of CDOs are hedge funds, most of which borrow heavily from the banks. Yet the FSA is also right to think that, beyond setting up a new task force to monitor the private-equity market, it shouldn't interfere unduly. It would be a pointless exercise in any case. One way or another, the markets always manage to remain at least one step ahead of the regulators.

Executive pay: it just keeps on rising

The gap in pay between the workforce as a whole and those at the top continues to widen at an alarming rate. According to the latest survey by Incomes Data Services, the gap has more than doubled since 2000, with FTSE 100 chief executives now earning nearly 100 times the average for all UK full-time employees. If anything, these figures probably understate the true magnitude of the wealth gap, for they ignore the largely undisclosed pay of top earners in the City and private equity, where the scale of reward tends to be more extreme still.

Yet this is not simply a case of the rich getting richer and the poor getting poorer. Average earnings, too, have been rising steeply, having increased nearly 30 per cent for a full-time worker over the past six years. Only the very poorest elements of society have wholly failed to share in Britain's new-found prosperity. Yet the winner-takes-all mentality is still very much in the ascendancy.

Even in publicly quoted companies, greater transparency, improved remuneration practice, and new legislation to give shareholders a greater say in boardroom pay, has failed to dent the ever onwards and upwards march in the rewards of top earners. FTSE 100 chiefs have doubled their pay over the past six years. The phenomenon tends to be justified by the need to compete for top talent, both internationally in a fast globalising economy, and increasingly with private equity, where high levels of remuneration are not such an issue.

Yet though unions have jumped on the latest data as unjustified corporate greed, the level of debate about executive pay is less intense today than it has been in the past. In part, this is because boards have improved their remuneration processes. Executive pay still has a tendency to go up regardless of performance, the pattern being that, when a company fails, the new broom demands an even bigger package than his predecessor to take on the challenge of the required turnaround.

Yet the instances of obvious abuse, such as the payment for failure at J Sainsbury of Sir Peter Davis, seem to be fewer. There has also been a wider cultural acceptance of the notion that top talent is always going to demand top pay. Excessive levels of remuneration have never been an issue amongst top performers in the entertainment world - sports, movie and pop stars.

Nor is it common to challenge the rewards made by entrepreneurs. They are all thought in some way to have earned their riches. Maybe just a little of that is beginning to creep into attitudes towards the "fat cats" of industry too. Or perhaps it is just that they have bored everyone into submission. Like global warming and the common cold, ever higher executive pay is just a fact of life on which the world is impotent to act.

Even so, there must be limits on the tolerance of the workforce towards an ever-widening pay gap. Fast back to the 1960s and top executive pay was less than ten times that of the workforce as a whole. The silly money now being paid at the top of the pile creates a distance from ordinary employees which makes it ever harder for the senior executive to exercise decent standards of leadership by example.

For the time being, however, there's no reason to suppose the process is about to go into reverse. The competition for talent, at all levels of society, ensures that pay differentials will continue to widen. For unskilled or low-skilled workers, the outlook is bleak. Never mind eastern European immigration, the unskilled must increasingly compete with the newly included two billion of China and India for their work. At the top, the pressure is for ever greater levels of pay. At the bottom, it is for the time being relentlessly downwards.