Jeremy Warner's Outlook: Private equity's tax perks come under attack

House prices
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The Independent Online

Along with hedge funds, private equity has been the big investment phenomenon of the past 10 years. The stock market may have sunk deep into the mire, but through thick and thin the private equity boys, from Philip Green to Apax, have been coining it. Goodness me, you might have remarked when some young man from outside the neighbourhood bought the poshest house in the district. Where on earth did he get the money? Oh, he's something in private equity, would as likely as not be the whispered reply. Now along comes the Inland Revenue to spoil the party.

Private equity would like you to believe the fabulous returns made by its more successful players are all down to brilliant management and clever bargain hunting among the discarded flotsam and jetsam of corporate Britain. But a large part of it is simply financial engineering. Typically, a private equity transaction will work like this: Company X is bought for, say £100m, using £10m of equity with the rest borrowed from banks and related parties.

The company is then refinanced, securing the debt taken on for the purchase against the company's assets. If all goes according to plan, the debt is eventually paid off from the cash flow of the business. The underlying assets then revert to the equity holders. With luck, their £10m could be worth the original £100m purchase price.

Enter the Inland Revenue. Company X was reasonably profitable before it was taken over by private equity, and it would have paid tax on the profits it made. Once loaded up with debt, however, the profits all but disappear in servicing the interest costs of the debt, which are tax deductible. So the Revenue loses out.

Nor in many cases is the corporation tax loss made up for by the tax that would be paid by the banks and others earning the interest, for the deal may have been structured in a way that places the loans offshore. Alternatively, they may not have been on a fully arms-length basis at all, but instead be just a way of allowing the private equity investors to milk the tax-free cash flow of the company. Clever or what? Well, not particularly, but certainly extremely effective.

Dawn Primarolo, the Paymaster General, yesterday called it "tax avoidance". For private equity, it is just the way things have always been done. Nor is the technique confined to private equity. Publicly quoted companies that gear themselves up so as to engage in share buy-backs and special dividends are in essence doing much the same thing. One of the reasons why debt is sometimes referred to as a more efficient form of capital than equity is that its servicing costs are paid before tax, not afterwards, as with equity.

Of course, the Government doesn't propose to remove the tax-deductible attributes of debt interest payments altogether. That would indeed be a blow, not just to private equity, but to the entire corporate landscape. But it does want to deal with what it considers to be artificial debt structures designed to avoid tax.

So will Ms Primarolo's "initiative" kill off the private equity industry in Britain? One participant said yesterday that Britain was moving from having one of the most conducive and benign tax regimes for private equity to one of the harshest. In fact, Britain is only doing what several other European countries, Japan and the US have already done. The removal of the tax relief on debt in private equity transactions makes the alchemy of debt leverage less effective than it was, but it doesn't remove it altogether. What's more, private equity is filled with extraordinarily inventive people. One way or another, they'll find a different way of doing the same thing.

None the less, it's bound to make some sort of a difference. The amount of money in private equity has mushroomed in recent years. With ever more money chasing a quite limited pool of deals, returns have fallen sharply. Many private equity houses are already finding it hard to make the numbers add up. Yesterday's tax clampdown will make it tougher still. Trade buyers already have the advantage over private equity because of the synergies they can extract. This further tips the scales in their favour.

The very favourable tax treatment afforded to private equity has long been a bugbear for Gordon Brown and the Treasury. The debt relief is one thing, but private equity has also been one of the biggest beneficiaries of the reductions in capital gains tax rates the Chancellor has pushed through for privately owned businesses. Capital gains made through the stock market attract tax of 40 per cent; gains made on privately owned business assets carry only a 10 per cent tax rate.

The Chancellor might reasonably think he's only trying to even things up a bit for the benefit of those with more conventional capital structures. But he should be careful not unduly to harm private equity. Its top dogs make a lot of money, but they also create and save an awful lot of jobs, and by making companies more efficient, they add to rather than subtract from the general level of economic prosperity.

There was a palpable air of shock in the private equity industry yesterday. This is just the start, many were saying. There'll be more cannon blasts to come after the next election. The Chancellor must tread carefully, or he will throw the baby out with the bathwater. There's nothing wrong with making money, but private equity must be equally careful that it pays its fair share of tax. There's right on both sides here.

House prices

One of the more pleasing developments of the past six months is that house prices are no longer the hot topic of dinner party conversation. Indeed, to everyone's relief they seem entirely to have vanished, giving way to the more traditional fare of schools, holidays, crime, illness and who's sleeping with whom.

This is because the worry of constantly rising house prices, whether one might be missing out on them, and the fury of discovering that one's worst enemy from school has done so much better out of them than you have, has subsided with the market. Yesterday came further proof of the slowdown, with the Halifax survey showing a 0.5 per cent fall in February. With the year-on-year rate of house price inflation still in double digits, this hardly amounts to a crash, and there is some evidence that prices and transactions might now be picking up again after the recent hiatus.

However, it would probably be wise to discount estate agent reports that things are "really buzzing again". Given the outlook for disposable incomes, it's hard to foresee a return to rampant house price inflation any time soon. The bigger question is whether the Bank of England has indeed achieved the hoped for soft landing, or whether this is simply the calm before the storm.

In a recent speech on the housing market, Kate Barker, a member of the Bank of England's Monetary Policy Committee and the author of a government-commissioned report on housing supply, said she thought the likelihood of some decline in house prices, at least relative to earnings, now seems much greater than that of a further significant increase.

However, in the same speech, she said it was unclear whether house prices are at or above equilibrium, and if above, how far. This only confirms that the experts are no more capable of predicting what will happen to house prices than anyone else. Yet what Ms Barker can tell us is broadly what caused the recent bubble.

These she summarises as falls in short-term interest rates, which have reduced the front-end costs of buying a house, lower long-term real rates, which have caused house prices relative to rents to shift higher, constrained housing supply against a backdrop of a growing number of households, and finally increased investment demand. All these factors apart from one - constraints on supply - have now in all probability run their course.

To these I would add a more intangible cause, which is that as people grow more prosperous, bigger and better housing is one of the first things they aspire to. To know where house prices are heading, you first need to answer the question of how disposable incomes are going to pan out.