A year of living dangerously

Private equity is already under attack from politicians and regulators, and Mitt Romney’s presidential campaign is likely to attract even more unwanted attention. James Taylor and Nicholas Donato report

You’ll struggle to find many people involved in private equity who believe that further regulation is a good idea, either in principle or in practice. Nonetheless, this is the reality facing the industry today: in 2012 (and possibly beyond) the trend will be towards more regulation, not less.

This could be a momentous year for private equity: the year in which one of its own gets elected as the most powerful man in the world. At press time, Bain Capital alumnus Mitt Romney remained the bookmakers’ favourite to be the Republican nominee for this year’s US presidential election (although things may have changed by the time you read this). At a time when the industry is under attack from politicians and regulators on both sides of the Atlantic, that might sound like a good thing. But many in private equity fear that Romney’s elevated public profile is likely to make matters worse, not better, as his rivals depict Romney as a buyout baron who killed jobs and saddled companies with debt. 

“Unfortunately, I don’t know how much truth is going to get out. It’s partisan and meant to attack instead of inform,” one Bain limited partner said about the attacks on Romney’s Bain career. Adding to the problem is that the mainstream media “doesn’t get the private equity business, so there will be misinformation [distributed] purposely by the suppliers of that information”.

You can argue the industry, which has grown considerably in size and influence over the past two decades, hasn’t done enough to make a compelling case for its existence both within the corridors of power and the world at large (indeed, Mark Florman, head of the British Private Equity and Venture Capital Association, recently acknowledged this and urged GPs to engage the public more). So in that sense, some of these problems are self-inflicted.

But some of private equity’s problems are not (entirely) of its own making. After the events of the last few years, there’s a consensus now that laissez-faire or light-touch regulation was one of the main reasons for the financial crisis – and since governments are determined not to leave themselves open to the same accusations again, they’re trying to come up with new ways to limit risky investment activity. There’s also a broad desire among the general public to see the financial services industry punished for its past excesses – a bandwagon on which politicians are never slow to jump. In both respects, private equity is getting caught in the crossfire.


In the US, the biggest issue remains the Dodd-Frank financial reform act – and specifically the section usually referred to as the Volcker Rule, so-called because it was the brainchild of former Federal Reserve chief Paul Volcker. 

As originally envisaged in 2009, the rule was relatively simple: to stop banks using their own balance sheets for proprietary trading or investing in private equity or hedge funds. But after more than two years of wrangling, it has morphed into something far more complicated: the latest incarnation, released last October, ran to an almost impenetrable 298 pages and included no fewer than 394 questions for public consultation.

What’s more, it seems to have pleased nobody: Wall Street argues that it will be costly to implement and make US banks less competitive, while critics say it’s too complicated and riddled with loopholes (thanks, in part, to two years of frantic lobbying by said Wall Street firms). Even Volcker himself has criticised it.

Comments will be received until February 13 this year, with the rule slated to come into effect on July 21. But whatever the end result, it looks likely that lawyers will be the biggest winners. Indeed, the act as a whole has been cheekily dubbed by some in the industry as The Dodd-Frank Act for the Full Employment of Lawyers and Accountants. 

And it does amount to a major overhaul of the oversight of private equity in the US: funds managing more than $150 million in assets will have to register with the Securities and Exchange Commission, appoint a chief compliance officer, adopt comprehensive compliance policies and procedures specifically tailored to the compliance risks posed by their operations, and review these policies and procedures on an annual basis. Registration will apply to many foreign GPs, too, depending on factors including their proportion of US LPs.

The deadline for registration was supposed to have been last July, but there was so much confusion about the rules that it was pushed back to March this year. Since firms are supposed to allow the SEC a month to process their application, that effectively means the forms have to be in by the middle of February – and according to Jay Baris, chair of the investment management practice at law firm Morrison Foerster, there are quite a few smaller firms that look unlikely to meet that deadline. As always, the level of compliance is not such a hassle for larger firms, which can use their management fees to staff up a hefty compliance team; but it’s a big commitment for smaller GPs operating on far more limited resources.

Some argue that the registration process is overkill. “The SEC is interested in collecting certain information, so it has to cast a broad net,” admits Baris. “It’s aiming to have more information rather than less, to make sure it has the tools it needs. The idea is that blue sky cures all ills – and ultimately it should add to investor protection.” But compliance won’t be easy; particularly for non-US-based investors, who may not be clear exactly how the rules apply to them.


In Europe, financial institutions are also on the radar of politicians and regulators. The prevailing view –as exemplified by the new Basel III rules – is that the biggest banks need bigger capital buffers, so they can absorb heavier losses if things go wrong. The riskier the assets on their balance sheets – and private equity investments are classed firmly in that category by policymakers – the more capital they’ll need. As such, lots of banks are looking to shift some of these assets off their balance sheets, because it’s a lot easier than finding extra capital to cover against potential losses. The new rules are being phased in over a long time period, but many banks seem keen to press on and clear the slate.

If banks are forced to withdraw from private equity, that’s potentially bad news for GPs, because banks are a big source of their capital – somewhere between 10 and 15 percent, according to some estimates. With so many firms due to hit the fundraising trail this year, replacing such a big source of capital (and a sophisticated source at that) will not be easy.

It gets worse, too: under the proposed Solvency II rules, insurers – another big source of capital for the industry – are also going to face heightened capital adequacy requirements. As it stands, they’d have to put aside $49 for every $100 invested in private equity, which again might encourage them to dispose of their existing assets and stop investing in new ones. Industry body EVCA is desperately trying to convince the regulator its models need to be changed (it argues they assign too much risk to private equity). With the timetable for Solvency II implementation due this year, EVCA will hope at the very least to lobby successfully for a long transition period to allow institutions to get their houses in order.

But the EU isn’t finished there: it also has its eye on additional regulation for occupational pension schemes (another big source of the industry’s capital), again with a view to bringing in enhanced capital requirements. The basic principle of protecting pensioners’ money may seem incontrovertible. However, EVCA warns that it will just incentivise these schemes to stop investing in private equity, focusing instead on shorter-term assets that can be ‘marked to market’ more easily. 

“They should understand pension funds are different from insurance firms or banks and deserve their own tailored rules,” says Karsten Langer, EVCA’s chairman. “In fact, rules that push pension funds towards too much short-term holdings in the portfolio can increase portfolio risk, which is the opposite of policymakers’ intentions.”

And the trouble is, of course, that in most developed countries the workforce is shrinking relative to the number of pensioners it supports. So unless these schemes can generate the sort of double-digit returns private equity can provide, they will have a hard time meeting their long-term liabilities.

This proposal may yet not get off the ground. It’s already come in for some severe criticism: in the UK, PricewaterhouseCoopers, an accountancy, predicted the proposed rules could leave British businesses with extra costs for their pension schemes of up to £500 billion (€600 billion; $780 billion) – equivalent, as the firm put it, to killing off half the FTSE 100 (the index of Britain’s biggest public companies).

National regulations could also prove a headache for private equity firms this year, an inevitable consequence of the industry’s higher profile. In Britain, for example, proposed revisions to the Takeover Code would affect take-private deals by increasing the obligations on potential buyers. The US is also reforming its own competition rules in a way that is expected to increase GP reporting and compliance. And since economic nationalism tends to be a corollary of difficult markets, it’s also quite likely that cross-border deals could face new obstacles.

All things considered, 2012 was always going to be a tough year for private equity – a year in which it would have to convince the critics of its benefits, and continue its lobbying efforts to mitigate the impact of any new rules. 

But the shadow of the Romney presidential campaign undoubtedly complicates matters even further. Given how aggressively his Republican rivals have attacked his private equity background, Romney can expect even more hostility from the Democrats if he wins the nomination. This is likely to result in private equity becoming a political punching bag – and it may even result in further regulatory consequences in the future. Already, politicians in Illinois are reviewing whether its pensions ought to be investing in the asset class, following negative press coverage.

There’s a great deal at stake for private equity here. The increased scrutiny could result in changes to GPs’ personal tax treatment; the release of Romney’s tax returns have already prompted a debate on whether carry should be taxed as capital gains or ordinary income, and even, significantly, the tax deductibility of debt. But more worrying would be any additional regulation that would hamper fund managers’ ability to grow and transform companies, as well as investors’ capacity to support an asset class which they badly need to boost their portfolios. 

As such, the industry needs to play its cards very carefully in the coming months, engaging with the public and policymakers alike to ensure they understand the private equity model and its benefits. It won’t result in any lighter regulation – but it may help prevent things from getting any worse.  


Dörte Höppner, Secretary General of the European Venture Capital Association, talks to PEI about the association’s key regulatory priorities in 2012 

How worried are you about the AIMFD?

Many of our concerns have been addressed, but there remain areas of concern. For example, the recommendation for the calculation of “own funds” (the regulatory capital to be held by the GP) is currently only used by the most sophisticated credit institutions and investment banks and is unsuitable for closed-end, unleveraged funds. Also, the use of third-party depositaries still has the potential for “ex-ante” control, with investment decisions being taken from the GP and handed to a custodian.

Are you in favour of the EU fundraising passport (the voluntary regime that will allow VC funds to access the EU marketing passport without having to opt-in to the AIFMD)?

As this will be a “regulation” and not a “directive”, it will have uniform application across all the EU 27, so it’s vital we continue to ensure the scope of the investment strategies covered by this regime reflect the operating realities of small funds.

Are European VC firms currently too reliant on state cash? 

In H1 2011, government agencies accounted for over 50 percent of the investment in VC funds. In the current economic climate, it’s vital that national public and pan-European investors, such as the EIF, continue to support venture capital if we are to build the next generation of Europe’s high-tech goliaths. But longer term, we have to attract private sector investors back to venture capital.

The Commission has produced its financing programmes for equity investment in growth and innovation. EVCA has argued that these programmes should include private sector-managed funds of funds, with the Commission investing alongside private sector investors. 2012 will see a dual approach of continuing technical discussions with the Commission and fund-of-funds managers, while making the political case for public/private sector partnerships with the European Parliament and Council.  

You’ve also been lobbying hard against the Solvency II capital adequacy rules for insurance companies that invest in private equity. Why?

The current proposals will affect the ability of investors, such as pension funds and insurers, to commit capital to private equity and other long-term asset classes. Solvency II, which is now at the implementation phase, will require insurers to apply a base shock of 49 percent to their investments in private equity when calculating their solvency capital ratio. EVCA and the national associations are challenging the basis for this calculation on a technical level, while working to try to recalibrate the risk weighting for private equity.

In 2012, the implementation date of Solvency II will be decided, with the potential for a transition phase with much lower risk weightings. In addition we are working to develop risk-measurement guidelines for private equity that could be used by insurers in calculating their own internal models. If approved by the regulator, these could significantly reduce the standard risk weighting for private equity.

The Commission is also reviewing European regulation for occupational pension schemes, with a view to applying capital adequacy requirements similar to those for insurers. What are the dangers of this?

The application of “marked to market” valuation principles will encourage a flight to short-term investments, exacerbated by potentially punitive risk weightings for asset classes such as private equity.

This would cause pension fund trustees attempting to meet long-term liabilities with short-term investment strategies. In a low-interest environment compounded by the demographic challenges of ageing populations, fixed return or defined benefit schemes will find it increasingly difficult to meet their liabilities without the option of investing in long-term, growth-orientated assets. We’ve responded to the first consultation from the European Insurance and Occupational Pensions Authority and will continue through 2012 to make the case for long-term investment and for a thorough assessment of the economic impact of the proposed revisions to the IORP Directive.


It’s too early to tell whether China’s nationwide private equity legislation will have teeth

Risk of fraud in China’s private equity industry has caught the government’s attention. To protect investors, the National Development and Reform Commission (NDRC) issued a notice in December extending rules nationally that previously only applied to six jurisdictions. That effectively created China’s first nationwide private equity law.

It requires all private equity funds in China (regardless of size) to register with the government. It also set new guidelines on private equity fundraising and the operation of funds, including setting some definitions for qualified investors.

“Until now, the Chinese private equity industry has depended on self-regulation, and it hasn’t been clear to investors where to take their complaints or even who the regulator is,” says Helen Jiang, a Shanghai-based counsel at Weil, Gotshal & Manges. “This notice is important partly because it makes it crystal clear that the NDRC is that regulator and will be going forward.”

But in reality, the notice may not live up to intentions. Industry insiders say many firms have not made necessary recordals to the NDRC since the previous notice (which applied to six provinces) was issued in January 2011. And it’s hard to see whether this time would be different, as the “penalty” for funds that fail to do so only means their names will be published on NDRC’s website.

“The effects of the rule may be muted because the regulatory framework needs to develop further to foster a stronger compliance culture among Chinese fund sponsors,” says John Fadely, partner and head of the funds practice for Asia at Weil.

Many private equity firms are taking a wait-and-see attitude due to the lack of clarity and slow implementation. After all, the government moves far slower than the private equity industry. But a few high profile domestic fraud cases could change that.