Chancellor’s closing of loophole needs targeting to avoid harming UK innovation, says William Cullerne Bown
Like most members of the Labour Party, I am intensely relaxed about private equity firms paying more tax. So the idea that Rachel Reeves will squeeze them in the budget raises no problem of principle.
The trouble is the method the chancellor seems to have in mind. She is reportedly focused on raising the rate of tax on the payments that fund managers take out of companies’ profits, known as carried interest.
Presently, this is treated as capital gains and taxed at up to 28 per cent. Labour’s manifesto called this a loophole: after the budget on 30 October, carried interest might be treated as income. At the top rate, this is taxed at 45 per cent plus national insurance, although reports suggest the chancellor is unlikely to go this high.
Fine. If the private equity crowd don’t like it, they are welcome to try their luck in Paris or Dublin. However, unless any change is properly targeted, it will also catch venture capital firms, and we really don’t want to lose them.
Takers and makers
The difference between PE and VC can seem vague. And indeed, they share some characteristics. In both cases, managers (general partners) take money from investors (limited partners) and invest it in firms in which they take an active role in managing.
In both cases, limited partners are paid partly in carried interest, which depends on the ultimate profitability of their investments, and partly as a percentage of the amount of funds under management. However, the similarities stop there. Here’s a list of important differences:
- PEs invest in companies across all industries, while VCs focus largely on tech.
- PEs mostly acquire a controlling interest in mature companies, while VCs acquire a minority stake in younger companies. PEs avoid market and technology risk, in other words, while VCs embrace it.
- PEs expect to sell up and exit their firms entirely, while VCs expect to stay with a firm even as their shareholding is diluted.
- PEs often focus on operational reforms, such as staff cuts, to improve profitability. This is because their acquisitions are usually funded partly by bank debt, which needs to be paid back out of operating cash flow. By contrast, VCs typically build value by focusing on growing revenue.
- PEs have skills in cost management and deal-making and tend to attract accountants and investment bankers. By contrast, VCs must be experts in products or technology, with a strong market awareness. VC firms tend to recruit engineers, product managers, consultants, successful entrepreneurs and MBAs with a science or technology background.
It is not easy for a deep tech startup to succeed. The journey from a potentially good idea to convening a team, making the entity real, finding an operating location that’s flexible and close to other startups and getting early funding is daunting.
This involves innovating, finding a fit between a product and a market, building conviction inside and outside the company, convening the additional talent needed to execute the vision and finding the capabilities above and below the kernel innovation to properly address the market opportunity. Innovation in personal computers, for example, typically depends on chips below and software above.
This often needs the strong encouragement and insights of others who have done something similar before (and sometimes an honest appraisal of when an idea won’t work). VCs provide all this support; PEs don’t.
Venture, not vulture
It is obvious, then, that VC firms are vital to any kind of tech renaissance in the UK, while PE firms are not. PEs claim they make the firms they invest in more efficient, but their role at the centre of debacles such as Thames Water makes these claims ring hollow.
In his recent book The Unaccountability Machine, business writer Dan Davies makes the case that PE has transformed Anglo-Saxon capitalism itself, destroying value while enriching its partners. Certainly, the UK is very familiar with the endemic short-termism that PE has fostered.
Any increase in tax on PE therefore needs to be limited to PE. A simple way to do that would be for the government to compile a list of VC firms and exempt them. As the bullet points above suggest, it’s not hard to distinguish between the two.
William Cullerne Bown is the founder of Research Professional and a former adviser to Labour’s science team.
Correction 29/10 – The definitions of limited and general partners were originally mixed up; this has been corrected.
