Skin in the game
Sarbanes-Oxley is threatening one of private equity's main mechanisms of motivating portfolio company managers. But there are legitimate ways to work around it, says Franci J. Blassberg.
PEI: How dramatic an impact is Sarbanes-Oxley going to have on private equity?
FB: Sarbanes-Oxley was designed to impact publicly listed and actively traded companies, but it has broader application within the group of private equity firms that access the public debt market and that consider accessing the public market as an exit. For buyout firms investing in deals with a mezzanine or high yield debt requirement of $75m or more, there will be a serious impact. A typical portfolio company can become subject to Sarbanes-Oxley by either accessing the public debt market or merely by filing a registration statement in connection with a proposed public offering.
PEI: How is such a portfolio company going to be affected?
FB: First of all, there are prohibitions on loans to senior management that will wreck havoc with a long-standing mechanism of incentivising officers and directors. Private equity firms want managers to have ?skin in the game? and to be partners in the building of the business. In order to facilitate that, senior managers typically purchase stock in the portfolio company. Most senior managers don't have enough money to buy a significant enough piece of stock, so very often a third party lending institution will loan the manager the money, but that loan will be guaranteed by the portfolio company. Alternatively, the company may make the loan directly. But even a guarantee of top managers' loans would create a problem for a company with public debt that is subject to Sarbanes-Oxley. As a result, one of the primary techniques to incentivise management needs to be revised in order to accommodate this legislation.
PEI: What could this revision look like?
FB: One thing you can do is to simply give top managers the stock, but that's a very different economic result from the loan. It's also not a good idea. And it's quite ironic: imagine a law that prohibits loaning executives money to buy stock, but lets you give them equity? A better idea is to require management to put in as much money as they are comfortable investing or borrowing without credit support from the company. You can then incentivise them with options, even though this is less effective in that options have no possible downside and do not qualify for favourable tax treatment. It also means that companies are going to have to face difficult issues relating to accounting for options.
Another solution is to create a limited liability company above your portfolio company and basically share the carried interest with the manager. He would be allocated a special profit and loss interest in an LLC, which should also give him the extra benefit of capital gains treatment, whereas the options do not. The problem with this idea is that it provides a profit interest, but doesn't align interests as effectively as a financial commitment from the manager. The answer therefore is to combine some of these techniques to get the best outcome. In any case, the loan prohibitions are criminal statutes, so you need to be very careful.
PEI: Is loan prohibition the main issue facing financial sponsors?
FB: Yes, but there are other areas. I would also point to the need for an independent audit committee as stipulated by Sarbanes-Oxley. We believe that these rules are only intended to apply to listed companies, i.e. companies with public equity. But that doesn't mean that they don't apply to private equity firms at all. They apply to those investing in public companies by way of PIPEs for instance. If a private equity firm takes a 10 per cent position in a public company, it would generally expect to have a seat on the audit committee, the importance of which is now enhanced thanks to Sarbanes-Oxley. Under the new legislation, unless the SEC creates a new definition of what ?independent? means, we believe that representatives of this private equity firm would not be able to serve on the committee, even though its interests are significantly independent from those of management and their participation would be welcome by the other public shareholders.
A third area is the requirement that CEOs and CFOs need to personally certify financial statements. This means that when you are buying businesses on which you will have to certify historical financial statements, there has to be a very pronounced rigour in the review of these financial statements for periods in which the private equity firm or the incumbent management firm did not participate in the running of the business.
PEI: Are GPs sufficiently aware of this?
FB: We hosted a conference on Sarbanes-Oxley and its implications in New York recently, and over 200 people attended. We thought we'd get about a third of that, so I think people are paying real attention to it.
PEI: Some believe the new rules could eliminate the incentive for private companies to seek access to the public markets altogether?
FB: I don't think Sarbanes-Oxley is going to kill the public market, but it may make life even more difficult for smaller companies that are listed. Sarbanes-Oxley means that access to the public market has become more expensive at a time when the public market isn't as attractive as it once was. The timing is not great, but that will only have an impact on the margins. Also, creating a business in the public spotlight has always been difficult, and I think today it may be even more difficult because of this legislation and intense public scrutiny from so many different sources, and people may be reluctant to step into a morass where each quarter they are being judged. But that has to do less with Sarbanes-Oxley than it does with the times we live in.
PEO: Should the legislators have done more to consider the special case of private equity?
FB: As far as the US Congress is concerned, private equity is a real subtlety and not very significant. As a policy matter, am I surprised that they didn't carve out companies that have public debt, but no public equity? No. But legislation is always overbroad. Right after September 11, the US Patriot Act was passed, which mandated that all financial institutions, including private equity firms, put together antimoney laundering compliance programmes. Now, can you imagine somebody using a private equity firm to launder money? You make a commitment to put money into a fund over ten years, you never know when the GP is going to ask for it, and you never know if or when you're going to get the money back. That's no way to launder money!! But the way the legislation was drawn meant small buyout firms were going to have to put in place a programme. However, the Treasury Department has just issued regulations, partly in response to a lot of lobbying by private equity firms, that if there is no right of redemption, the legislation does not apply – a good bit of news for private equity. It would be nice if the regulations from the SEC that will be forthcoming on Sarbanes-Oxley took notice of the unique characteristics of private equity in a similar fashion.
PEI: What's to come?
FB: We're awaiting SEC guidance on many provisions of the Act. My theory is that public debtholders already have significant protections, because they are the beneficiaries of an indenture of a contract with the company, and most indentures have limits on management loans. They're sophisticated financial institutions and parties to a contract with the company that covers this very point. I don't know whether the SEC is going to recognise this and make some exemption. I think the right thing to do is to make companies who ask for access to the public filing system comply with the disclosure provisions (such as the certifications of financial statements), but the you-can-not-loan-money requirements, which are purely substantive, really shouldn't apply to the issuers who have no public equity but have accessed the public debt market.
Franci J. Blassberg is a partner at Debevoise active in its Private Equity and Mergers and Acquisitions practices and a member of the firm's Management Committee.