Private Equity - Implications for Economic Growth in Asia Pacific

8/6/2019 Private Equity - Implications for Economic Growth in Asia Pacific

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Private Equity:Implications for Economic Growth inAsia Pacific

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private equity


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Excessive leverage

Lack of transparency

Potential conflicts of interest

Tax leakage

Negative impact on employment

Other issues

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30Case studies

Little Sheep in China

Austar in Australia

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Contents

2007 KPMG International. KPMG International is a Swiss cooperative. Member firms of the KPMG network of independent firms are affiliated with KPMG International. KPMGInternational provides no client services. No member firm has any authority to obligate or bind KPMG International or any other member firm vis--vis third parties, nor does KPMGInternational have any such authority to obligate or bind any member firm. All rights reserved.


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The lure of Asia Pacific for private equity houses has increased dramatically overthe last few years and showed no signs of abating during the first six months

of 2007. Last year, private equity (PE) companies in Asia Pacific raised USD

32.9 billion in new capital, up 39 percent from 2005 and five times the total just

four years ago. Deal volumes jumped 79 percent in 2006, with a total of 1,495

transactions completed and average deal size up by 8 percent to USD 41.3

million.1 According to the Asian Venture Capital Journal, private equity houses

invested USD 61.8 billion of new funds during the year and total private equity

funds under management across the region rose by almost 30 percent to USD

158.5 billion, from USD 122 billion in 2005.Initial figures for the first six months

on 2007 indicated that these trends have all continued.2

This sudden growth has caused excitement, but also some alarm. To a degree,this reflects a lack of understanding about this industry and its somewhat brash

image when seen against the quiet dedication of Asian businesses and financial

institutions. Media opinion pieces have cautioned against the PE houses

excessive and lightly-taxed profits and their use of high levels of debt to fund

buyouts. In turn, this is influencing a wider political and regulatory debate.

In Australia, these sentiments have been voiced by several prominent politicians.

If private equity funds broaden their market activity substantially they can

affect our whole economy, Senator Andrew Murray recently warned. If as a

consequence the market as a whole is exposed to too much higher risk, then so

is Australia exposed to much higher risk.3 Although a Senate inquiry found no

case for further regulation at present, it did note and recommend the ongoing

vigilance of the corporate and taxation authorities.

The anxiety is by no means confined to Asia Pacific. In the United States,

congressional hearings are being held to examine the risks of hedge funds and

private equity funds, and whether the tax rates these funds pay should be sharply

raised. The US Securities and Exchange Commission recently adopted a new

anti-fraud rule for hedge funds and private equity funds, which are technically

not covered by the Investment Advisers Act of 1940.4 In the United Kingdom,

the Walker Commission into private equity has now handed down its report,

recommending a variety of measures designed to enhance the transparency of

private equity funds to their stakeholders and the community at large.

1 Asian Venture Capital Database, 24 September 2007

2 Data provided by AVCJ Research show that private equity houses made n ew investments of USD 37.4 billion in the first half of 2007, up 24.7

percent from the same period in 2006, while total private equity funds under management across Asia Pacific topped USD 171 billion, from USD138.5 billion in the first half of 2006.

3 Private Equity: Higher risk, higher return, higher danger, online opinion by Senator Andrew Murray in Australian Democrats, 6 February 2007

www.democrats.org.au.

4 On 11 July 2007 commissioners of the US Securities and Exchange Commission (SEC) voted 5-0 to adopt a new rule that will make it a

fraudulent, deceptive, or manipulative act, practice, or course of business for an investment adviser to a pooled investment vehicle to make

false or misleading statements to, or otherwise defraud, investors or prospective investors in that pool. In a media statement, SEC Chairman

Christopher Cox said the rule applies to investment advisers not only of hedge funds, but also of private equity funds, venture capital funds,

and mutual funds. Source: SEC Votes to Adopt Antifraud Rule Under Investment Advisers Act, media release by the US Securities and

Exchange Commission, 11 July 2007.

Introduction

Private Equity: Implications for Economic Growth in Asia Pacific2



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Private equity investments in Asia Pacific are quite modest by international

standards. In Australia, a major destination for private equity investment, the

value of all businesses purchased by private equity funds in 2006 amounted to

less than 1.4 percent of the market capitalisation of all companies listed on the

Australian Securities Exchange.5 At the regional level, USD 61.8 billion of private

equity deals were announced in 2006,6 coming to a minuscule 0.5 percent of

market capitalisation.7

Nevertheless, these complaints and criticism have swayed opinion among the

wider public, many of whom would have barely heard of private equity more than

a year ago. Private equity has now been made very public. The turmoil in the debt

and equity markets over July and August 2007 has further focused the spotlight

on private equity, particularly the large leveraged buy-outs with their substantial

covenant-lite debt packages. While it is still too early to call just how markets in

the region will react over the next year as the debt crisis in the sub-prime US

home loan market works it way through the global financial system, it is fair to

say that, at least over July and August 2007, there seems to have been minimal

impact on announced deals in this region where the focus is on growth capital

rather than leveraged buy-outs.

The speculation about how the industry may fare in this new world where risk

has been re-priced has illustrated how little is known about private equitys core

investment rationale. This report presents some basic facts about private equity

funds in the region, including their size, their deals, their investment approach,

exit strategies and plans for the future. By assembling information directly from

the ground, we hope to inject a measure of objectivity into the emotional debate

on private equity in Asia.

5 Private Equity in Australia, submission by the Australian Private Equity & Venture Capital Association Limited (AVCAL) to the Senate Standing

Committee on Economics, May 2007.

6 Asian Venture Capital Journal database. According to the World Federation of Exchanges, the combined market capitalisation of 17 Asian stock

markets, including those in Japan, Hong Kong, Australia, China, India and South Korea, topped USD 12 trillion as of the end of 2006.

7 WFE Annual Report and Statistics 2006, annual report by the World Federation of Exchanges.

David Nott

Regional Leader

KPMG's Private Equity Group

Private Equity: Implications for Economic Growth in Asia Pacific 3

2007 KPMG International. KPMG International is a Swiss cooperative. Member firms of the KPMG network of independent firms are affiliated with KPMG International. KPMGInternational provides no client services. No member firm has any authority to obligate or bind KPMG International or any other member firm vis--vis third parties, nor does KPMGInternational have any such authority to obligate or bind any member firm. All r ights reserved.


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In March 2007, KPMG member firms in Asia Pacific commissioned a survey of119 private equity funds across the region. The following are the key findings:

Generalist, venture and growth capital are likely to remain as private equitys bread

and butter. Only one-tenth of respondents describe their fund as a buyout fund, meaning

that their strategy is to acquire other businesses, usually by borrowing against the target

companys assets (10 percent). The vast majority of those polled describe their fund as

generalist, meaning it invests in all stages of a companys development (44 percent),

provides venture capital to start-up enterprises (27 percent), acts as a fund-of-funds that

finances other private equity funds (11 percent), or injects growth capital into later-stage

companies in need of expansion support (8 percent). This indicates that while high profile

buyouts may dominate the headlines, most private equity funds will continue to take

stakes in private companies and work with existing management to build more profitable

and competitive enterprises.

While public to private (P2P) transactions are comparatively rare in the region,

they look set to become more of a focus. Only 39 percent of the respondents say

they conduct P2P deals. Looking forward, another 47 percent say that, while their

fund currently does not engage in P2P, they may consider doing so in the future. A key

determinant of the reluctance to participate in P2P deals is the high execution risk, as

Australian PE funds have found in recent times. There also needs to be a degree of

maturity in the capital markets and a regulatory acceptance of this type of takeover

activity.

Whatever the investment approach, the respondents describe their company as an

active participant in the task of growing businesses. The vast majority, 90 percent,

say their company is a hands-on investor. They agree strongly with statements that

say private equity companies supply the capital needed to expand businesses, provide

management guidance at the board level and improve corporate governance. In terms of

their impact on economies, the respondents say their main contributions lie in improving

the ability of regional businesses to compete globally (India, Korea, Japan and Oceania),

helping a country attract external investment (China, India), and growing small businesses

(Southeast Asia). This reflects the core thesis of private equity funds that, while they

may bring some debt to a deal, there must be a core growth of earnings proposition. At

the very least this should increase value based on a current multiples and it should also

create the possibility for a multiple shift as the underlying quality of earnings is raised.

Mezzanine finance will increasingly be used to help structure private equity

investments. Slightly more than half of respondents expect increased borrowings from

Asia Pacific banks (55 percent), local banks (53 percent) and international banks (48

percent). In addition, the majority (70 percent) see increased levels of borrowing from

mezzanine funds or providers.

Executive summary




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Future investments are likely to diversify risks because they will be pan-regional

rather than focused on a single country. Six out of ten respondents (66 percent) say

the next fund they raise will have a pan-regional focus, with only 34 percent saying their

next fund will concentrate on a single market. This investment mandate gives the fund

managers flexibility in applying the funds to work, reduces overall fund risk and reflects

a view of the region, or segments of it, as an integrated economic whole rather than as

a collection of disparate countries. The one exception to this is likely to be Japan. Most

likely due to the size of its economy and M&A market, it is expected that pure Japan

focussed funds will continue to attract much interest.

Going forward, private equity investment is likely to continue growing strongly

across the region. Asked the primary reason for investing in the Asia Pacific, the

overwhelming majority (94 percent) cite economic growth, a trend that looks set to

continue particularly in China and India in the foreseeable future; 83 percent expect

to see deal sizes increase in the next two years, with only 15 percent forecasting no

change. In the next five years, the top two target markets will be China 74 percent of

respondents say their company will remain or put in new money there and India (63

percent). More than one-third each say they will be in Taiwan (38 percent), Australia (37

percent) and Vietnam (36 percent). They expect to be investing in consumer markets,

healthcare, environment, services and renewable/alternative energy.

The growth of private equity in Asia appears to be having a positive effect in

driving economic gains across the region. The findings of this report suggest

that private equity is fulfilling an important development function in mentoring

entrepreneurs and mid- and late-stage managements about operational best

practices, transparency and corporate governance, and achieving regional

and global competitiveness. Private equity houses have also pursued "roll-up"

strategies, building economies of scale and creating companies that have the

potential to expand out of their Asian roots and become more serious globalplayers.

Both advocates and antagonists have noted, however, that the industry can do

more to communicate its contributions. To do this, it has been suggested that

the industry needs to engage with the media and the investment community,

and disclose its results not only to its shareholders but also to the larger market.

Some proponents suggest that at the very least it needs to clearly explain to

outsiders why and when certain information cannot be shared publicly. Private

equity firms could also consider adopting a code of practice and code of ethics,

and pursue more self-regulation to pre-empt more heavy-handed regulatory

oversight.

Private Equity: Implications for Economic Growth in Asia Pacific



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About the study

This report is based on a survey of 119 general partners (65 percent), investment

directors (19 percent), investment executives (13 percent), and fundraising/investment

relations executives (3 percent) in the Asia Pacifics private equity industry. The

respondents were based in Greater China (29 percent), Oceania (19 percent), Southeast

Asia (18 percent), India/Pakistan (11 percent), and Japan/Korea (10 percent). The 13

percent who came from the rest of the world were making investments in the region.

The anonymous online survey was conducted in March 2007 by i.e. consulting on behalf

of KPMG.

Respondent Job Function

n Partner/equivalent

n Investment Director

nInvestment Executive

n Fundraising/Investor Relations

65%

3%

13%

19%

n Greater China

nOceania

n Southeast Asia

Respondent Location

29%

10%

11%

13%

19%18%

n Rest of World

n India/Pakistan

n Japan/Korea

China

India

Australia

Singapore

Taiwan

Korea

Japan

Malaysia

New Zealand

ThailandIndonesia

Vietnam

Philippines

61%

37%

29%

29%

28%

26%

21%

18%

18%

18%14%

10%

8%

Current Investment Profile

0% 10% 20% 30% 40% 50% 60% 70% 80%

We would like to thank all the executives from private equity houses and private equity

organisations that were interviewed in the course of this research.




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Private Equity 101

Private equity is long-term, committed share capital that helps companies to grow and

succeed. Whereas debt financing entails a legal right to interest on a loan and repayment

of the capital, irrespective of success or failure, private equity is invested in exchange for

a stake in the company and, as shareholders, the investors returns are dependent on the

growth and profitability of the business.

The entity that makes the investments is usually structured as a limited partnership and

is known as a private equity fund. The investors in this fund, known as limited partners,

primarily include pension funds, insurance companies and wealthy individuals. A private

equity fund is managed by a general partner, who is tasked with deciding where and how

to invest the funds money, in accordance with the focus defined in the funds terms of

reference.

Different private equity funds have different objectives, such as backing start-up

companies (venture capital funds) or investing in mid-stage/mature enterprises that

need expansion support (growth capital funds). A third focus of many international funds

is the buy-out of existing equity holders, in a public to private deal, a privatisation of

government owned assets, a takeover of a division of a larger company or the acquisition

of a private company from retiring shareholders. Whatever the objective, they have a

medium to long-term investment horizon, typically three to five years, during which

they provide management with guidance, experience and expertise on the board and

operations levels. Private equity funds make money (or cut their losses) by exiting their

investments through an initial public offering or sale of their stake to another company

(a trade or secondary sale, where the latter is a sale to another private equity fund). In

the emerging markets of Asia, private equity investment has predominantly been growth

capital, even when conducted by the larger buyout private equity houses.

Private equity funds are often mistaken for hedge funds, but these two investment

classes are fundamentally different. While private equity funds have a long-term

investment horizon and add value to their holdings by playing an active role in strategy

and operations, hedge funds concentrate on company and industry hedging strategies,

short-term performance and returns. Whereas private equity funds typically focus on

long-term valuation methodologies, hedge funds frequently mark their investment to

market (or model), and utilise this valuation methodology in decisions concerning exit

strategies.

While the differences in approach are significant, a convergence between private equity

funds and hedge funds may occur in one of three ways:

Hedge funds have been involved in private equity deals, such as building stakes inpotential public-to-private deals (for example, Airline Partners failed USD 10.95 billion

bid in 2006 for Qantas Airways), buying leveraged loans in the debt markets or co-

investing with private equity funds in target companies.

Hedge funds have participated in private equity-type investing, as illustrated by the r ise

of activist hedge funds in the US.

Private equity funds and hedge funds are sometimes owned and managed by the

same entity, as is the case with Blackstone, the US global alternative investment

company.




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exhb 1

Value, volume and new fund-raising by private equity funds

Source: Asian Venture Capital Journal database

Private equity funds are rapidly growing in size in the Asia Pacific. As tracked by

the Asian Venture Capital Journal, total private equity funds under management

across the region were valued at USD 158 billion last year, up nearly 30 percent

from 2005.8

70

60

50

40

30

20

10

0

1600

1400

1200

1000

800

600

400

200

0

Value of deals

2002 2003 2004 2005 2006

Funds Raised Volume of deals

The regions private equity funds have large volumes of capital to invest. Last

year, they raised USD 32.9 billion in new money, an increase of 39 percent from

2005 and five times new fund-raising in 2002. They are now aggressively putting

that money to work. The number of private equity deals last year jumped 79

percent to 1,495 transactions, from 834 in 2005 and just 532 in 2002. The value

of the 2006 deals topped USD 61 billion, up 94 percent from 2005 and over five

times the value of 2002 transactions.

A key driver in this growth has been a move up the transaction value chain

between 2003 and 2005 there were on average eight deals a year in excess of

USD 500 million; in 2006, there were 24 completed deals. Similarly, the average

deal size has grown from just USD 18.5 million in 2002 to USD 41.3 million

in 2006. Asked about deal size in the next two years, the vast majority of our

respondents (83 percent) expect this trend to continue.

Inside private equity

in Asia Pacific

8 These figures and other data in this section were extracted from the database of the Asian Venture Capital Journal, on 24 September 2007,

unless otherwise stated.

Valueofdealsandfundsraised,

USDbn

Volumeofdeals




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exhb 2

How do you expect deal sizes to change over the next two years?

Source: KPMG survey of 119 private equity firms in Asia Pacific, 2007

n Increase

nDecrease

n Stay the same

83%

15%

2%

exhb 3

What are your key reasons to invest in Asia Pacific?


Economic growth

Pricing

Dealflow/Investment opportunities

Demographics

Less competition

Market size

Quality of management/entrepreneurs

Local knowledge/networks

Skilled workforce

Market inefficencies

Stability

Sophisticated capital markets

Technology

Regulation

Labour costs

Exit opportunities

Manufacturing capabilities

Debt markets

94%

26%

23%

15%

13%

8%

8%

7%

7%

6%

6%

5%

5%

4%

4%

3%

2%

2%

0% 20% 40% 60% 80% 100%

Mk f chcThe key factor that makes the Asia Pacific region so compelling for private

equity fund managers is the economic growth of the region 94 percent of our

respondents singled this out (Exhibit 3). It is not surprising, therefore, to find

that the market receiving the most interest from private equity funds is China.

Economic growth eclipsed other considerations such as pricing, deal flow and

competition. The upward pressure on the pricing of deals in Europe and the

US has also made the region more interesting, with very few respondents

mentioning low labour costs as a factor.

Six out of ten respondents say their private equity fund has assets in China. India

is in a distant second (37 percent), followed by Australia (29 percent), Singapore

(29 percent) Taiwan (28 percent) and Japan (21 percent). Of our sample set, the

least penetrated markets are Vietnam (10 percent), the Philippines (8 percent),

and Mongolia (3 percent).




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exhb 5

What will the geographical focus of your next fund be?


n Pan-regional

nSingle country focus

66%

34%

When asked to project five years out, respondents still choose China as the

prime target market (74 percent, see exhibit 4). India becomes far more popular

(63 percent), however, whilst Taiwan (38 percent), Australia (37 percent) and

Singapore (34 percent) remain attractive. The biggest mover is Vietnam, which

vaults from near bottom to fifth place (36 percent). In terms of growth over

time, the number of funds that expect to invest in Vietnam in the next five years

represents an increase of 258 percent, though admittedly from a low base. Other

big movers include the Philippines (130 percent), Indonesia (100 percent), India

(70 percent), and Malaysia (68 percent).

exhb 4

Which countries do you think you will be targeting in five years time?

China 74%

India 63%

Taiwan 38%

Australia 37%Vietnam 36%

Singapore 34%

Korea 34%

Japan 31%

Malaysia 31%

Indonesia 29%

Thailand 25%

New Zealand 23%

Philippines 19%

Mekong Delta (ex-Vietnam) 17%Source: KPMG survey of 119 private equity firms in Asia Pacific, 2007

The future make-up of private equity investments could be a force for continued

stability. Future investments are likely to diversify risks because they will be

pan-regional rather than focused on a single country (Exhibit 5); 66 percent of

the respondents said the next fund they will raise will have a pan-regional focus,

with only 34 percent saying their next fund will concentrate on a single market.

This should help bring more stability to Asias private equity industry, and thus

to financial markets and economies as a whole, since the ability to hold assets

in multiple markets should lower overall risk. A wide investment mandate gives

the fund managers flexibility in putting the funds to work, reduces overall fund

risk and reflects an investors view the region, or segments of it, as an integrated

economic whole rather than as a collection of disparate countries.




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exhb 7

Average deal size in selected industries


350

300

250

200

150

100

50

0AverageDealSizeUSDmillion

2002

tg c

In 2002, private equity funds in Asia most often invested in computer hardware

and information technology companies (Exhibit 6). By 2005 and 2006, these

remained the most popular sectors, but others were catching up fast. Average

deal size has grown steadily from USD 18.5 million in 2002 to USD 41.3 million in

2006, although when looking at individual industries the figures can be skewed by

one large deal (Exhibit 7).

exhb 6

Top private equity investment by value, USD million, with

volume of deals in brackets2002 2003 2004 2005 2006

Financial services 2,715 (45) 3,419 (34) 1,867 (40) 8,634 (70) 10,318 (115)

Telecommunications 1,899 (53) 3,637 (33) 2,739 (19) 304 (21) 8,201 (33)

Media 100 (8) 205 (9) 36 (6) 237 (7) 7,059 (24)

Travel/Hospitality 77 (11) 1,185 (10) 571 (8) 2,130 (26) 4,295 (48)

Retail/Wholesale 388 (20) 338 (20) 1,229 (26) 2,328 (37) 4,095 (74)

Consumer products/services 393 (21) 250 (20) 383 (21) 1,078 (28) 3,888 (69)

Medical 250 (45) 960 (42) 943 (64) 2,044 (93) 3,687 (127)

Transportation/Distribution 502 (15) 928 (37) 3,314 (36) 2,368 (47) 3,306 (75)

Manufacturing - Heavy 505 (25) 1,055 (36) 480 (57) 1,089 (61) 2,771 (116)

Computer related 663 (107) 1,199 (72) 2,061 (89) 3,730 (99) 2,265 (158)

Electronics 255 (41) 547 (35) 443 (56) 2,801 (42) 2,033 (89)

Information technology 272 (57) 585 (37) 262 (79) 890 (116) 1,874 (221)

Ecology 14 (3) 61 (5) 17 (3) 103 (6) 1,709 (7)

Mining and metals 146 (8) 176 (15) 125 (18) 708 (26) 1,645 (43)

Non-Financial Services 232 (23) 243 (31) 456 (38) 293 (36) 1,469 (97)

Construction 1 (5) 311 (8) 158 (8) 1034 (7) 849 (30)

Infrastructure 449 (1) 263 (3) 283 (7) 177 (3) 748 (23)

Utilities 27 (5) 1544 (18) 764 (18) 200 (19) 472 (34)

Manufacturing - Light 345 (17) 132 (19) 276 (19) 491 (40) 460 (36)

Textiles and clothing 19 (3) 138 (4) 81 (10) 841 (24) 307 (27)

Agriculture/Fisheries 310 (4) 30 (6) 0 (1) 7 (5) 220 (15)

Leisure/Entertainment 273 (15) 754 (11) 58 (17) 374 (21) 110 (34)

Total 9,836 (532) 17,960 (505) 18,919 (640) 31,800 (834) 61,782 (1,495)


2003 2004 2005 2006

Average Transaction Size - All Industries

Telecommunications

Financial services

Media

Computer related




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exhb 8

In five years time, which sectors will you be investing in?

Consumer/Retail/Services 25%

Environment/Renewable/Alternative/Clean Energy 19%

Healthcare 13%

Telecommunications, Media and Technology 11%

Energy/Resources 9%

Biotech/Life Science 6%

Distribution/Logistics 4%

Financial Services 4%

Infrastructure 3%

Transport 2%

In terms of value, however, financial services (USD 10.3 billion),

telecommunications (USD 8.2 billion) and media (USD 7.1 billion) are actually

the three dominant industries. Computer-related enterprises (USD 2.3 billion)

and information technology (USD 1.9 billion) lag far behind, exceeded in value

by various other diverse sectors. Deals in telecommunications may be fewer

in number, but the individual volumes being invested are larger compared with

deals in IT and computer-related sectors.

Looking ahead, our respondents expect the investment profile to be very

different. Asked which sectors they think their private equity fund will be focusing

on by 2012, the respondents put consumer markets, including the retail sector,

at the top of the list (Exhibit 8). This is an industry that had received relatively

little private equity investment in the past five years. The interest in personal

consumption reflects the growing wealth and personal disposable incomes of

millions of consumers in markets such as China and India, the opening of new

markets in countries like Vietnam with its young population and and the potential

for a consumer revival consumer revival in Japan.

The second most popular sector is environmental technologies, including

renewable energy and waste technologies. This, too, is not among the hot

sectors today, but the respondents evidently see a bright future for it going

forward, reflecting global concerns about sustainable development and global

warming. Healthcare, telecommunications, and media and technology (especially

in areas relating to IT and computer hardware) are projected to remain strong

target sectors over the next five years.

ex gAccording to the Asian Venture Capital Journal, 2006 was a record year for

IPOs in Asian private equity: PE-backed offerings doubled to USD 30.4 billion as

mainland Chinese banks were floated in Shanghai and Hong Kong. Trade sales

were a distant second at USD 11.6 billion, down 48 percent from 2005 as bank

disposals in Korea stalled.9

The executives surveyed were asked how they exit today, and how they think

their equity fund will dispose of their investments in two years and five years

time (Exhibit 9). IPOs emerged as the preferred exit strategy currently (52

percent), ahead of trade sales (42 percent).

9 Extracted from the database of the Asian Venture Capital Journal.




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Respondents predicted that the situation could reverse within two years, with

trade sales (46 percent) surpassing IPOs as the preferred exit route (44 percent).

This outlook will however be affected by developments in the debt and equity

markets, as this will determine the extent and the ease with which companies

can leverage their investments and the attractiveness of the stock markets to

new listings.

exhb 9

How do you exit your investments today, in two years, and in five years?


60%

50%

40%

30%

20%

10%

0%

52%

n Now n2 years n5 years

IPO Trade sale Secondary buyout Other

44% 43% 42%46%

37%

5%9%

17%

3%1%1%

Interestingly, in five years time, respondents see a more significant role for

secondary buyouts (17 percent), which involve selling the investment to another

private equity fund. This may indicate expectations of a continued boom inprivate equity funds, with newcomers seen as willing to pay premium prices for

the holdings of older funds in order to get a foothold in the market. While still

substantial, trade sales will account for a lower 37 percent of disposals. IPOs will

remain steady at 43 percent.





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Criticisms of

private equityand regulatoryresponsesThe private equity industry has been under sharp attack in the US and the UK,

and to a lesser extent in Australia. In a recent report10 widely picked up by

the media, credit-ratings agency Moodys challenged some of the benefits PE

houses claim to bring to businesses. Even though PE-backed private companies

in the US are not covered by the strictures of the Sarbanes-Oxley Act and the

requirement to report quarterly earnings, the current environment does not

suggest that private equity houses are investing over a longer term horizon than

do public companies, the report asserts. Moodys also expressed concern about

the willingness of private equity houses [in the US] to issue special dividends

despite commitments to reduce leverage, sometimes within 12 months of the

transactions closing.

Reports such as this have added to the demands from investors, politicians,

trade unions and other quarters for more regulation of the industry; regulators

and legislative bodies are beginning to respond. In the UK, the Financial ServicesAuthority is keeping a watching brief on leverage, transparency and conflict-of-

interest issues. In Australia, the Takeovers Panel has circulated a draft Guidance

Note on insider participation in control transactions for private equity companies

and other M&A participants. In Taiwan, the Financial Supervisory Commission is

considering raising the threshold for de-listing of public companies to head off

possible de-equitisation caused by PE buyouts.

PE players say they recognise the need for reasonable regulation, but they

worry that emotionalism, fear-mongering and misunderstanding among

certain stakeholders could force regulators and politicians to impose overly

restrictive requirements. One alarming example is Korea, where prosecutors are

investigating or have indicted at least three international private equity houses foralleged price manipulation, insider trading and other supposedly illegal practices.

One Korean newspaper publicly accused a US private equity firm of being a

habitual and wicked tax evader.11

Controversy is perhaps bound to arise as more and bigger private equity players

enter the arena, larger deals are announced, and iconic listed companies are

targeted. The following sections of this report detail some of the common

criticisms levelled at private equity and the regulatory responses that have arisen

in key markets.

10Rating Private Equity Transactions, special comment by Moodys Investors Service, July 2007.

11Public Scorn for Private Equity, in BusinessWeek, 4 December 2006.




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exc lgThere is a growing perception in the public mind that PE firms saddle the

company they have taken over with heavy debts, an impression caused in part

by the massive sums private equity players recently paid to buy out public

companies. In the first half of 2007, for example, private equity groups agreed topay USD 8.9 billion for Orica Limited in Australia, USD 976.8 million for Fu Sheng

Industrial in Taiwan, and USD 698.4 million for MMI Holdings in Singapore.12

These transactions followed a USD 8.7 billion bid in 2006 for Australias Qantas

Airways, a deal which fell apart despite the airlines board acceptance of the offer.

Along with the equity component of PE investments, there is usually a significant

component of debt. PE players say they do leverage their portfolio companies

balance sheet when needed, but they insist that it is in their interest to borrow

prudently. In Australia, David Jones, managing director of CHAMP Private Equity

notes that, the average ratio of debt to equity in buyouts has been almost

exactly 70 percent debt, 30 percent equity, regardless of the size of the buyout,

which is a reasonable ratio.13 Jones notes that the Reserve Bank of Australia

(RBA) came to a favourable assessment, which concluded that private equity

exposures currently amount to less than 3 percent of total loans in the Australian

banking system.14

The debt-to-equity ratio may be lower in the rest of Asia, where local banks,

having gone through the crucible of the 1997 Asian financial crisis, generally

follow conservative lending practices. Chris Rowlands, Managing Partner Asia at

3i, estimates the debt-to-equity ratio of PE-backed portfolio companies across

Asia Pacific at 50-50.15 In Europe in the last few years, weve seen debt levels

increasing strongly as the banking industry became aggressive, Rowlands says.

In Asia, typically with the cycles and volatility here, we have seen more balance

between equity and debt.

The global debt market

The unprecedented nature of the global

debt market has helped fuel the recent

PE boom. Its features include:

Low interest loans driven by high

levels of liquidity and the reduction in

risk spreads

High leverage there is no doubt

that in the larger deals in the US, the

banks have also loosened their lending

requirements, helping to drive the

record volume of leveraged buyouts.

And it is this leverage that changed

significantly over the past four years;

according to Standard and Poors

analysis, in 2001 deals were being

done at 4x EBITDA while in the first

half of 2007 they were being done

at over 6x EBITDA (source: Ratings

Direct Report, Standard & Poors, July

2007)

Favourable financing structures

particularly covenant-lite financing

arrangements which lacked the

protective covenants that subject theborrower to tests to show they are

maintaining financial ratios at agreed

levels. One covenant lite feature was

toggle notes which allowed borrowers

to either make interest payments

in cash or borrow more money to

pay interest on the money already

borrowed.

Collateral requirement loosened

where there was no security over

assets/business for the loans

Bridge loan facilities typically were

provided by the banks capital markets

arm with the understanding that the

buyout firms would find investors to

take over the banks stake after the

deal closed.

exhb 10

Sources of new debt in the next two years


Local banks

n Decrease n Stay the same n Increase

100%

60%

80%

40%

20%

0%Regional

(Asia-Pacific)

banks

Intemational

(North American/

European) banks

Mezzanine

funds/providers

Hedge funds

12Top PE Buyouts in Asia, 1H07, report by Thomson Financial, 7 July 2007.

13KPMG interview with David Jones, Managing Director of CHAMP Private Equity and Chairman of the Australian Venture Capital & Private Equity

Association, July 12 and 20, 2007.

14Financial Stability Review, report by the Reserve Bank of Australia, March 2007.

15KPMG interview with Chris Rowlands, Managing Partner Asia, 3i, 13 July 2007.




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Going forward, the respondents to this study say the banking system is not likely

to become more of a source for private equity debt (Exhibit 10). Over the next

two years, just about half of our respondents expect increased borrowings from

Asia Pacific banks (55 percent), local banks (53 percent), and international banks

(48 percent). In contrast, 70 percent expect to see increased levels of sourcing

from mezzanine funds or providers. The worries that Asias financial systems

may face higher risks because of increased exposure to private equity buyouts

thus appear to be overblown. Mezzanine funds typically source capital from

sophisticated individual and institutional investors that are hedged and able to

absorb losses.

exhb 11

Types of private equity funds


n Generalist

n Venture

n Fund-of-fund/gatekeeper

n Buyout

n Growth Capital

44%

8%

10%

11%

27%

Moreover, despite their current high profile, buyout specialists are still in the

minority in Asia Pacifics private equity industry. Asked to describe what type

of private equity firm they are, only 10 percent of our respondents characterise

their fund as a buyout fund (Exhibit 11). A larger share say their fund is generalist,

meaning it invests in all stages of a companys development (44 percent),

provides venture capital to start-up enterprises (27 percent), acts as a fund-of-

funds that finances other private equity funds (11 percent), or injects growth

capital into later-stage companies in need of expansion support (8 percent).





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All that said, however, the indications are that buyouts may become more of an

area of focus in Asia Pacific. Nearly half (47 percent) of respondents say that,

while they are not engaged in P2P today, they may consider doing so in the

future (Exhibit 12). Rowlands, for example, says that 3i is planning to launch a

buyout business in Asia Pacific. To date, 3is regional strategy has concentrated

on growth capital, but Rowlands sees opportunities with mid-sized targets in the

USD 2 billion range. These may be public companies that could be taken private,

family corporations with no business successor, or conglomerates looking to sell

off stakes or non-core divisions.

What this means for leverage trends in the region and how regulators will

respond to them is an open question. In a survey of 13 banks in the UK, the

Financial Services Authority (FSA) found a 17 percent increase in bank exposure

to leveraged buyouts, from EUR 58 billion as of June 2005 to EUR 67.9 billionas of June 2006.16 The FSA judges system-wide exposures to be substantially

greater because banks are increasingly distributing debt to non-banks such

as managers of Collateralised Loan Obligations (CLOs) and Collateralised Debt

Obligations (CDOs), and hedge funds. The authority has not taken any action so

far, except to continue monitoring bank lending.

In the US, the spate of mega-buyouts such as the USD 45 billion private equity

deal for electricity generation company TXU and USD 33 billion for hospital chain

HCA have raised concerns about the return of the disastrous junk-bond boom of

the 1980s. US buyouts are typically funded by a mix of bank borrowing, high-yield

bonds and equity. According to the Moodys report, leveraged buyouts accounted

for 18 percent of new high-yield issuances in the beginning of 2007, comparedwith about 5 percent between 2003 and 2004. But the Private Equity Council,

the recently formed industry group in the US, estimates that the average PE

deal since 2002 is in the range of 60 to 66 percent debt, still lower than the 90

percent or more in the 1980s.17

exhb 12

Do you buy public companies to turn them private (P2P)?


n Yes

n No, but would consider it

n No, and would not consider it

39%

47%

14%

16Private equity: a discussion of risk and regulatory environment, Financial Services Authority discussion paper, June 2006.

17Testimony of Douglas Lowenstein, President of the Private Equity Council, before the House Financial Services Committee of the US Congress,

16 May 2007.




20/46

The recent turmoil in global markets caused by problems in the sub-prime

mortgage sector in the US has cooled any excessive leverage in private equity

buyouts. Banks have re-priced risk upwards after the collapse in July of two

hedge funds run by US investment bank Bear Stearns and the decision by

Frances BNP Paribas in August to halt withdrawals from three investment funds.

The five funds held securities and derivatives tied to sub-prime mortgages. The

resulting credit crunch has affected the financing of already agreed private equity

buyouts such as the takeover of US carmaker Chrysler18 and caused market

speculation about the impact on a number of large, unconcluded deals, including

the aforementioned TXU and HCA buyouts.

Some deals have collapsed, such as JC Flowers consortium bid for Sallie Mae,

with others delaying their completion as buyers and sellers wait for more clarity

from the markets or deals are renegotiated. Future deals will almost certainly

be affected, but a slowdown, rather than an implosion, is the most likely

consequence. There are a handful of transactions that LBO firms could sign in

March that they couldnt sign today (particularly mega-market deals), concludes

PE Week Wire, an industry newsletter published by Thomson Financial. But LBO

firms can do most of them, so long as they are willing to accept less favourable

terms and buyout firms have proven quite apt at acceding to such requests.

Remember Clear Channel and all those other deals where public shareholders

kept demanding higher prices? Well, now its the lenders turn.19

It is also a market where vendors need to be more realistic about asset prices.

Less leverage which is more expensive means that prices should fall. In August

the sale of the Home Depot distribution business was re-priced from USD 10.3

billion to USD 8.7billion as the debt crisis took hold. The markets should expect

lower debt/EBITDA multiples in future. According to Standard & Poor's,20 these

multiples averaged 4x in 2002 but grew to over 6x by 2006.

Finally, this is now a market where trade buyers will be more competitive as the

synergies from a deal they may obtain outweigh the gains no longer available to

PE from higher leverage than a listed corporation typically has.

Private equity houses have consistently brought more than simply leverage to

their investments in Asia Pacific. At this point in the credit cycle, their governance

model, with its unrelenting focus on operational improvement for value

enhancement, is needed more than ever. Private equity must now operate in a

more risk-averse environment, but it is one in which their core propositions and

governance model designed to enhance shareholder wealth should continue to

make a significant contribution to the economy and to those who invest in them.

18JPMorgan, Goldman Bond Risk Rises as Chrysler Loan Sale Fails, Bloomberg, 25 July 2007. The two banks could not sell USD 10 billion in

Chrysler loans for a takeover by Cerberus Capital Management, forcing DaimlerChrysler, Chryslers European parent, to lend Cerberus part of

the money needed to complete the deal.

19PE Week Wire, 27 July 2007.

20Ratings Direct Report, Standard & Poors, July 2007





21/46

Rowlands of 3i sees a silver lining. The recent tightening of credit will bring

greater discipline to current M&A activity, he argues. The larger private equity

players will broadly welcome an adjustment. At 3i, with a strong balance sheet,

in-depth sector knowledge and a wide international network, we can work

closely with companies in which we have already invested and take balanced and

informed decisions about new opportunities. As banks shy away from covenant-

lite lending, there would be less scope for private equity firms to load balance

sheets with excessive debt.

Accusation Country Regulatory/legislative opinion and industry response

Excessive

leverage used as

part of PE deals

UK The UKs Financial Services Authority (FSA) noted in 200621 that credit from lenders in

respect of PE-backed buyouts and acquisitions has risen substantially, raising concern

that PE houses are relying on excessive debt. No action has been taken other than

to continue monitoring bank lending. The British Private Equity and Venture Capital

Association (BVCA) maintains that this is not a regulatory issue for PE, as rising credit

levels is a trend that also applies to banks and other areas of the financial sector.22

US In testimony before the US House of Representatives Committee on Financial Services

in May 2007,23 Andrew Stern, president of the Service Employees International Union

(SEIU), complained that leverage involved in buyout deals can create significant

pressures that could result in bankruptcy. In response, Douglas Lowenstein, president

of the Private Equity Council, said that PE deals in the US since 2002 average in

the range of 60 to 66 percent debt, much lower than the 90 percent or more in the

1980s.24 Both the House of Representatives and the Senate are considering legislation

to address the risks of excessive leverage and other private equity issues.

Austral ia The Counci l of Financial Regulators comprised of the heads of the Australian

Prudential Regulatory Authority (APRA), the Australian Securities and Investments

Commission (ASIC), the Australian Treasury, and the Reserve Bank of Australia (RBA)

conducted a review and concluded that higher leverage levels due to LBO activity do

not pose a significant near-term risk but said the council will monitor developments

closely.25 AVCAL, the Australian Private Equity & Venture Capital Association, endorsed

the comments and findings, in particular the councils comments on debt, effects on tax

revenue, and broader effects on the capital markets.

China and Southeast

Asia

Leverage is not yet an issue in Asias developing markets since the majority of private

equity investments to date has been growth capital and cash investments. There are

also limits on the amount of leverage that can be used in many markets. But leverage

may become an issue as buyouts increase in number and deals become more complex

with the increasing use of mezzanine and other types of debt.

India According to current foreign exchange regulations, foreign owned holding companies

are required to bring in requisite funds from abroad and are not permitted to leverage

funds from domestic market for investments in Indian companies. If debt is taken at

the foreign holding company level with the intention of pushing it down to the Indian

company by merging the foreign holding company into the Indian company, the debt

in the Indian company would qualify as an External Commercial Borrowings (ECB)

and would be subject to the ECB guidelines which are inter alia stringent in terms of

restrictive end use requirements. Tax Deductibility of interest expense in the hands of

the Indian merged company is also a contentious issue.

21Private equity: a discussion of risk and regulatory environment, Financial Services Authority discussion paper, June 2006.

22Issue affects non-PE backed companies in the same way, British Private Equity and Venture Capital Association submission to the Treasury Select Committee, May 2007.

23Statement of Andrew L. Stern, President of the Service Employees International Union, to the US House of Representatives Committee on Financial Services, 16 May 2007.

24Testimony of Douglas Lowenstein, President of the Private Equity council, before the House Financial Services Committee, 16 May 2007. The council represents ten of the leading PE firms in the US, including Bain Capital,

Blackstone Group, Carlyle Group, Kohlberg Kravis Roberts & Co, and TPG Capital.

25March 2007 Financial Stability Review, report by the Reserve Bank of Australia. The relevant section states: While the recent increase in LBO activity in Australia has led to some pockets of increased leverage within

the corporate sector, it does not appear to represent a significant near-term risk to either the stability of the financial system, or the economy more broadly. The exposure of the Australian banking sector to private equity

is well contained, and both the leverage and the debt-servicing ratios for the corporate sector as a whole remain relatively low. Looking forward, however, it is likely that the increase in b usiness leverage that is currently

underway has some way to run. Given this, together with the potential implications of LBO activity for the d epth and integrity of public capital markets, as well as the importance of investors understanding the risks they

are taking on, the agencies that make up the Council of Financial Regulators will continue to monitor developments closely.




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Lck f nncThe trend of private equity firms taking over large corporations and turning them

private is also raising questions about transparency. Unlike publicly traded

companies that are subject to securities laws, it is well known that private equity

buyout firms operate outside of the public eye, with little oversight, AndrewStern, President of the Service Employees International Union, recently told a US

House of Representatives committee.26 It is critical that the industry provide

more transparency and disclosure so that the people who might be affected by a

given deal workers, community members, shareholders and others are aware

of the potential impact on their lives.

In general, PE funds are transparent with their own stakeholders. They have to

be, says a private equity professional in Hong Kong, who requested anonymity.

The general partner knows everything about the portfolio company he wants

to know; if he doesnt, hes unprofessional. The limited partner gets all the

information he needs from the general partner, if he wants it. If he doesnt get

it, he has picked the wrong GP, but then there are very few of those out there.

The information then gets passed on to the institutional funds and individual

investors that put money in the limited partnership. As for regulators, they

get the information needed, this interviewee says, because like other private

companies, PE-backed portfolio companies must register and file annual returns

with the companies registry, as well as pay taxes to the revenue authority.

The question, therefore, is how much information should be shared with wider

public and the media. Its about journalists who believe they have a right to

this information because they are the ultimate protector of the public, says the

PE practitioner. I disagree. If you give me your money to manage and we have

a contract, there is no reason why the world should know about this contract.

Its not a public company, after all. In a public to private deal, the situation is

different and stakeholders will need more information.

Commercial and competitiveness issues must also be taken into account in

dealing with the media and other outsiders. The reality, however, is that the

media can wield great influence on public opinion, and thus on the actions of

politicians and regulators.

In the UK, the FSA has noted the limited transparency of the PE industry to

the wider market, and said it was monitoring the situation. In response, the

British Private Equity and Venture Capital Association (BVCA) asked Sir David

Walker, former Executive Director of the Bank of England and former Chairman of

the Securities and Investments Board, to head a working group that would draft

a voluntary code of practice to improve private equitys transparency. In a recent

consultation document,27 the Walker Working Group judged as satisfactory the

reporting arrangements between PE firms and investors, but said the buyout end

of private equity has inadequately informed employees, suppliers and customers

as well as the wider public interest. It should be noted, however, that tends

to be during the buyout process. Once the process is complete, it is usually

in the buyer's interest to ensure that there is a flow of information between

stakeholders to motivate and retain relationships.

26Testimony of Andrew Stern, President of the Service Employees International Union, before the House Financial Services Committee of the US

Congress, 16 May 2007.

27Disclosure and Transparency in Private Equity, a consultative document by the Walker Working Group, July 2007.




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Sir David proposed that portfolio companies that were formerly listed as FTSE

250 companies or where the equity consideration on acquisition exceeded

GBP 300 million or where the company has more than 1,000 employees

and an enterprise value in excess of GBP 500 million should report to an

enhanced standard beyond that required in the 2006 companies legislation.

The suggested requirements include filing of the annual report on a company

website within four months of the year-end, and financial reporting covering

balance sheet management, including links to the financial statements to

describe the level, structure and conditionality of debt.

General partners are asked to publish an annual review on their website

that informs their approach to business and the governance of their portfolio

companies. In addition, private equity firms will be expected to be more

accessible to specific enquiries from the media and more widely. Confidentiality

concerns will constrain responses that can be given in some situations, but the

line between openness and secretiveness should be drawn with much greater

flexibility than hitherto, especially in respect of large transactions which, in the

listed sector, would attract very full public presentation.

If adopted by the BVCA, these voluntary guidelines will also cover the Asia

Pacific units of UK private equity firms, such as 3i. But US and other funds,

including local PE houses, are not obligated to follow them, although it is

possible that they will at least adapt some of the standards that they believe

are applicable to the region. We are studying the report to see what will have

relevance for us here in Australia, says Katherine Woodthorpe, Chief Executive

of the Australian Private Equity & Venture Capital Association (AVCAL).28


Lack of

transparency

UK In its June 2006 discussion paper, the FSA stated that transparency of the PE industry to

the wider market is limited, even though transparency to existing investors is extensive. It

is maintaining a watching brief on this issue. The BVCA has formed a working group that

aims to implement a voluntary code of practice to improve the level of disclosures made

by entities backed by PE houses.

US Public officials and others in the US have called for greater transparency in the US private

equity industry. The Private Equity Council places the issue in the context of PE firms

getting listed. PE firms that go public will be required to meet the same disclosure as

all other public companies, including Sarbanes-Oxley and other securities laws, it says.29

But the council warns that moves in the Senate to substantially raise taxes on private

equity funds that seek to become publicly-traded partnerships will discourage such

listings, and therefore negatively affect private equity transparency.

28KPMG interview with Katherine Woodthorpe, Chief Executive of the Australian Private Equity & Venture Capital Association (AVCAL), 23 July 2007.

29Private Equity and Publicly-Traded Partnerships S. 1624, response by the Private Equity Council to S.1624, a bill increasing taxes on private equity funds that seek to be come listed partnerships introduced by Senator

Max Baucus and Senator Charles E. Grassley on 14 June 2007.




24/46

pnl cnflc f nThe issue of conflict of interest has been raised mainly in the UK and Australia.

A primary concern is that the fund manager must run the fund both to maximise

the returns to the investors while balancing this with the returns it should make

to itself as the fund manager (under pressure from its owners and staff). Whileno regulatory action has so far been taken, in the UK the Financial Services

Authority has been raising awareness of the issue through speeches and

newsletters. In Australia, the Takeovers Panel is asking for submissions on a

proposed Guidance Note and Issues Paper on Insider Participation in Control

Transactions, which was driven by PE but covers all public M&A transactions.

The private equity industry participated in the drafting process, and AVCAL has

expressed support for the Guidance Note.


Potential

conflicts of

interest

UK The FSA sees conflicts of interest since the fund manager must run the fund both to

maximise the returns to the investors and also to balance this with the returns it should

make to itself as the fund manager (under pressure from its owners and staff). The FSA

also believes that conflicts of interest may arise in dealing with the affairs of customers,

investors and companies owned by the fund. It is using speeches and newsletters to

raise awareness of this issue. In response, the BVCA has developed guidelines promoting

an ethical culture where conflicts of interest should be addressed and not be taken

lightly.30

Austral ia On 21 February 2007, the Takeovers Panel published a draft Guidance Note and Issues

Paper on Insider Participation in Control Transactions, which was driven by PE but covers

all public M&A transactions. Submissions have been received, but the findings have yet to

be published. The private equity industry was represented on the Takeovers Panel during

the preparation of the draft Guidance Note and issues paper. AVCAL has written to the

Takeovers Panel to express its support for the draft Guidance Note.31

tx lkgA common perception in Asia and elsewhere is that private equity firms are

making such windfall gains that they should be required to share their bounty

with the rest of the community. In the US, some in the House of Representatives

want to double the tax on the earnings of PE firms from 15 percent to 30

percent. The Private Equity Council warns that entrepreneurial risk-taking would

suffer and the efficiency of capital markets would be impaired if the measure

were to pass.32

In Korea, some PE firms have been criticised as tax evaders and profiteers. In

the case of the Korea Exchange Bank, for example, the original private equity

investment in 2003 is estimated at KRW 1.4 trillion. When the PE firm asked

for bids for the bank last year, the offers reportedly went as high as five times

30British Venture Capital Association

31Private Equity in Australia, submission by the Australian Private Equity & Venture Capital Association (AVCAL) to the Senate Standing

Committee on Economics, 10 May 2007.

32Private Equity and Carried Interest HR 2834, position paper by the Private Equity Council, 2007.




25/46

the original investment. The sale has been delayed pending resolution of legal

problems. Until the tax authorities introduced a new withholding tax regime on

Korean source income, those gains would have been taxed at a minimal rate.

In Japan, various changes in legislation in recent years provide a mechanism to

tax private equity profits on exit from their investments. The so-called Shinseitax levies a 20 percent tax on sales of investments by funds, a measure that

was prompted in part by the exit of a consortium of private equity firms from the

former Long Term Credit Bank, which the consortium bought out of receivership

in 2000. Renamed Shinsei Bank, the bank was sold in 2005 for more than four

times the original investment, with no local tax payable. Such exits would now

be subject to tax, although US-based funds may not need to pay because the

Japan-US tax treaty gives them protection in certain situations.

Tax leakage is not an issue in Hong Kong and Singapore, where capital gains

are not taxed. In China, however, the newly approved Enterprise Income Tax

Law could lead to the introduction of a 20 percent withholding tax on dividends

paid out of Chinese portfolio companies. Several funds are in the process of

relocating the intermediate holding company from the British Virgin Islands to

Hong Kong, Mauritius or Barbados to mitigate the adverse impact of a dividend

withholding tax. In India, tax exemptions enjoyed by foreign venture capital

investors (FCVIs) outside of specified sectors such as nanotechnology, bio-

technology and IT hardware and software have been withdrawn.

Some form of taxation is probably inevitable in most jurisdictions, but private

equity firms should at least make their voices heard before new taxes are

imposed.





26/46


Tax leakage UK Corporate entities claim that tax relief for shareholder debt given to PE houses is

inequitable. The UK government has responded to this by stating that the Treasury has

no plans to examine the tax-deductible status of interest. The BVCA has denied that there

is special treatment afforded to PE houses, in that tax deductibility of interest on debt isavailable to all UK companies; only arms length interest is tax deductible for the borrower.

US Senate bill S. 1624 aims to tax publicly-traded partnerships such as the recently listed

Blackstone Group at the standard rate of 35 percent corporate tax, instead of the capital

gains tax rate of 15 percent. In the House of Representatives, House bill HR 2834 aims to

raise taxes on the investment gains of private equity funds (regardless of whether they are

listed or unlisted) to 35 percent from the current 15 percent. The Private Equity Council is

lobbying against both bills, arguing among other things that they will hinder entrepreneurial

risk-taking, hold back PE firms from acquiring and enhancing the competitiveness of

underperforming or undervalued companies, and potentially reduce the returns of pension

funds, foundations and university endowments that provide the bulk of private equity

capital.

Austral ia The Senate enquiry into the economic impact of private equity, having regard to

submissions from the Australian Taxation Office as well as industry funds, found that there

is no compelling case for leakage from the tax system but did note that this was an area

for continued close monitoring.

China In China, private equity investments have generally been conducted through offshore

special purpose vehicles (SPVs) to minimise tax liabilities, as well as to allow an exit route

via overseas listing. In September 2006, several Chinese regulatory agencies met to revise

and promulgate the Regulations for the Acquisition of Domestic Enterprises by Foreign

Investors. In relation to PE investors, these regulations created additional barriers due to

the difficulty for PRC founders to create offshore SPVs so as to receive PE investments.

In addition, this new regulation further imposes a one-year listing requirement when PRC

founders are permitted to establish offshore SPVs.

A newly approved Enterprise Income Tax Law proposes to introduce a 20 percent

withholding tax on dividends paid out of Chinese portfolio companies. This will have an

impact on PE fund structures using the Cayman Islands and the British Virgin Islands to

hold the Chinese portfolio companies. Several funds are in the process of restructuring

their investments, seeking to mitigate the adverse impact of dividend withholding tax

by relocating the intermediate holding company from BVI to Hong Kong, Mauritius or

Barbados.

India Until recently, a foreign venture capital investor (FVCI) could invest in any Indian sector

and all streams of income earned by them were tax exempt in India. However, in the

2007 tax budget, the exemption was limited to investments in specified sectors (including

nanotechnology, IT hardware and software, bio-technology, dairy and poultry industries,

pharmaceutical R&D sector, and certain hotel/convention facilities). Income earned from

PE investments made in non-specified sectors will now be taxable at both the PE fund

level and the beneficiary level. But as most PE FVCI investment vehicles are housed in tax

favourable jurisdictions (such as Mauritius or the Cayman Islands), the impact has not been

far-reaching.

The 2007 tax budget also amended Employee Stock Ownership Plan (ESOP) regulations,

whereby ESOPs will now be taxable in India as a fringe benefit payable by the employer

company. This amendment could have an impact on actual profitability (and hence the

valuation) of the company in which PE investments have been made




27/46


tx lkg

(cnn)

India Preference share (other than fully convertible) capital will now need to comply with

External Commercial Borrowing (ECB) guidelines on interest/dividend coupon caps and

end-use fund restrictions on the purchase of capital goods, implementation of new

projects, modernisation or expansion of existing units/business facilities, and overseasdirect investment in joint ventures/wholly owned subsidiaries. It is estimated that about

30 percent of Indian PE investments are structured as preference share capital, and so the

new end-use restrictions could negatively affect PE investors. Funds raised via preference

shares can no longer be used for general corporate purposes, funding of working capital,

repayment of existing loans and acquisition of shares and/or real-estate.33

These guidelines also place restrictions on borrowers raising ECB in order to modulate the

capital inflows through ECB by modifying some aspects of the policy34

India has entered into Double Taxation Avoidance Agreements with several countries. It is

interesting to note that the data published by the Government of India suggests that about

37 percent of total FDI into India made during the last 15 years has been routed through

Mauritius to take advantage of the favourable tax treaty between India and Mauritius.

While tax concessions under the India-Mauritius treaty have been a constant matter of

debate within Indian Revenue circles, a recent ruling of the Apex Court in India upheld

the benefits conferred under this treaty. However, there are indications that the Indian

Revenue may consider amending the India-Mauritius Treaty by including anti-treaty abuse

clauses.

Japan There have been various changes in legislation in recent years aimed to provide a

mechanism to tax gains on exit from private equity investments. The so called Shinsei

tax was introduced, aimed at grouping the holdings of partnerships in order to calculate

thresholds that would determine whether the transactions are taxable in Japan. There have

also been numerous amendments to the M&A rules (both tax and regulatory) allowing

various mergers that were previously not p

Private Equity - Implications for Economic Growth in Asia Pacific

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