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Industry Viewpoint - Fall 2009

What Next for Private Equity? - continued

THE IN-HOUSE COUNSEL

David Spuria

Private equity has traditionally been a lightly regulated industry in the United States. That may be about to change, as Washington looks to overhaul regulation of the financial sector. The implications could be far-reaching for private
equity firms, their investors and the broader economy.

Three reforms are looming on the regulatory landscape. First, there is an effort underway to increase taxes on private equity firms. Under current law, investments made by private equity funds are treated as capital assets, and the general partner’s carried interest share of the net gains is taxed on a ‘pass-through’ basis as capital gain. That translates to a tax rate of 15%. But the Obama Administration is expected to support congressional efforts to strip carried interest of its status as a long-term capital gain, and thus treat it as ordinary income. And that translates to a federal tax closer to 40%. The impact? Less capital for private equity firms to deploy and do what they do best: buy companies, restructure them and sell them – a process that has generated jobs and income. 

The second regulatory reform proposal that’s looming would change the legal status of private equity firms in ways that would alter how they operate and what they disclose to the public. One proposal in particular would alter how private equity firms are treated by the Investment Advisors Act of 1940. This law requires all investment advisors to register with the U.S. Securities and Exchange Commission, which creates significant compliance obligations related to disclosure, bookkeeping and audits. 

Today, advisors with fewer than 15 clients are exempt from the law – and many private equity firms have stayed below the 15-client threshold. But as part of the financial regulatory reform package, that exemption could be scrapped. The Obama Administration has also proposed legislation that would require any entity with at least $30 million under management to register with the SEC as an investment advisor (this would include virtually every private equity firm in existence). If enacted, these changes would bring higher compliance costs for private equity firms, as they would be required to disclose borrowing, off balance sheet exposures, counterparty credit risk exposures, and trading and investment positions. 

The third regulatory proposal that has private equity firms concerned is one that would place new restrictions on their contacts with their largest class of investors: state pension funds.  The proposal has bubbled up in the aftermath of a controversy earlier this year involving Quadrangle, a leading private equity firm. News reports indicated that Quadrangle paid large sums to ‘placement agents’ to help the firm gain access to officials at state pension funds. The Carlyle Group was also ensnared, and in May it announced it would pay $20 million as part of its settlement with the State of New York. 

The use of placement agents has been common throughout the industry.  But now there are moves afoot to prohibit any payments to such agents, with the SEC proposing a rule to this effect in mid-September. This has private equity firms worried, given the outsized role that capital from pension funds plays in the private equity industry. Any interference with that pipeline would inject further instability into the industry, which is still reeling from the broader market turmoil of the past two years.

Intensifying the stress on private equity firms is one non-regulatory issue: heightened tension between fund managers and their limited partners.  Many firms are seeing anemic returns, and because there’s so little deal activity underway, these firms are not making distributions to the LPs. Yet they are still collecting management fees – typically 2% of assets under management. This is leading some LPs to call for fund managers to reduce or suspend their fees. Some LPs are suing fund managers, and there are even instances of LPs suing each other, when capital calls aren’t being met.

Some of these issues will dissipate as the economy strengthens, and new business niches will emerge. And the private equity industry’s success in helping to create jobs, and wealth, will help to deflect some of the regulatory onslaught. But one thing is clear: the future is not looking as bright as the past. 

David Spuria is a Partner and General Counsel at Southlake Equity Group, a private equity firm, and a former general counsel at Texas Pacific Group.