My speech to the London Business School, 8th March 2007

  1. It is an honour to be invited here today to speak at the London Business School. I want to start by thanking your acting Dean – Sir Andrew Likierman – for offering me this platform today.
  2. It is appropriate that Sir Andrew should be chairing today’s event as we approach the 10-year anniversary of this Government.
  3. Because Sir Andrew was there in 1997 when we first arrived at the Treasury – a member of the Treasury management board and head of the Government Accountancy Service.
  4. Indeed it was Sir Andrew that I spoke to during the general election campaign – with, I should add, the permission of the then Permanent Secretary, Sir Terry Burns – to discuss with him our plans for a National Asset Register and departmental incentives to release surplus land and property – and to confirm how this fitted into the wider move to resource accounting and budgeting that Sir Andrew was overseeing.
  5. And Sir Andrew also advised us on the details of the move to Bank of England independence in the first few days of this Government – the first of a number of reforms to entrench a more long-term approach to British economic policy.
  6. So today I want to look back on some of those reforms – through the lens of long-termism – a lens which, as I will argue, is also the right way to view recent debates in relation to different models of ownership of British companies.

A platform of long-term stability

  1. You would be forgiven for thinking Bank of England independence was the first economic policy decision of the new Government.
  2. But there was a prior announcement in the Chancellor’s statement of 6th May 1997 – the decision to restore to the heart of British economy policy the objectives first set out in 1944 of high and stable levels of growth and employment.
  3. And the decision to make the Bank independent was justified that morning on the basis that these long-term goals could only be achieved based on a platform of long-term stability.
  4. Our aim was to break free of the short-term tinkering and behind-the-scenes political wrangling, which had bedevilled British economic policy for decades – and led consistently to high inflationary expectations in financial markets, stubbornly high wage settlements and damagingly high hurdle rates of return by companies, as the CBI showed in its 1994 survey.
  5. Our judgement was that the flexibility that monetary policymakers needed to respond to economic developments could only be achieved within a framework which could command long-term credibility and trust – not just from financial markets but also from investors, employers and employees alike.
  6. Monetary policy was not the only place where reforms were needed to establish long-term credibility and deliver high and stable levels of growth and employment for the long-term. The new fiscal framework, enshrined in legislation by the code for fiscal stability, set down two strict fiscal rules which have now also been in place for almost a decade: the golden rule and the sustainable investment rule.
  7. These fiscal rules, alongside the greater requirements for independent audit and transparency in the fiscal code, enabled us both to get our national debt down in the late 1990s and to ensure fiscal policy supported monetary policy during the difficult years for the global economy in the early part of this decade.
  8. And the results are there to see. Long-term interest rates, wage inflation and consumer inflation expectations have all fallen markedly. Britain has avoided recession while America, France, Germany and Japan all had consecutive quarters of falling output. And this stability, alongside the pro-active new employment policy of the New Deal and reforms to make our labour markets both more flexible and fairer, has allowed employment to reach a post-war high.
  9. Of course, our commitment to stability is constantly being tested: look at the impact of high oil and food prices on inflation in recent months and the continued need for discipline in wage bargaining. And the market turbulence of recent weeks demands that policymakers are continuously vigilant to potential downside risks and continue to take a forward-looking approach to policy.
  10. But it is low inflation, low national debt and the long-term credibility of our new monetary and fiscal frameworks that allow UK policymakers the flexibility to respond, when necessary, to short-term pressures without sacrificing our long-term goals.

Productivity and economic change

  1. So our reforms to tackle short-termism in the British economy, and reforms to deliver high and stable levels of growth and employment, began with macroeconomic and employment policy. But they have gone much wider into tax and industrial policy too.
  2. For decades the UK’s productivity performance has lagged behind that of many industrialised economies. And while the macroeconomic instability of the past had contributed to these productivity gaps, the problem of short-termism in the British economy ran deeper – and goes to the heart of how a modern and dynamic economy works.
  3. The fact is that most productivity improvement does not come from weak firms becoming strong. It comes from innovative and profitable firms expanding, new firms entering and the weak going out of business. It is this process of competition in which lies the very essence of a dynamic economy. And in such dynamism lies not only the strength and resilience to adapt to survive, but the flexibility to respond to new markets and new opportunities – driving the economy into a cycle of increasing productivity.
  4. So a dynamic and successful economy depends on two key characteristics. First, competition so that firms experience pressure to adapt and change. And second, companies succeeding through making the right long-term investments in the areas which are critical to competitive advantage – with government playing a vital role in promoting competition, supporting companies to make long-term investment decisions and equipping employees with the skills and opportunities they need to prosper and move from job to job.
  5. On both these dimensions, the British economy in 1997 was lagging behind. I do not discount the importance of aspects of the pre-1997 reforms in improving the flexibility of the UK economy, in particular the Big Bang which revolutionised the City. But on competition policy, the UK was significantly behind the rest of the world. Our law was ineffective in punishing cartels; there was little effective control over the unilateral behaviour of firms with significant market power; and it was very different from EC law, with which firms also had to comply.
  6. And our levels of long-term investment were also low. In 1997, UK business investment in R&D was on a declining trend as a proportion of GDP, and was substantially lower than France, Germany, America, and Japan. And while the UK had a reputation for excellent research, there was little interaction between businesses and the research base to turn new knowledge into innovative products and services. And our levels of adult skills were consistently worse than other advanced industrial economies.
  7. Since 1997, our wider approach to industrial and economic policy has been to understand and tackle barriers to long-term investment and dynamism. Our approach has been shaped around what we have called the five “drivers” of productivity growth: competition; enterprise; innovation; skills; and investment.
  8. Let me briefly take each in turn.
  9. First, the Government has radically overhauled Britain’s competition regime so that it is now rated among the world’s best – making the decisions of the OFT and Competition Commission independent of Ministers, introducing market investigations, encouraging private actions, and ensuring cartels face the possibility, for the first time, of criminal penalties.
  10. Second, the Government has supported enterprise so that small and high-potential businesses achieve their growth aspirations: cutting the effective rate of capital gains tax on qualifying business assets from 40 per cent to 10 per cent; addressing the equity and finance gap often faced by new and growing businesses, with interventions such as the Enterprise Capital Fund, improvements to the Small Firms Loan Guarantee and strengthening the Enterprise Investment Scheme; and encouraging more engagement by venture capitalists and business angels to invest in and guide starts-ups, or to turn around business performance.
  11. Third we have invested heavily in science and innovation, more than doubling funding for science and introducing new tax credits for research and development investment by companies.
  12. And fourth, as Lord Leitch set out in his review last year, while we have achieved much in raising standards in education and skills, there is still a long way to go to close skills gaps in the adult workforce. Leitch is right to call for a new long-term partnership between Government, employers and individuals to raise our game.
  13. So across these first four drivers – competition, enterprise, innovation and skills – we have seen progress.
  14. It is the fifth driver, investment, that I want particularly to focus on today – and where the issue of long-termism arises most acutely.
  15. A decade of stability has undoubtedly helped improve the environment for UK businesses to invest – and since 1997 we have seen the fastest growth in business investment in any nine-year period since data began in the 1960s. We have also reformed the tax system to support long-term investment, matching CGT reform with the R&D tax credit. And we are responding to business concerns about regulations with all regulators now introducing a risk-based approach as set out by Philip Hampton’s report and annual simplification plans to outline what government departments are doing to reduce burdens and remove old laws.

The Investment Chain

  1. But the environment which determines the climate for investment is not simply a function of macroeconomics, tax, or regulation, vital though these all are. Investment decisions are also determined by a chain of relationships – we call this the “investment chain” – linking the owners of capital, through savings products or pensions, to institutional investors, to fund managers to the boards of companies, themselves accountable to shareholders.
  2. The development of this sophisticated investment chain – the roots of which lie in the financial structures developed to finance the industrial revolution here in Britain – is a remarkable achievement. The efficient functioning of the investment chain is critical to the effective allocation of capital, and therefore to the UK’s productivity and long-term economic performance.
  3. But despite the sophistication of this investment chain – and despite the UK having some of the most open, liquid and advanced capital markets in the world of which we are rightly proud – the UK’s history when we came into office was one of relatively poor rates of capital investment.
  4. Weaknesses in the functioning of the investment chain including a failure to correct potential short-term biases in investment decision-making were in part responsible – and this was not a new diagnosis in 1997. The strong view put to us by business in the period before 1997 was the need for a much clearer focus on long-term investment decision-making. And the previous efforts of Cadbury, Hampel and Greenbury – as well as the then Financial Secretary, Stephen Dorrell – show how strong and widespread was the desire to confront these issues.
  5. Since 1997, we have set out systematically to review each link in the investment chain, and have conducted a number of major reviews – by Paul Myners, Ron Sandler, Sir Derek Higgs and Sir Derek Morris – to look different aspects of the workings of the chain. These have identified a number of important issues.
  6. First, a lack of effective pressure on companies and institutional investors from consumers of financial saving and investment products to pursue their long-term best interests. This arises partly from a lack of financial skills on the part of savers, partly from a lack of transparency in certain products; but also from historic weaknesses in the role and expertise of those whose role it is to protect customers’ interests – especially pension fund trustees.
  7. Second, the sheer complexity of the chain and real questions over whether those acting at each stage of the chain have the right incentives and expertise to ensure that the long-term interests of savers and pension fund beneficiaries are effectively represented.
  8. Third, concerns around the governance of public companies, including the need to strengthen the oversight of non-executive directors and their accountability to shareholders.
  9. Fourth, Myners pointed to the tension inherent in money being invested for the very long term – in pension or life funds – but typically managed by fund managers judged on the basis of quarterly performance league-tables and the risk of unnecessary short-termism as a result.
  10. A great deal of change in some areas of the investment chain has been achieved – partly as a result of market developments and conditions, partly as a result of regulation and self-regulation following these reviews:
  • In response to Sandler, we have worked with the FSA to develop a suite of simpler and more transparent longer-term investment products, to increase the focus on investment performance, while FSA rules have enhanced disclosure of the costs of advice.
  • To improve the quality of trustees’ investment decision-making and their interactions with advisers, we endorsed the comply-or-explain “Myners principles”, a framework for effective trusteeship and investment decision-making. We also changed the Pension Act so trustees are now required by law to have an understanding of legal, funding and investment issues so that they can perform effectively.
  • In response to Myners, the Institutional Shareholders Committee has developed a voluntary code for shareholder engagement, which has raised levels of engagement. More recently, after reviewing the code the ISC has developed an action plan to further lift the quality and scope of engagement.
  • Meanwhile, the FSA and the industry have produced a package of rules and voluntary disclosure arrangements which have improved the disclosure of brokerage and soft commission arrangements to institutional investors.
  • In the market for investment consulting advice, the Government is taking forward the Morris recommendations for improving pension funds’ assessment of advisors and their advice, and their market testing and contracting for such advisory services.
  • And in relation to public companies, we have made great strides, through a revised Combined Code which incorporates Derek Higgs’s recommendations. Standards of corporate governance in quoted companies in the UK have improved markedly over the last two decades. I think most observers and practitioners would now say that the UK’s corporate governance regime matches the best in the world, striking a careful balance in combining high standards with flexibility, which is rightly the envy of others.
  • Finally, we have had a continuing programme, undertaken in conjunction with the FSA and FRC, spanning the length of the investment chain to improve levels of transparency in accounting, auditing and reporting, and thus to facilitate proper accountability.
  1. These changes represent real progress – but more can certainly be done, for example to further strengthen shareholder engagement and the effectiveness of trustee decision-making. So we fully support the current review of the Myners principles by the National Association of Pensions Funds, to determine whether the gaps that we identified in 2004 have closed. This is an area where I believe employers and trade unions must make an important contribution to promoting their members’ interests by actively participating in the pension fund governance debate and by promoting the role of active trustees.
  2. A further area highlighted by Myners I want to mention particularly is the need for greater accountability for the exercise of voting rights attached to shares – a crucial element in an effective engagement strategy. Again, some progress has been made, but there is clearly a long way to go. We have taken a reserve power in the recent Companies Act to enable us to require disclosure, but our preference is for voluntary, industry-led approach, with an effective ‘comply or explain’ code of practice based on a clear set of principles.
  3. I met the Institutional Shareholders Committee this week to discuss progress with a voluntary approach and am pleased to say that the ISC have agreed that we should have an industry comply or explain code up and running by the Summer, following a period of consultation. The Treasury will cooperate fully with the ISC in this and we will encourage them to involve a wide range of interested parties in the development of this code.
  4. So in this area too, we look forward to further progress.

The debate about private equity

  1. What our work on the investment chain has not suggested, however, is that – from the point of view of the health of the British economy – any particular form of ownership is inherently to be preferred over any other. On the contrary, whatever the form of ownership – the real issue for the investors whose money is at stake, for the health of the company concerned, for the workers whose jobs depend on the company’s success, and ultimately for the economy as a whole, is how effectively that ownership is exercised, in promoting the long-term creation of value, investment and employment.
  2. Which takes me to the debates of recent weeks about the role of private equity in the British economy. It is in this context of effective ownership to meet these long-term goals that we should view private equity.
  3. You will know that, starting from some high profile specific cases, wider fears have been raised that private equity firms can be particularly short-termist – and therefore impact negatively on jobs and investment in the companies in which they take an interest.
  4. For some, the fear is that private equity is simply based on financial engineering – rearranging a company’s balance sheet and potentially taking on excessive debt without transforming the underlying commercial reality of the business. For others, the fear is that private equity relies on “hollowing businesses out”, dressing companies up for sale, making short-term earnings look good at the expense of long-term investment in capital, skills or R&D.
  5. But, as I have argued, we know too that private equity can be a positive form of governance and help to reinvigorate a company and strengthen its long-term prospects. This is achieved mainly through changing management incentives, improving productivity and making more efficient long-term investment decisions.
  6. Let me start by with a few words of caution:
  • First it is important to keep this in perspective – private equity remains a relatively small, although growing, part of our economy;
  • Second, this is not a subject about which it is easy to generalise. Transactions vary very widely in their nature and impact – and the picture is also constantly changing;
  • And third, although this is proving a rich area for more academic study, the evidence base remains weak and the results that emerge are inevitably to some extent conflicting and mixed.
  1. Nevertheless, some facts are reasonably clear.
  2. First, while private equity does play a relatively small role in our economy, it is significant and growing. Private equity investment in UK firms amounted to approximately £7 billion in 2005, an increase of almost £4 billion on the rate in 1997. And it is this growth that has heightened interest in the sector.
  3. Second, there is a reasonable consensus that private equity investment has – on average – a positive impact on productivity. For example one study of over 35,000 UK manufacturing firms found a substantial increase – of over 90% – in productivity for those firms which received private equity investment.
  4. Third, private equity can also have an impact on employment – though this may be more complex than it first appears. A study by Nottingham University shows that whilst employment typically fell in the first year following a leveraged buy-out, it rose strongly thereafter with employment levels 26 per cent higher after five years.
  5. Fourth, evidence suggests that private equity firms do, in fact, tend to hold onto companies for the length of time it takes to add the value they can to the business before selling on. And on average this is around three years – 20 per cent longer than the average length of time institutional investors hold shares, suggesting that private equity, without the short-term pressure of quarterly reporting, may, in fact, be able to take a longer-term view.
  6. Fifth, of course, as with all investments, there are ‘bad’ ones as well as ‘good’ ones. Particular private equity transactions can and do occur that add no value, or conceivably even destroy it. But the fear that this is the norm is very difficult to square with the aggregate evidence about the sector’s impact. The conclusion I draw from the evidence, taken overall, is that private equity can play an important role in our economy, and especially in exposing companies to dynamic competitive challenge.
  7. So what should be the attitude of government?
  8. Private equity, like any other form of ownership, has good and bad aspects – and it has features of both long-termism and short-termism. But the evidence does not suggest that Government has any intrinsic reason either to “favour” private equity or to do the opposite.
  9. Our aim should be to support economic dynamism and long-term investment and job creation. And the Government’s objectives in the field of private equity should be no different from its objectives in relation to any other form of ownership: to promote an environment of long-term, sustainable business success, underpinned by a strong culture of clear disclosure to, and engagement with, underlying investors. This is the way to ensure that “good” long-term investment propositions prosper.
  10. One potential advantage of private equity is that the long and complex chain of ownership and communication does not exist, giving the owners of capital much clearer direction of the businesses which they are financing. The shorter chain, the clearer targets and accountabilities, and the stronger incentives which can be put in place, all have the potential to provide higher levels of efficiency. These advantages will in some cases outweigh the benefits of public market ownership, such as access to large amounts of long-term risk capital and the ability to attract top management talent, although investors need to be vigilant, too, about any potential for misalignment of incentives within the private equity model. Moreover, it is harder for private equity to do this if it fails to provide the information needed to judge its contribution to a modern economy, or if there is any obscurity in its information flows to its investors.
  11. A number of important issues relating to private equity have been highlighted in recent weeks and I would like to comment on each of them in turn. They relate particularly to regulation, disclosure, and tax.
  12. First, regulation.
  13. With the private equity market becoming an increasingly important component of UK and international capital markets it is right to consider whether there is currently an appropriate level of regulatory engagement with the sector.
  14. The FSA regulates the private equity market activity through, for example, the authorisation of firms conducting regulated activities such as investment management. It manages potential systemic risks via the potential channels of contagion through effective supervision of the institutions which lend to private equity, including specifically monitoring exposures to leveraged buy-outs. The FSA issued a discussion paper in November, identifying potential risks the sector may pose such as excessive leverage or unclear ownership of economic risk. As the report stresses, these are risks that also arise in other types of markets with other types of institutions and the FSA concludes that its approach to the risks is both risk-based and proportionate. Whilst confident that the current arrangements are robust, the FSA has also identified a number of potential options to improve further the efficiency and effectiveness of their regulatory approach, on which they are seeking comments through their consultation exercise.
  15. Also, in the field of pensions regulation, private equity firms share the same responsibilities as other companies who have made pension commitments to their staff. We created The Pensions Regulator in April 2005 to ensure that, in common with companies with other forms of ownership, private equity firms act responsibly to properly fund work-based pension schemes over time, including following any company restructuring. We also set up the Pension Protection Fund in April 2005 to protect pension scheme members’ benefits should the sponsoring employer become insolvent when the scheme is in deficit. All defined benefit pension schemes which could qualify for help must pay a levy to ensure their scheme members are protected should the worst happen.67. Second, disclosure.
  16. Large private equity-owned companies are not required to provide operating and performance data of the same quality and depth as listed companies. And what they are required to publish can be published much later.
  17. This difference is logical – it is rooted in the distinction between keeping a small group of private shareholders informed, and reporting to markets as a whole. Nevertheless, large businesses, and particularly those in the public eye, have a wider responsibility to engage with the community in which they operate and to meet the legitimate interests of stakeholders, both employees and the wider public, in how their operations affect them. As the private equity sector has grown and as some major companies have moved from transparent public to opaque private markets, this need has become more acute.
  18. The recently introduced Business Review – which is substantially improving the depth and forward orientation of narrative reporting requirements – is an important step to bridging this gap. However, as the debate has shown, additional disclosures would clearly improve understanding of, and confidence in, private equity’s stewardship of important UK businesses. It would also assist the private equity in addressing fears that there is something inherently “short-term”, or value-destructive about the industry’s approach.
  19. There has also been a lack of clear, consistent and complete information on the valuation and performance of private equity investments, and a consequent gap in the ability of institutional investors in handling the governance, monitoring and engagement issues raised by this new investment opportunity. This is not good either for the industry itself or for investors.
  20. Substantial improvements have recently been made in best practice in this area. However, there is an opportunity to take this further through the development of a stronger body of best practice in valuation and disclosure to investors – which in turn has the potential to drive further improvements in the investment and monitoring decisions of institutional investors in private equity.
  21. So we welcome the announcement last week that Sir David Walker will chair an independent working party to develop a voluntary comply-or-explain code to improve the private equity industry’s transparency and level of disclosures for large companies in these areas. This initiative has received wide support across the industry, demonstrating a commitment to make this happen, and also a desire to meet the legitimate concerns of interested parties.
  22. By increasing the quality and timeliness of disclosures, the code has the potential both to improve the engagement of the private equity industry with stakeholders, and improve its performance. We will watch developments very closely.
  23. And third, tax.
  24. The Government has actively promoted a number of tax measures which have been particularly relevant to investment in early-stage firms. These include the Enterprise Investment Scheme, R&D tax credits payable for small businesses and capital gains tax taper relief. But the question has been raised in recent weeks as to whether our tax system gives an unfair advantage to private equity over other forms of ownership – in particular as a result of the tax-deductibility of interest.
  25. There is, of course, nothing specific to private equity in the tax-deductibility of interest. Any kind of company can claim it, and most quoted companies do. It is also the international norm – that interest is in general treated as a business expense and deductible from taxable profits for companies in any form of ownership. We have no plans to review this principle.
  26. However, concerns have been raised with the Treasury that something further may in some cases be occurring – in particular, that ‘shareholder debt’ is replacing the equity element in highly leveraged private equity funding arrangements. This shareholder debt is a form of risk-bearing equity that is treated as debt for tax purposes, giving these arrangements a tax advantage that is inconsistent with the principle that interest is a business expense. Tax legislation already distinguishes between debt and equity and contains detailed provisions to ensure that equity is not disguised as debt to obtain a tax deduction. Rules have changed from time to time over many years to adapt to the development of new financial instruments and forms of debt, most recently changes in 2005 to enable the transfer pricing rules to be applied more readily to the issue of shareholder debt.
  27. Today, I can announce that the Government will review the current rules that apply to the use of shareholder debt where it replaces the equity element in highly leveraged deals in the light of market developments, to ensure that existing rules are working as intended and report back by the Pre-Budget Report. This is consistent with the Government’s focus on ensuring that commercial decisions are taken on a level playing field, take a long-term view and maximise opportunities for employment and investment.

Conclusion

  1. So, I end where I started – the Government’s central economic objective of high and stable levels of growth and employment and the importance of encouraging the long-term investment and engagement to get there.
  2. We have made great strides in the last decade in bringing about a stable economic environment that supports long-term decision-making to promote investment, productivity growth and job creation.
  3. We have taken important steps to make our economy more dynamic and competitive – and globalisation has also driven us further down that road.
  4. At the same time. Government also has an increasingly important role to play in supporting people affected by economic change and redundancy. Currently the Rapid Response Service helps affected employees find new jobs, helping to identify transferable skills, and providing additional training where people lack the skills they need to find work again. And working closely with the Department of Work and Pensions, we are looking at the arrangements for rapid employment and skills response as part of our on-going Sub-National Review of Economic Development.
  5. I know that productivity growth in the private sector depends not on Government but on countless decisions by individual businesses, especially relating to investment.
  6. But the Government does have an interest and a responsibility to develop a better understanding of the “investment chain” that profoundly influences these decisions and whose efficient working is vital to the economy, to companies, and to investors and savers.
  7. This is the lens through which I think it is right to interpret recent controversies about private equity.
  8. The industry’s announcements last week represent an important development. I have set out some further steps today. We will be watching developments with a very close interest. And it is whether these changes support our long-term goal of delivering high and stable levels of growth and employment that their – and our – success will be judged.

Thank you.

Posted November 26th, 2015 by admin