Private Equity’s New Rules
Private equity always has been significantly private, afforded more freedom and flexibility than other, more tightly regulated parts of the investment world. But now, after the economic crisis, that’s about to change, thanks to sweeping financial regulation in the U.S. and pending reform in Europe.
Under new U.S. rules, most private equity firms will have to register with the Securities and Exchange Commission, and they will be required to set compliance policies for handling potential conflicts in business relationships and employee stock trades; hire chief compliance officers; disclose more information about investor agreements, prospectuses for raising money, and portfolio company valuations; and submit to regular (and sometimes lengthy) SEC inspections. While new European rules have yet to be finalized, their impact could be even more far-reaching. The panelists at a recent FTI-sponsored discussion on the topic were Heather Cruz, partner, Investment Management, Skadden, Arps, Slate, Meagher & Flom; Patrick Steel, senior managing director and co-head of the financial sponsors group, FBR Capital Markets; Kenneth M. Socha, senior managing director, Perseus; Travis Larson, senior vice president, FD, the strategic communications segment of FTI Consulting; and John Gabbert, CEO, PitchBook Data Inc.
Among the 2,300 pages or so of U.S. legislation, what elements of the Dodd-Frank Wall Street Reform and Consumer Protection Act are most important for private equity?
CRUZ: Private equity fund sponsors that are part of banking entities should be concerned about the Volcker Rule, which curtails banks’ ability to sponsor private equity and hedge funds. Those banks will generally be prohibited from sponsoring and investing in private equity funds and will have to divest, although the act provides certain carve-outs for qualifying fund sponsorship and investment in seed capital, provided all such investments do not exceed certain aggregate limits as a percentage of Tier 1 capital. Others should be readying themselves for registration with the SEC, which will entail developing a host of compliance policies and procedures. In addition, a Financial Stability Oversight Council will have the power to determine whether a fund manager is a “systemically important nonbank financial entity.” If the council thinks a fund’s failure would pose risk to the stability of the overall economy, the Federal Reserve Board may impose capital and quantitative limits on the manager.
What do you see as the impact of the Volcker Rule on the industry?
STEEL: This will mean less bank capital in the private equity system. But the rule’s provisions will be implemented over a period of years, so drastic changes won’t be required in the short term. It’s not as though private equity general partners will have to reposition their portfolios because their limited partner banks suddenly have to divest. The way the law is constructed allows for a very orderly liquidation of these investments. Even so, private equity firms that are used to having banks as sponsors will have to adjust. And some banking firms have already begun major divestments. This change could create greater opportunities for existing funds that haven’t been sponsored or backed by banks.
GABBERT: Bank-backed private equity firms have well over $100 billion in private equity assets under management and have more than 400 U.S. companies in their PE portfolios. Most of these PE groups are likely to be spun out, but others will be sold off piece by piece. These sales will provide a tremendous opportunity for secondary deals, acquisitive PE firm growth and a wave of possible new investments. This change may also limit the potential conflict of interest with banks having PE divisions but at the same time advising other investors.
SOCHA: Volcker Rule restrictions apply to “affiliates of banks.” Because of the overly broad definition of “banking entity,” a fund of funds controlled by a bank would be a “banking entity” and could not invest in funds not controlled by the bank. I don’t think legislators intended this result. This will have to be resolved by regulation.
What about SEC registration? Which firms are affected?
CRUZ: The short answer is, most advisors to private equity funds must register. The legislation eliminates a commonly used “private advisor” exemption, which in the past allowed advisors with fewer than 15 clients not to register. Under the prior exemption, an advisor firm might have 200 investors in its fund, but by counting each fund rather than each individual investor as a client, many if not most advisors could avoid registering. Under the new law, the private advisor exemption is no longer available.
What will the practical impact of registration be?
STEEL: Private equity is already accustomed to a very high standard of diligence in reporting to limited partners. So having to register and report that information to regulators won’t be a significant burden. It may require some additional personnel, but beyond that, at least in the short term, I don’t think there is a significant impact.
SOCHA: Registration is going to impose a significant amount of additional record-keeping and cause increased legal and accounting fees. There will be SEC oversight, unscheduled visits by regulators, and a lot more process imposed on previously unregistered firms. Requiring an industry to institutionalize the way it does business isn’t necessarily a bad thing, but I’m not sure that after balancing the costs and benefits to the industry we will agree that the additional regulation and associated costs will benefit private equity investors all that much.
LARSON: The larger firms will be able to handle the new burdens more easily, but firms of various sizes have expressed concern that these new rules allow the agency a regulatory beachhead — which easily could be expanded and made more obtrusive if the political winds change.
How will the new laws affect the level of service investors can expect?
SOCHA: These new regulations won’t make a whole lot of difference to investors one way or another. It’s a firm’s investment record that matters to them. At Perseus, we already keep good records and communicate well with our investors. We work hard to make sure that all of our employees understand what they are obligated to do. Our clients are very smart and sophisticated. We do everything in our power to make sure they’re satisfied with our performance and the way we communicate with them.
Europe is busy reforming its own financial regulations. How might this movement impact the private equity industry?
LARSON: The European Union originally expected to have its new Directive of Alternative Investment Fund Managers in place by August 2010. But the European Parliament and the Council of Ministers have proposed different sets of regulations that now must be aligned. So far that process hasn’t gone smoothly.
Initially, there were fears about restrictions against funds not based in Europe raising capital in the EU — essentially, that U.S. private equity firms would be locked out. That now appears extremely unlikely. More likely, non-EU firms will be allowed to operate in Europe so long as their host countries conform to rules pertaining to tax treaties, market access and compliance.
Three other issues remain up for debate. The first is disclosure. It’s likely that firms held by private equity in portfolio will be required to increase their disclosure of financial information. Second, there are likely to be limits on how much leverage private equity investors can use in acquiring companies. Third, there may be rules on how long firms must own a company before divesting. Some speculation puts that number at four years. The problem here is that these rules disadvantage the private equity, venture capital and hedge fund industries but do not target other types of buyers that might use similar financing, such as a firm making a strategic investment.
CRUZ: There’s probably greater reason for concern over regulation in Europe than in the U.S. Regulation in the U.S. essentially requires firms to register and provide more information on operations. In Europe they are talking about actively limiting leverage and setting guidelines regarding when a fund may sell a portfolio company.
SOCHA: My sense is the EU will go further than the U.S., with stricter regulations. Eventually, that could force some money out of Europe and into the U.S., but I don’t believe that will have much effect on most U.S. private equity firms. Most investors these days are more interested in investing in Asia and Canada than in Europe, in part because of the low growth rates there and the fact that European banks are not yet dealing realistically with their loan portfolios. Banks in Europe are still inclined to extend and amend, rather than take a write-off on their loan portfolios.
Is everything on hold as firms await the new regulations related to Dodd-Frank?
GABBERT: Not at all. While the legislation will inevitably be on people’s minds, investments will continue. I do, however, believe that a larger concern will be the changes in the tax treatment of carried interest. Nonetheless, the number of deals rose 10% in the first half of 2010, compared with the first half of 2009. Even more promising, the amount of capital invested rose over 100% as investors are starting to do larger deals. Credit is also starting to come back a little, and valuations are trending up. Nearly everyone we speak with is busier than they’ve been in the past year and a half. Lower levels of uncertainty and solid company performance are going to drive dealmaking more than this legislation is going to hold it back.
SOCHA: In addition to requiring many more firms to register, this legislation creates three new agencies, mandates approximately 60 new studies on a wide range of issues and requires an untold number of new regulations. Few of these studies and regulations directly impact PE, but the act has injected uncertainty into the larger market, which makes investors and markets uncomfortable. The act adds to the already present concerns about the cost benefits of health care legislation, high unemployment and budget deficits.