The past few years have seen a remarkable broadening and deepening of European financial markets. European private equity has ridden on the crest of this wave. The asset class grew four-fold in the space of a decade. A strong European private equity industry offers significant benefits to the European economy. It provides an alternative source of funding for capital-rationed companies. It can re-energise flagging companies. It injects better management when better management is required. And it provides an often appropriate route for family businesses to realise the value they have built up in an enterprise often over several generations or more. It is also an investment opportunity for institutional and expert investors capable of assuming the associated risks.
I believe that private equity has now established itself as a permanent and welcome fixture in the European financial landscape. But private equity, like all other areas of financial and business life, now faces a period of uncertainty.
Recent developments have revealed that some of our recent financial growth was built on shaky foundations. It was 'doped' on cheap credit. While due diligence undertaken on investment in private equity entities was generally thorough and professional, (unlike in some other asset classes), some issuers, investors and supervisors stopped asking sufficiently hard questions about significantly rising amounts of leverage in the investments and the likely robustness of the capital structures for much more challenging times. This, of course, is not unusual in financial markets. We are, however, now traversing a period of considerable turbulence as some of the excesses of recent years are corrected.
Will Rogers, the great cowboy humorist, said that 'things will get better – despite our best efforts to improve them'. That observation is particularly apposite now. There is a real risk that well-intentioned desires to address market failures translate into rushed, clumsy and counterproductive regulation. Many of the frailties that have been exposed deserve serious consideration and a proportionate response. But actions should not be taken in the heat of the moment. Remember Sarbanes-Oxley.
Our first priority is to stabilise financial markets and restore them to some semblance of normal working order. Prudential and monetary authorities are pulling out all the stops here. In Europe, authorities are working closely together as this difficult process unfolds. With careful judgement, timely and well executed interventions by the monetary and prudential authorities, we will get through this.
However, it is already clear that the days of easy and cheap credit are gone for the foreseeable future. Lending institutions will be heavily focussed on rebuilding their balance sheets. They will be risk-averse. This environment is likely to prove challenging for anybody who needs to borrow funds. This includes private equity funds.
You don't need me to tell you this. You are at the sharp end of this process. The reports that I have seen suggest that bank lending to the private equity industry in the first 3 quarters of 2008 was one-sixth the amount in the same period in 2007. Deals will become less leveraged but the prices at which private equity firms will be able to acquire assets should be a good deal more attractive. I am confident that European private equity has a bright, long-term future and a meaningful and valuable role in the further development and restructuring of Europe's economies.
As the share of the productive economy which is partly or fully owned by private equity funds increases, it is inevitable that there be greater public scrutiny of your business. According to a recent estimate, over 850'000 Europeans were employed in PE portfolio companies. The political reality is that this makes it difficult for the private equity industry to fly under the political radar. Your industry will have to square up to its critics. Those critics are likely to become more vocal and more numerous if a significant number of heavily leveraged portfolio companies struggle to meet interest payments or obtain refinancing.
You have started to engage with your critics at a national level in some Member States. Most notably through the Walker report in the UK. At European level, EVCA has been proactive in promulgating codes of best practice.
Now the political debate has moved to the European stage. The Rasmussen and Lehne reports issued by the European Parliament mark the opening of a new chapter in the EU level debate on private equity and hedge funds.
These reports call for a European overlay to regulation of hedge funds and private equity. In particular, they call on the Commission to come forward with legislation extending public oversight and capital requirements to hedge funds and private equity by the end of the year. The reports are dismissive of self-regulation as an alternative to regulatory intervention.
The Parliament has flagged at least six clear demands in relation to private equity. Their demands include the application of capital requirements regulations, increased disclosure and monitoring, demands on compensation structures, limits on leverage, information and consultation of workers, and criticisms of alleged asset stripping and capital depletion.
If followed through, the Parliaments' recommendations would involve a significant change in the operating environment for private equity. I emphasise that these reports do not automatically herald new EU legislation. It remains the prerogative of the European Commission to determine whether legislative action is needed and to come forward with the relevant proposals. The Commission needs to study these reports in detail and evaluate the justification for action before reaching any conclusions.
The European Parliament has given a strong signal of intent. The reports command cross-party support and carry strong political weight. It is in this context that the Commission must now form a judgement on these issues. In the Parliament's plenary hearing, I expressed the view that these reports stem from real concerns about the build up of leverage in the financial system, including in private equity funds, and how this may distort the functioning of the real economy. The reports correctly identify some of the failings that have contributed to the financial turmoil.
I have explained what the Commission and Member States are doing to correct a number of the failings we have seen in the financial markets. I also restated my longstanding conviction: all known regulatory concerns relating to the impact of hedge funds and private equity on the financial and economic system are already addressed – either in European or national legislation. The concerns relating to private equity stem from the perceived impact of this business on the social economy – in particular, implications for stakeholders in buy-out companies. I am also in agreement with the report's call for obligations on information and consultation of workers – current EU legal provisions apply to private equity takeovers as to any other. The demand that workforces are treated sensitively and carefully about major changes in the life of their company is perfectly legitimate.
I will now be looking more carefully at EP demands in order to assess the justification for their demands and to respond in detail in the coming months. We do need to respond to the concerns of our democratically elected Parliaments. But I want to do it in a way that does not detract from the major contribution that the private equity industry has made – and will continue to make – to the development of the European economy. The industry's proactivity in restructuring businesses to under pin their competitiveness is a positive in the long term that doesn't destroy sustainable employment – it protects it. Protectionism or excessive restrictions on restructuring could threaten sustainable employment, living standards and growth because it may get in the way of enabling firms to adapt to the ever-changing competitive landscape. Therefore, we need to look at these issues with care.
In relation to leverage, I would be the first to acknowledge and recognise that at the top of every economic cycle leverage rises to levels that are not prudent. In this particular cycle, financial innovation facilitated that process to an extent never heretofore experienced. We are and will continue to examine all aspects of our regulatory framework to see where it fell down on the job. We must be honest and open about this: There must be no sacred cows. But it seems to me that one of the most appropriate ways of addressing shortcomings in this area is via a comprehensive assessment of all aspects of our current capital requirements framework. We have proposed some amendments to this to date but we are likely in due course to have to propose more. But I have to say, it would take some persuading to convince me that we should legislate for leverage ceilings per se on private equity companies. Why? Because the risk characteristics of every private equity business are different and therefore the capacity of different private equity companies to carry varying levels of leverage is different : A business's capacity to leverage is a function of many things: the business's cyclicality, its market share, the flexibility of its cost-base to adapt to changing market circumstances, its capacity and track record on innovation, the calibre and depth of its management, the diversity of its earnings stream. These are just a few of the factors that need to be considered and that's why a fixed percentage cap on leverage would not, in my view, be appropriate. However, there is much in the report with which I find myself in agreement. Concerns about compensation are legitimate and I welcome the attention devoted by the Rasmussen and Lehne Reports to this topic. As in the case of the banking industry, we need to see remuneration structures much more closely aligned to long-term rather than short-term performance.
Ladies and gentlemen,
Let me conclude.
The opening speech at a conference should boost morale. I am aware that this has not been much of a pep-talk. This is a sign of the difficult times in which we are living.
Let me end on a more optimistic note.
I believe that we will emerge from this difficult period – battered and bruised. But able to bounce back quickly if we avoid fiscal and regulatory over-reaction. I believe that many of the changes in European financial markets will deliver an enduring and positive legacy. I believe that a strong private equity industry will become an established and integral part of the European economic and social fabric.
However, we are about to engage in a debate on the terms on which private equity finds a home in Europe. It is important this debate be based on a proper understanding of private equity business. And on an objective appraisal of its impact on the European economy. This is the perspective that I will bring to bear in this debate.
