Expert Commentary: Private equity regulation and operational excellence

The next era for the private equity industry will see leading firms focusing on enhanced client services and shoring up investments and their investor base, rather than pursuing new mega-deals, says Jack Klinck, executive vice president and global head for State Street Alternative Investment Solutions.

This article originally appeared in the September 2009 Private Equity Manager Monthly, a monthly printer-friendly publication delivered to subscribers to Private Equity Manager.

The private equity industry has, for the most part, come to terms with the idea that new regulatory regimes will likely impose registration and reporting requirements on industry-leading firms. But as details of proposed regulation in the United States and Europe continue to evolve, it may be worth revisiting some of the principal questions that surround this debate.

In the United States, the Obama administration has proposed that hedge funds and other “private pools of capital,” including private equity and venture capital firms above a certain threshold, register with the SEC, and that those deemed to be “systemically significant” fall under additional oversight of the Federal Reserve. This registration would require firms to comply with new reporting requirements regarding counter-parties and investors and their use of leverage, if any.

The first reaction from the private equity industry was to question whether their firms should be considered systemically significant. In defining systemic significance, the proposal articulated defining factors such as the notion that the failure of a firm would have a systemically significant impact on financial markets and the larger economy; the combination of a firm’s size, leverage, off-balance sheet exposure and reliance on short-term funding; the firm’s function as a source of credit for households, businesses and state and local governments; and the role that the firm plays as a source of systemic liquidity.

While many in the industry have accepted the principle of fund registration, they have pointed out that almost none of these criteria apply to the private equity industry. For its part, the venture capital industry, with only $30 billion invested per year, makes the case that even a catastrophic collapse of their entire industry couldn’t possibly threaten the financial stability of a multi-trillion-dollar investment market.

The second issue that the industry has raised is the notion that businesses as different as private equity, venture capital and hedge funds being placed under a “one-size-fits-all” regulatory regime. Those favoring this approach have noted that, were hedge fund and private equity firms be regulated separately, investment firms may be tempted to “shop” for preferential regulation by declaring themselves to be either hedge funds or private equity firms, so as to qualify for a particular set of rules.

But some in the private equity and venture capital industries have observed that their business functions are sufficiently different from those of hedge funds to merit different regulatory treatment. Where hedge funds tend to be more liquid, private equity investments typically involve multiyear commitments of capital. Hedge fund strategies often centre on trading, whereas private equity usually concentrates on private ownership of companies. Where hedge funds manage client funds, private equity firms comingle their own capital with that of their limited partners.

The use of leverage also distinguishes the two approaches. Over the course of the credit boom of recent years, some private equity firms did employ debt, but not at the debt ratios used by some hedge fund managers. And with the arrival of the financial crisis, private equity has undertaken marked draw-downs of leverage, and the return of firms to their traditional means of doing business.

Private equity funds have been termed “patient capital” that is committed to ownership and management, and operating on a multi-year timeline. As with any new regulation, policymakers should draw a critical balance between defending markets from systemic risk and impeding the work of private equity groups that play a constructive role in venture funding of new ideas, restructuring of companies and driving corporate productivity.

It falls to private equity firms themselves to ensure that new regulatory regimes improve markets and do nothing to inhibit the freedom and productivity of both general and limited partners.

Trends in Europe

Pending regulation in Europe has sounded rather louder alarm bells. The European Commission’s proposed Directive on Alternative Investment Fund Managers (AIFM) has been the subject of intense debate since its April unveiling. At every possible opportunity the private equity industry has cited increased levels of disclosure with which the industry would have to comply, the proposed placement of private equity firms and hedge funds into unitary regulation and the fact that other forms of private ownership will face no analogous increase in regulation.

Industry observers have stated that the substantial anticipated costs of regulatory compliance for mid-market firms would be inappropriate, given the lack of systemic risks posed by the industry. And they have noted that some 60 percent of European private equity activity takes place in the United Kingdom, where firms are already regulated by the Financial Services Authority (FSA).

Many UK-based private equity investors have suggested that the alternative investments regulatory discussion has even woken up traditional intra-European rivalries that sometimes seem to lurk just beneath the surface of European Union affairs. It has been stated that the alternative investments industry is finding itself pressured by Continental European governments that have long-expressed suspicion over the motivations and activities of UK-based hedge funds and private equity firms as compared with Continental traditions of State ownership, cross-holding, conglomerates and family-office ownership.

Those opposed to the proposed Directive state that new capital requirements would create a major obstacle to the establishment of new firms, funds and innovation. They also believe that disclosure requirements would create a comparative disadvantage with EU investors and that proposed requirements for independent valuation are unwarranted, given that private equity investors do not subscribe or redeem at net asset value and that portfolio companies can only be truly valued upon their sale.

Operational excellence

While the private equity industry bore little responsibility for the systemic crisis of 2008 and 2009, those extraordinary market events will surely change the way that the private equity industry does business. The industry will likely undergo a period of regrouping — shoring up finances, more transparently engaging their limited partners, seeking out more diverse sources of funding and probing for new investment opportunities, notably amid the rubble of distressed assets.

As partners demand greater clarity and closer cooperation, and as regulators around the world consider new requirements, leading firms will increasingly look to knowledgeable third-party administrators for assistance with reporting and compliance, proven control procedures and custody and lending services. The next era for the private equity industry will see leading firms focusing on enhanced client services and shoring up investments and their investor base, rather than pursuing new mega-deals.

General partners will devote more time to the kind of transparency, streamlined administration, robust operations and technology systems that limited partners and regulators will likely demand. As a result, private equity firms may increasingly attempt to leverage the value proposition of leading third-party administrators. By moving these kinds of responsibilities to dedicated service providers, general partners (the private equity firms) will be able to concentrate on their core competencies.

For limited partners (investors), third-party administrators will facilitate the efficient transfer of information while at the same time providing a measure of confidence amid the complex restructuring and re-financing of the industry. As the private equity industry evolves, the industry must step up to alleviate the public concerns of regulators. A simple win-win for all is to deliver operational excellence that makes clear that business practices are sustainable, transparent and above reproach.

From this base of administrative strength, firms can set out to rebuild the industry and position themselves to both contribute to and profit from renewed investment growth and economic recovery.

(This article originally appeared in the September PDF issue of Private Equity Manager Monthly).