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Last Updated: Wednesday, 20 June 2007, 17:02 GMT 18:02 UK
Q&A: Private equity debate
The private equity industry says it is a vital UK investor
Some of the leading lights in the UK's private equity industry have been questioned by a Treasury select committee.

It is investigating whether the sector - accused of using too much debt to finance deals and cutting jobs - needs tighter regulation and to pay more tax.

And the bosses faced a tough time in the chamber.

What is private equity?

Private equity refers to how investment companies raise the funds they use.

Instead of going to the stock market and selling shares, private equity companies raise cash from private sources usually borrowing money from banks, or pooling groups of smaller investors in private equity funds.

Private equity companies then often add their own funds, and use the money to buy companies that they have identified as underperforming, but with the potential to do far better.

Many of the firms they buy are listed on the stock exchange and are then withdrawn so that the private equity firm can try to turn the business around and sell it on at a future date.

As BBC Economics Editor Evan Davis puts it: "Private equity does for companies what some builders I know do with houses: they get a hefty mortgage to buy one, do it up as fast as possible and then re-sell it at a profit."

Why is this select committee hearing taking place?

Until recently, the phrase "private equity" meant very little to most people.

However, it is now a key talking point in the business world.

And while some consider it a force for good, others see it as embodying the worst aspects of capitalism.

Certainly it is an industry that has raised concerns - hence the appearance of bosses of private equity firms including Permira, 3i and KKR at the committee.

Did the private equity bosses take the hearing lightly?

Earlier Treasury select committees have given a tough time to those giving evidence, and so those taking part were well-prepared.

After the last hearing, the head of the British Venture Capital Association (BVCA) quit his post in response to criticism that he had given a weak defence of his industry.

Taxation featured heavily in the questioning. What is at stake?

One of the big objections to private equity is the tax breaks given to the industry and MPs are sure to ask about them.

The most controversial is the tax on the "carry".

Private equity executives pay taxes on their basic pay and bonuses, but a large part of their income comes from carried interest - the carry - which is the 20% slice of profits they can claim once they have paid back their investors.

This money is classed as a capital gain and, as such, is subject to a tax level of 10%.

Critics say it should be charged at a normal tax rate.

Reports have suggested that some key industry figures have come to accept that the law does need changing.

It is an emotive subject, with one private equity boss saying that some of the richest men in Britain were paying tax at a lower level than the cleaners who tidied their offices.

If taxes are raised, is there not a danger of the UK being seen as a less attractive place to invest?

One of the arguments being raised by representatives of the industry is that radical changes to the status quo could drive capital and talent away from the UK.

Documents submitted to an earlier hearing of the select committee said more than 80bn had been invested in about 29,500 firms since 1983.

The argument for keeping taxes low is that, even if it may seem unjust, it is better for the Treasury to have a small slice of somebody's income than nothing at all.

"if the government increases the tax on the private equity industry sharply, a very large chunk of it can move offshore and go from paying some tax to paying no tax," says John Moulton, chairman of Alchemy Partners, the fund that tried unsuccessfully to buy Rover cars.

"So it could be very un-clever to put a heavy tax regime on to the private equity market."

The BBC's Business Editor Robert Peston is doubtful that changes to the law would have a sweeping effect.

This is because about two-thirds of the UK's 180 main private equity partners are not British and so do not pay any tax in the UK anyway.

If tax changes were also applied to smaller private equity players, there is a risk that entrepreneurial partners "would do other things", our business editor adds, "and the supply of investment capital to smaller companies would diminish".

Is this anti-private equity feeling just a British phenomenon?

No. Two US senators have proposed a sharp rise in the tax that private equity firms have to pay.

Businesses in the US are taxed at a standard level of 35%, while partners in investment funds are taxed at 15%.

However, funds should pay tax at the same level as other businesses, say Max Baucus and Charles Grassley - the two top members of the Senate finance committee.

What is the impact of private equity on companies? Is it better for firms to be run publicly?

Another key question from MPs was whether private equity really benefits the firms that it buys.

Private equity groups use a mixture of their own money and debt to buy firms which they feel are underperforming.

They usually look for a profitable sale within three to seven years.

As they do not have to keep shareholders happy or meet stock market disclosure rules, private equity firms argue that the companies they control are more able to make difficult or long-term decisions.

Gordon Brown has praised their ability to create jobs quickly and contribute to the economy.

So private equity buy-outs are a good thing?

You might not think so if you were an employee of the AA or Birds Eye - iconic UK firms that were bought out and subsequently saw hundreds of job cuts made.

And if you are an employee of Alliance Boots, set to be taken over by a consortium headed by Kohlberg Kravis Roberts, you may also be feeling a little unsure about your future.

One of the main criticisms of private equity is that they "asset-strip" - sacking people and selling off property, having used too much debt to finance their deals.

What other issues cropped up at the committee hearing?

The transparency of private equity was another concern, since a lack of accountability means that decisions are made behind closed doors.

The longer-term potential risk and financial stability of private equity funds was also questioned.

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