In February 2007, Sir David Walker was asked by the British Venture Capital Association and a group of major private equity firms to review the adequacy of disclosure and transparency in private equity (the Walker review).

The Walker review was launched in response to criticism of private equity, sparked by a period of rapid growth that saw private equity takeovers of a number of big household names, such as Alliance Boots. For this reason, the Walker review focused on medium and large-scale buyout transactions, rather than the venture and growth parts of the industry, which have not attracted the same controversy.

The consultation document seeks views on a number of proposals for voluntary guidelines (proposed guidelines) to which the industry would conform on a “comply or explain” basis. “The comply or explain approach is welcome,” says Edmund Tyler, a senior associate at SJ Berwin LLP, one of the organisations consulted as part of the Walker review. “It will provide for greater openness in the industry, without detracting from the freedoms of private status.”

The proposed guidelines are designed to bring about greater openness in the following:

Portfolio companies. The Walker review found that, while the reporting arrangements between private equity funds and their investors are generally satisfactory, employees and other stakeholders in the largest portfolio companies also have a legitimate continuing interest in the state of the business. The consultation document therefore proposes that certain companies should report to an enhanced standard, beyond existing statutory requirements (see box “Enhanced reporting thresholds”).

The consultation document places more weight on narrative rather than financial reporting, other than in relation to debt and debt structure. The proposals include:

“A lot of what the consultation document recommends reflects existing best practice in the industry,” says Charles Geffen, a partner at Ashurst. “For example, many private equity firms already publish the annual accounts for their portfolio companies online because they find them to be useful as marketing tools.”

The AA, under CVC and Permira’s ownership, published its 2006 annual report on its website. That report contained more information about the company on a stand-alone basis than had historically been included in the annual report of Centrica, its previous owner. However, this highlights an area of tension in relation to the enhanced reporting proposals. “One big question, outside the scope of the Walker review, is how you square greater transparency requirements for private equity-owned companies with more limited information available about big private companies that are not owned by private equity,” says Geffen.

The consultation document also notes that a valuable role can be played in portfolio companies by non-executive directors, but that it would be inappropriate to set any blueprint for board composition. A number of larger private equity firms, such as TPG and 3i, say that they already use outside directors in at least some of their portfolio companies.

General partners. The consultation document recommends that general partners of private equity firms should publish an annual review which should include:

It also recommends that private equity firms be more accessible to specific enquiries, particularly on large transactions, from the media and other interested parties.

Industry as a whole. The consultation document notes that there is a major role for systematic data collection, aggregation and dissemination on an industry-wide and authoritative basis, and recommends that data be collected on a wide range of matters such as the scale of funds raised, existing private equity portfolios and recent buyout activity.

It also recommends that the industry’s representative body make arrangements to keep the proposed guidelines under review by a small group of trustees chaired by an independent outsider.

The Commons inquiry has, like the Walker review, focused primarily on highly-leveraged buyouts. However, it is much wider in scope, looking at the impact of the private equity industry on the UK economy as a whole and touching on tax and risks to financial stability as well as transparency.

The interim report does not make detailed recommendations but instead identifies areas of concern and raises questions for further examination. These include:

Pension fund security. The Committee considered that it was vital to ensure that company pension fund commitments be securely funded when changes, such as an increase in leverage, occur in relation to the company. They will return to this matter in the autumn.

Financial stability. The interim report notes that higher levels of leverage are likely to create additional risk, and urges the Bank of England to research the potential impact of an economic downturn on highly leveraged firms and the wider economy. The Committee strongly supports the Financial Services Authority’s (FSA) proposal to conduct biannual surveys of banks’ exposure to leveraged buyouts to enable the timely identification of risk.

Covenant-lite loans. The interim report urges the FSA and the Bank of England to continue to monitor covenant-lite loans (that is, loans with few or no maintenance covenants). In practice, the tightening of credit markets since the interim report was published seems to have put an end to aggressive covenant-lite deals, at least in the short term.

Transparency. The interim report welcomes the Walker review’s proposals to increase transparency, but asks for more detailed guidance on certain aspects of the information to be provided and suggests that there be additional independent monitoring of the proposed guidelines.

Tax. The interim report acknowledges that the tax regime for private equity is one of the most controversial areas and that the tax system should treat different sorts of businesses fairly. Two areas are particularly controversial: the currently generous level of tax relief for capital gains on carried interest (that is, the proportion (generally 20%) of the profits of a matured fund above a certain level that is payable to the private equity partners) and the tax deductibility of interest on debt.

It recommends that the Treasury and HM Revenue & Customs consider the tax treatment of carried interest as part of their current review of taxation in the area and, in addition to considering the tax treatment of shareholder debt in highly-leveraged transactions, examine whether the tax system unduly favours debt over equity, thereby creating economic distortions. The timing of this last suggestion is unfortunate: the government ruled out any wide-ranging changes to the interest relief regime in its discussion paper on “Taxation of the foreign profits of companies”, published on 21 June 2007 (see News brief “Corporate tax reform: in with the new” www.practicallaw.com/2-374-1965).

“Overall, the Commons inquiry has been a very useful learning experience. It was important for the Committee to understand how private equity really works, and for the private equity industry to understand the political environment in which it currently operates,” notes Geffen.

The Walker review consultation runs until 9 October 2007. Sir David Walker intends to draw up guidelines later this year. The Commons inquiry will reopen in the autumn and the Treasury is expected to report on its review of tax treatment of debt in highly-leveraged transactions in the Pre-Budget Report, expected to be delivered in October.

In the meantime, it has been reported that the Chancellor, Alistair Darling, is considering changes to the tax relief for capital gains on carried interest that would lengthen the qualifying period for relief from two to five years and increase the tax rate from 10% to 20% (Financial Times, 17 August 2007).