How HMRC allowed private equity partners to multiply their money several thousandfold tax-free

 

Do private equity fund managers get paid loads because they are so good at rescuing failing businesses? Fund managers don’t make their money only by gouging fees from their clients. With a little help from their friends at Her Majesty’s Revenue & Customs, they have had various other cosy little arrangements. One of these is in the form of “carried interest”. HMRC came to an agreement with the British Venture Capital Association in 2003 that cleared the way for 'leveraged buyouts'. As a result of this little understanding, made in the midst of the boom in easy credit, naïve wannabe homeowners were joined by hi-jacked companies in their irrationally exuberant borrowings.

What may have been a worthy idea for true ‘angelic’ venture capitalists – investing money into risky infant companies with lots of ideas and no assets – was pounced upon by the leveraged buy-out outfits unashamedly flying the Jolly Roger.

The terms of the Memorandum of Understanding are so specific it seems that the boys from the BVCA couldn’t believe what was being offered to them, and needed it spelled out:

“So, you are saying I can sharpen a stick? You know, the long thin things you get off a tree? And I can poke it into your eye?  Left and/or right? Those two round things just above your nose? And you are fine with that? Can you right that down for me, just to be sure.”

So HMRC wrote it down. The Inland Revenue’s Memorandum of Understanding states:

“The carried interest holders will contribute capital so as to ensure that they have 20% of the total capital contributions such that, after repayment of the loans  and the preferred return (see below), they become entitled to a 20% share in the net profits if the fund is successful. 

For example, in a fund of £100 million of investor money the investors might subscribe for capital of £10,000 and loan commitments of £99,990,000. The carried interest holders will subscribe (usually via another partnership or by the assignment methods - see paragraph 7.7 for capital of £2,500 which will then represent 20% of the total capital contributions of £12,500 (£10,000 from the outside investors and £2,500 from the carried interest holders).”

In plainer English, if the above isn’t plain enough, the partners of a private equity fund are allowed to own 20% of the profits and assets of a £100million fund for a payment of £2,500. And if that isn’t enough, the way capital gains are taxed in Britain means our jolly fund manager doesn’t need to pay any tax on the boom in his assets.

Of course, sitting on £99,990,000 of debt is uncomfortable for most people – except for those who are willing and able to unload it onto a captive company. The model for a leveraged buyout:

a)      Set up a fund of £100 million, made up of £2,500 from the fund managers, £10,000 from investors conditional on the investors also lending a further £99,990,000. Total funds = £100million from investors (who now own 80% of the fund), £10,000 from fund managers (who now own 20% of the fund).

b)      Buy a company for £100 million.

c)      Now that you are in control of the company, get it to borrow £99,990,000.

d)      You then get the hostage company to pay you £99,990,000 as a ‘special dividend’

e)      Voila! A £100million company that once belonged to someone else now belongs to your fund. And you own 20% of it, for the princely sum of £2,500.

Fund managers don’t know how to rescue businesses. Their knowledge of food manufacturers, furniture makers, and car manufacturers is limited to what can be found in their kitchens, bedrooms, and garages. Fund managers do know how to spot a company that is healthy enough to convince banks and other investors to lend it lots of money. Fund managers know how to extract the money in the form of special dividends.

So long as the company is able to support the debt, the fund can continue to collect the profits or can sell the company on to another investor. If the company collapses under the weight of its borrowings, the fund just loses the £10,000 it put up and walks away.


Nice work if you can get it.